CFTC and SEC Issue Final Swap-Related Rules Under Title VII of Dodd-Frank

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1 CFTC and SEC Issue Final Swap-Related Rules Under Title VII of Dodd-Frank CFTC and SEC Issue Final Rules and Guidance to Further Define the Terms Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant EXECUTIVE SUMMARY On April 24, 2012, the Commodity Futures Trading Commission and the Securities and Exchange Commission approved final rules to define the terms swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The final rules seek to address concerns raised by a variety of commenters that the proposed definitions would have captured a large number of commercial market participants within the definition of swap dealer. The CFTC estimates approximately 125 entities will be covered by the definitions of swap dealer and major swap participant and of those entities, six or fewer will be covered by the definition of major swap participant. The SEC estimates that 50 or fewer entities may ultimately need to register as security-based swap dealers and that five entities, or perhaps no entity, will be required to register as a major security-based swap participant. The final rules will become effective on July 23, However, most of the requirements imposed on dealers and major participants will not be effective until the CFTC and the SEC approve additional final rules defining the terms swap, security-based swap and mixed swap. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 Table of Contents I. SWAP DEALER AND SECURITY-BASED SWAP DEALER... 3 A. GENERAL CONSIDERATIONS FOR THE SWAP DEALER ANALYSIS Use of the Exchange Act Dealer-Trader Distinction Holding Oneself Out as a Dealer in Swaps or Security-Based Swaps, or Being Commonly Known in the Trade as a Dealer Market-Making... 6 B. EXCEPTIONS FROM DESIGNATION AS A SWAP OR SECURITY-BASED SWAP DEALER Activities Not Part of a Regular Business Interim Final Rule Excluding Swaps Entered Into For Hedging Physical Positions Exclusion for Swaps in Connection with Originating a Loan Inter-Affiliate Swaps and Security-Based Swaps Application to cooperatives C. DE MINIMIS EXCEPTION Phase-in Procedure Specific Factors Implementing the De Minimis Exception D. LIMITED PURPOSE DESIGNATION AS A DEALER E. FLOOR TRADERS II. MAJOR SWAP PARTICIPANT AND MAJOR SECURITY-BASED SWAP PARTICIPANT A. MAJOR CATEGORIES OF SWAPS AND SECURITY-BASED SWAPS B. SUBSTANTIAL POSITION Exclusion for Hedging or Mitigating Commercial Risk Availability to financial entities Positions Held by ERISA Plans C. SUBSTANTIAL COUNTERPARTY EXPOSURE D. HIGHLY LEVERAGED AND FINANCIAL ENTITY E. CERTAIN OTHER MATTERS F. IMPLEMENTATION STANDARD, RE-EVALUATION PERIOD AND MINIMUM PERIOD OF STATUS G. CALCULATION SAFE HARBORS H. LIMITED DESIGNATION I. EFFECTIVE DATE AND IMPLEMENTATION III. ELIGIBLE. CONTRACT PARTICIPANTS A. DEFINITION B. COMMODITY POOL LOOK-THROUGH FOR RETAIL FOREX TRANSACTIONS C. ECP STATUS FOR FOREX POOLS OPERATED BY REGISTERED CPOS OR CPOS EXEMPT FROM REGISTRATION UNDER CERTAIN CONDITIONS D. ECP STATUS FOR COMMODITY POOLS UNDER CLAUSE (A)(IV) VS. CLAUSE (A)(V) E. DEALERS AND MAJOR PARTICIPANTS AS ECPS F. SWAPS USED TO HEDGE OR MITIGATE COMMERCIAL RISK IN CONNECTION WITH THE CONDUCT OF AN ENTITY S BUSINESS G. CONSEQUENCES RELATING TO ECPS i-

3 BACKGROUND In December 2010, the Commodity Futures Trading Commission (the CFTC ) and the Securities and Exchange Commission (the SEC ) (jointly, the Commissions ) proposed rules and interpretations to define further the terms swap dealer, security-based swap dealer, major swap participant, major security-based swap participant and eligible contract participant (the Proposed Rules ). 2 After considering the comments received on the Proposed Rules, the Commissions issued a joint release (the Adopting Release ) adopting final rules (the Final Rules ) to define these terms, as required by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or Dodd- Frank ) and issued interpretive guidance with respect to those terms. The Adopting Release and the Final Rules, among other things: provide interpretive guidance on the definition of swap dealer and security-based swap dealer and criteria used to evaluate an entity s dealing activity; set forth the conditions for meeting the expanded de minimis exemption from registration as a swap dealer or security-based swap dealer; create a new interim final rule to exempt swaps entered into for the purpose of hedging commercial risk from the swap dealer analysis; establish minimum thresholds that will determine whether a swap position qualifies as a substantial position, or a person has substantial counterparty exposure, for purposes of registering as a major swap participant or major security-based swap participant; and further define eligible contract participant ( ECP ). The Adopting Release, in great detail, responds to comments and concerns raised by commentators. This is consistent with the Commissions focus on addressing concerns and criticisms over the sufficiency of their cost and benefit analysis in adopting rules under Dodd-Frank. Consistent with this approach, the Adopting Release contains an explicit severability clause to the effect that the invalidity of any of the Final Rules will not affect the validity of the other Final Rules. To address concerns over the potential scope of the definitions: the CFTC estimates that 125 entities will be covered by the definitions of swap dealer and major swap participant, of which six or fewer will be covered by the definition of major swap participant; and the SEC estimates that 50 or fewer entities may ultimately need to register as security-based swap dealers and that five entities, or perhaps no entity, will be required to register as a major security-based swap participant. The Adopting Release does not set forth any proposed rules regarding substantive compliance issues to which swap dealers, security-based swap dealers, major swap participants or major security-based swap participants would be subject, nor does it cover the registration process, as such rules have been or will be addressed through separate rulemaking. The Final Rules will be effective July 23,

4 However, most of the requirements imposed on swap dealers, security-based swap dealers, major swap participants and major security-based swap dealers will not actually become effective until after the date of the adoption of the final rule to define the terms swap, security-based swap and mixed swap. Although the Commissions have not yet scheduled a vote to finalize the product definition rule, it is anticipated that a rule will be considered in June. Although most of the ECP provisions will become effective July 23, 2012, the rules relating to commodity pools participating in retail foreign exchange transactions and commodity pools with total assets not in excess of $5,000,000 will become effective on December 31, I. SWAP DEALER AND SECURITY-BASED SWAP DEALER Section 721 of Dodd-Frank defines a swap dealer as any person that: holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties in the ordinary course of business for its own account; or engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. Section 761 of Dodd-Frank defines a security-based swap dealer in substantially the same manner as swap dealer, replacing security-based swap with swap. Pursuant to Dodd-Frank, swap dealers and security-based swap dealers will be subject to a variety of new requirements, including registration, minimum capital, margin, recordkeeping, reporting and business conduct requirements. Dodd-Frank provided several statutory exemptions from the definition of swap dealer and security-based swap dealer, including an exemption for a person that enters into swaps or security-based swaps for the person s own account, either individually or in a fiduciary capacity, but not as a part of a regular business, and an exemption for a person that engages in a de minimis quantity of swap or securitybased swap dealing in connection with transactions with or on behalf of its customers. Finally, an insured depository institution is not to be considered a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer ; there is no comparable exemption from designation as a security-based swap dealer. A. GENERAL CONSIDERATIONS FOR THE SWAP DEALER ANALYSIS Under the framework set forth in the Adopting Release, to determine if a person is engaged in swap or security-based swap dealer activity, the person should begin by applying the statutory definition, and the provisions of the rule which implement the four statutory tests and the exclusion for swap activities that are not part of a regular business. 3 With respect to the swap dealer determination, the Final Rules include provisions that will exclude swaps entered into for hedging physical positions (as discussed under -3-

5 Section I.B.2 below Interim Final Rule Excluding Swaps Entered Into For Hedging Physical Positions ), swaps between majority-owned affiliates, swaps entered into by a cooperative with its members, and certain swaps entered into by registered floor traders. The exclusion for inter-affiliate swaps is also explicitly available with respect to the security-based swap dealer determination, and the SEC also expects that persons who use security-based swaps to hedge business risks, absent other activity, will likely not be dealers. If a person determines that it is engaged in swap or security-based swap dealing activity, the next step would be to determine if the person is engaged in more than a de minimis quantity of dealing. If so, the person is a swap or security-based swap dealer, as applicable. When the person registers, it may apply to limit its designation as a dealer to specified categories of swaps or security-based swaps, or to specified activities of the person in connection with swaps or security-based swaps. To facilitate this analysis, the Adopting Release includes interpretive guidance regarding the application of the SEC s existing dealer-trader distinction to the swap dealer and security-based swap dealer definitions; the holding out and commonly known criteria; market making; the not part of a regular business exception; the hedging exclusion; and the overall interpretive approach to the definitions. 1. Use of the Exchange Act Dealer-Trader Distinction In determining whether a person is a swap dealer or a security-based swap dealer, the Commissions expect to incorporate principles from the SEC s dealer-trader distinction, which has long been used to identify persons falling under the Exchange Act s definition of dealer and therefore subject to registration as a broker-dealer. The Adopting Release states that the following activities (certain of which overlap with other elements of the entity definitions) indicate that a person is acting as a swap dealer or securitybased swap dealer: Providing liquidity, or seeking to profit by providing liquidity, in connection with swaps or security-based swaps. This may be evidenced by: accommodating demand for or facilitating interest in swaps or security-based swaps; holding oneself out as willing to enter into swaps or security-based swaps (independent of whether another party has already expressed interest); being known in the industry as being available to accommodate demand for swaps or security-based swaps; receiving particular forms of compensation (e.g., a spread, fees or other compensation that is independent of the instrument s value); or with respect to security-based swaps, maintaining a sales force in connection with securitybased swap activities (although a person may be covered as a security-based swap dealer even if it uses an affiliate to market and/or negotiate the security-based swaps). Acting in a market-maker capacity on an organized exchange or trading system for swaps or security-based swaps. -4-

6 Providing advice in connection with, or structuring, swaps or security-based swaps. This may include advising a counterparty as to how to use these instruments to meet hedging objectives, or structuring the instruments on behalf of a counterparty. 4 Having a regular clientele and actively advertising or soliciting clients (whether or not they are counterparties or customers ) in connection with swaps or security-based swaps. 5 Helping to set the prices offered in the market (such as by acting as a market maker) rather than taking those prices (i.e., a price maker rather than a price taker ). Using inter-dealer brokers (particularly with respect to security-based swaps). Engaging in one or more of the activities above is not a prerequisite to being covered as a swap dealer or security-based swap dealer, and the Adopting Release notes that in each case the determination will turn upon the relevant facts and circumstances. In addition, in response to commenter concerns, the Adopting Release includes additional interpretive guidance with respect to the Commissions application of the above principles: Hedging. The Adopting Release maintains that the use of swaps and security-based swaps to hedge business risks, absent other activity, likely would not be indicative of dealing. The SEC further notes that using security-based swaps to hedge positions subject to the interaffiliate exclusion, absent other activity, should not ordinarily lead a person to be a securitybased swap dealer. Conversely, security-based swap activities connected with the indicia of dealing (such as seeking to profit by providing liquidity in connection with security-based swaps) would suggest security-based swap dealing activity. Position in the market. A willingness to enter into swaps or security-based swaps on both sides of the market is not a prerequisite to dealer status; regularly being willing to enter into transactions on one side of the market may be sufficient to trigger dealer registration. Sole or predominant business. The dealer analysis should not turn on whether a person s dealing activity constitutes that person s sole or predominant business. Customer relationship. As noted above, the presence of a customer relationship with a person s counterparties is not a prerequisite for dealer status, and contractual provisions disclaiming a customer relationship with a counterparty or stating that the counterparty is not relying on the other person s advice likely will not factor into the analysis. For example, a person may be a security-based swap dealer by virtue of entering into security-based swaps on a security-based swap execution facility, even in the absence of a customer relationship with any of its counterparties. The application of the dealer-trader distinction in identifying dealing activity is one of the many aspects of the swap dealer and security-based swap dealer definitions that will be studied by the CFTC and SEC staff reports discussed below in Section I.C.1, Phase-in Procedure. -5-

7 2. Holding Oneself Out as a Dealer in Swaps or Security-Based Swaps, or Being Commonly Known in the Trade as a Dealer The joint release to the Proposing Rules (the Proposing Release ) 6 listed the following non-exclusive factors that could indicate that a person is holding itself out as a dealer or is commonly known in the trade as a dealer: contacting potential counterparties to solicit interest in swaps or security-based swaps; developing new types of swaps or security-based swaps and informing potential counterparties of their availability; having membership in a swap trade association in a category reserved for dealers; providing marketing materials (such as a web site) that describe the types of swaps or security-based swaps one is willing to enter into with other parties; and generally expressing a willingness to offer or provide a range of financial products that would include swaps or security-based swaps. In response to commenter concerns that these factors could be triggered by end users that use swaps or security-based swaps for hedging purposes (for example, many commercial end users actively seek out and negotiate swaps from time to time), the Adopting Release clarifies that these factors are not per se conclusive and should be considered within the context of whether a person engages in the activities with the purpose of facilitating dealing activity. The Adopting Release indicates that, for example, these factors may be indicative of a business purpose of seeking to profit by providing liquidity in connection with security-based swaps. 3. Market-Making 7 The CFTC provides additional guidance in the Adopting Release with respect to the market-making component of the swap dealer definition. The CFTC clarifies that a person making a market in swaps routinely stands ready to enter into swaps at the request or demand of a counterparty, but does not have to do so continuously, as many types of swaps are not entered into on a continuous basis. Furthermore, market-making activity may occur on or off an exchange and it is possible for a person making a one-way market in swaps to be a maker of a market in swaps. The activities that are indicative of whether a person routinely stands ready to enter into swaps include: quoting bid or offer prices, rates or other financial terms for swaps on an exchange; responding to requests made directly, or indirectly through an interdealer broker, by potential counterparties for bid or offer prices, rates or other similar terms for bilaterally negotiated swaps; placing limit orders for swaps; or receiving compensation for acting in a market-maker capacity on an organized exchange or trading system for swaps. -6-

8 The Adopting Release notes that the dealer-trader framework (described above) may be helpful in determining whether a person s routine presence in the market constitutes market making under these four factors. For example, under the dealer-trader distinction, seeking to profit by providing liquidity to the market is an indication of dealer activity. Therefore, it is useful to consider whether the person is seeking, through presence in the market, compensation for providing liquidity, compensation through spreads or fees, or other compensation not attributable to changes in the value of the swaps it enters into. B. EXCEPTIONS FROM DESIGNATION AS A SWAP OR SECURITY-BASED SWAP DEALER Dodd-Frank provides for certain exceptions from designation as a dealer. Therefore, an entity encompassed within the definition of a dealer, as described above, might nevertheless be eligible for an exemption from registration. 1. Activities Not Part of a Regular Business Dodd-Frank provides that the definition of a swap dealer or security-based swap dealer does not include a person that enters into swaps or security-based swaps for its own account, either individually or in a fiduciary capacity, but not as part of a regular business. The Adopting Release identifies several activities that would indicate that a person enters into swaps as a regular part of their business, including: entering into swaps with the purpose of satisfying the business or risk management needs of the counterparty (as opposed to entering into swaps to accommodate one s own demand or desire to participate in a particular market); maintaining a separate profit and loss statement reflecting the results of swap activity or treating swap activity as a separate profit center; or having staff and resources allocated to dealer-type activities with counterparties, including activities relating to credit analysis, customer onboarding, document negotiation, confirmation generation, requests for novations and amendments, exposure monitoring and collateral calls, covenant monitoring, and reconciliation. The Adopting Release recognizes that some end users may have dedicated staff and resources for swap activities; so the analysis as to whether swap activity is swap dealing activity does not depend on the specific amount or percentage of resources or employee time spent on such activities, but on all appropriate circumstances related to swap activities. Although the CFTC agreed that in most cases, entering into swaps in connection with a person s physical commodity business does not constitute a regular business, the CFTC declined to provide a per se exclusion of such activity from the definition of swap dealer. 2. Interim Final Rule Excluding Swaps Entered Into For Hedging Physical Positions In response to comments that swaps used to hedge or mitigate commercial risk should not be considered in determining whether a person is a swap dealer, the CFTC adopted, as a safe harbor, an interim final rule that excludes from the swap dealer analysis swaps entered into for the purpose of hedging physical -7-

9 positions. Under the interim final rule, the CFTC will not consider a swap that the person enters in the swap dealer analysis, if: 1) the person enters into the swap for the purpose of offsetting or mitigating the person s price risks that arise from the potential change in the value of one or several 8 a) assets that the person owns, produces, manufactures, processes or merchandises or anticipates owning, producing, manufacturing, processing or merchandising; b) liabilities that the person owns or anticipates incurring; or c) services that the person provides, purchases or anticipates providing or purchasing; 2) the swap represents a substitute for transactions made or to be made or positions taken or to be taken by the person at a later time in a physical marketing channel; 3) the swap is economically appropriate to the reduction of the person s risks in the conduct and management of a commercial enterprise; 4) the swap is entered into in accordance with sound commercial practices; and 5) the person does not enter into the swap in connection with activity structured to evade designation as a swap dealer. Although the CFTC did not explicitly incorporate the bona fide hedging definition from its position limit rule, the physical hedging exclusion builds on that definition and depends not on the effect or consequences of the swap but on whether the purpose for which a person enters into a swap is to hedge a physical position. The CFTC stresses that the interim final rule is merely a safe harbor and that hedging activities that fall outside of the interim final rule are not necessarily dealing activity. While the Final Rules do not include an explicit exclusion for swap aggregators or other persons that use swaps in connection with the physical commodity markets (such as in connection with the generation, transmission and distribution of electricity), the CFTC believes that it is likely that most, if not all, of such financial instruments used for risk management will be forward contracts in nonfinancial commodities that are excluded from the definition of the term swap. The CFTC seeks comments on all aspects of the interim rule, including whether the exclusion should be limited to swap hedging risks related to physical positions or extended to encompass swap hedging financial risks or other types of risks. 3. Exclusion for Swaps in Connection with Originating a Loan The definition of swap dealer in Dodd-Frank excludes an insured depository institution ( IDI ) to the extent that it offers to enter into a swap with a customer in connection with originating a loan with that customer. 9 The Adopting Release clarifies that the statutory phrase means that the swap is directly connected to the IDI s process of originating the loan to the customer and would not apply to all swaps entered into between an IDI and a borrower at any time during the duration of the loan. Under the Final Rules, the -8-

10 exclusion would apply to a swap that is entered into no more than 90 days before or 180 days after the date of execution of the loan agreement, or no more than 90 days before or 180 days after the date of any transfer of principal to the borrower from the IDI (for example, a draw of principal) pursuant to the loan, so long as the aggregate notional amount of the swaps entered into in connection with the financial terms of the loan at any time is no more than the aggregate amount of the borrowings under the loan at that time, and the duration of the swap does not extend beyond the termination of the loan. The exclusion would be available to an IDI that is a source of funds to a borrower through participation in a loan syndicate, loan assignment or participation. The exclusion is not available to non-idis whether the non-idis purchase the loan in the secondary market or are part of the lending syndicate. The CFTC indicates that the term loan is to be given its meaning under common law; according to the CFTC this encompasses any contract by which one party transfers a defined quantity of money and the other party agrees to repay the sum transferred at a later date. 10 The Final Rules provide that it does not apply to a sham loan or synthetic loan, including a loan credit default swap or a loan total return swap. The Final Rules modify the Proposed Rules by applying the exclusion to swaps between an IDI and a loan borrower which are connected to the financial terms of the loan (such as the loan s duration, interest rate, currency or principal amount), or which are required under the IDI s loan underwriting criteria to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower s business. The notional amount of the swap related to the financial terms of the loan entered into by an IDI may not exceed the size of the loan tranche provided by that IDI, unless the IDI is the sole source of funds under the loan or is committed to be, under the applicable loan agreements, the source of at least 10 percent of the maximum principal amount under the loan. In all cases, however, the aggregate notional amount of all the IDI s swaps with the customer related to the financial terms of the loan may be no more than the amount lent by the IDIs to the customer. The Adopting Release clarifies that whether a swap hedges all of the risk or only some of the risk of a loan, or if the IDI later transfers or terminates the loan in connection with which the swap was entered into, is not relevant to application of the exclusion. If the swap is not accepted for clearing, it must be reported to a swap data repository ( SDR ). 4. Inter-Affiliate Swaps and Security-Based Swaps The dealer analysis will not apply to swaps and security-based swaps between counterparties that are majority-owned affiliates. Under the Final Rules, counterparties are majority-owned affiliates if one counterparty directly or indirectly owns a majority interest in the other, or if a third party directly or indirectly owns a majority interest in both counterparties to the swap. 11 Majority interest is defined as the right to vote or direct the vote of a majority of a class of voting securities of an entity, the power to sell or direct the sale of a majority of a class of voting securities of an entity, or the right to receive upon -9-

11 dissolution or the contribution of a majority of the capital of a partnership. 12 Although the Final Rules do not require the consolidation of financial statements for affiliates to qualify for the exclusion, the Adopting Release notes that a majority ownership standard is generally consistent with consolidation under GAAP Application to cooperatives The swap dealer analysis excludes swaps between a cooperative and its members, so long as the swaps in question are reported to the relevant SDR by the cooperative, are subject to policies and procedures of the cooperative which ensure that it monitors and manages the risk of such swaps and if the cooperative is a cooperative association of producers, the swap is primarily based on a commodity that is not an excluded commodity (i.e., a non-physical commodity). Cooperatives are defined under the Final Rules to include cooperative associations of producers and any entity chartered under Federal law as a cooperative and predominantly engaged in activities that are financial in nature. This definition is primarily intended to capture cooperatives of agricultural producers and financial entities such as Farm Credit System institutions and Federal Home Loan Banks. This exclusion does not apply to security-based swaps. Thus, any security-based swap entered into between a cooperative and its members will need to be analyzed separately for attributes of dealing activity. C. DE MINIMIS EXCEPTION Dodd-Frank requires the Commissions to exempt from dealer designation any entity that engages in a de minimis quantity of dealing in connection with transactions with or on behalf of customers. The Proposed Rules would have conditioned the exception on compliance with three numerical limits on the aggregate notional amount, number of counterparties and number of transactions. In response to comments that the proposed de minimis thresholds were too low and would sweep commercial market participants into the dealer definitions, the Commissions substantially raised the numerical thresholds of the de minimis exception, and eliminated the restrictions on the number of counterparties and swaps or security-based swaps. Accordingly, the Final Rule provides that, in order to be exempt from the definition of swap dealer or security-based swap dealer on the basis of de minimis activity, the aggregate effective notional amount of dealing activity over the preceding 12 months (subject in each case to the phase-in approach described below) cannot exceed the following threshold amounts: For swaps, the threshold amount is $3 billion. For security-based swaps that are credit default swaps, the threshold amount is also $3 billion. For other types of security-based swaps (including, single-name or narrow-based equity swaps or total return swaps), the threshold amount is $150 million. -10-

12 In each case, the threshold amount is $25 million with respect to swaps or security-based swaps in which the counterparty is a Special Entity. 14 Swaps and security-based swaps that do not involve dealing activity are excluded from the de minimis calculation. Thus, for example, swaps or security-based swaps entered into with majority-owned affiliates would not be included in the calculation. However, swap dealing positions entered into by an affiliate controlling, controlled by or under common control 15 with the person at issue would be aggregated. According to the Commissions, this is intended to prevent market participants from evading the dealer designation by dividing up dealing activities among multiple affiliates. This provision appears to require full aggregation across affiliates for purposes of the de minimis test. Therefore, if an entity is over the threshold as a result of affiliate dealing activity, the entity will be unable to rely on the de minimis exception, even if the entity is below the threshold in every category of swap and/or security-based swap. 1. Phase-in Procedure The Final Rules provide for a phase-in period with respect to the de minimis threshold amounts described above, during which the de minimis exception would cap a person s swap or security-based swap dealing activity (as applicable) over the prior 12 months at an effective notional amount of: $8 billion, with respect to swaps; $8 billion, with respect to security-based swaps that are credit default swaps; and $400 million, with respect to other types of security-based swaps. With respect to swaps or security-based swaps with Special Entities, the de minimis threshold will remain at $25 million. During this phase-in period, the CFTC and SEC staff will review their respective de minimis thresholds and will issue reports on (among other things) the impact of those thresholds on the market (the Staff Reports ). The CFTC Staff Report is to be completed no later than 30 months following the date that an SDR first receives swap data. The SEC Staff Report is to be completed within three years following the later of (i) the last compliance date for the registration requirements applicable to security-based swap dealers and major security-based swap participants and (ii) the first date on which trade-by-trade reporting for credit-related and equity-related security-based swaps to a registered SBSDR is required (the SEC Data Collection Initiation Date ). The reports will be available for public comment, and the Commissions will take the reports and comments into consideration when weighing further action on the de minimis thresholds at the end of their respective phase-in periods. Nine months after the publication of the CFTC Staff Report and SEC Staff Report (as applicable), the Commissions may end their respective phase-in periods by order or issue proposed rules to modify the de minimis thresholds. Regardless, the Final Rules mandate that the phase-in periods will end no later than five years after the date that an SDR first receives swap data (with respect to the swap dealer -11-

13 thresholds), or five years after the SEC Data Collection Initiation Date (with respect to security-based swap dealer thresholds). The phase-in period does not apply to transactions in security-based swaps with natural persons unless the natural person is an ECP by virtue of having over $5 million or more invested on a discretionary basis and using the security-based swap to manage the risk associated with such person s assets or liabilities. Any transaction in a security-based swap with a natural person who is not an ECP by virtue of this exception will not be entitled to the benefit of the phase-in period. This exception to the phase-in period only applies to security-based swaps and not to swaps. 2. Specific Factors Implementing the De Minimis Exception Calculation of notional amounts. The Adopting Release states that while notional amounts do not directly measure the exposure or risk associated with a swap or security-based swap position, such measures do reflect the relative amount of an entity s dealing activity. 16 As a result, the calculation of the de minimis thresholds does not permit netting or collateral offsets, as that would allow an unregistered entity to engage in large amounts of swap or security-based swap dealing activity while remaining below the de minimis threshold. In other words, the de minimis thresholds are based on activity, not exposure. For purposes of these thresholds, notional amount is calculated as effective notional amount rather than stated notional amount. Thus, to the extent the notional amount is leveraged or enhanced, such as if the exchange of payments required under an equity swap were based on a multiple of the return on the underlying security, the notional amount would be calculated giving effect to the leverage or enhancement. As an example, if an exchange of payments associated with a $1 million notional equity swap were based on three times the return associated with the underlying equity, the effective notional amount of the equity swap would be $3 million. No Customer Relationship is Required. The Final Rules do not require the existence of a current or former customer relationship. As adopted, the Final Rules neither require that a dealer accommodate the demand of an existing customer nor require the presence of a preexisting relationship. 17 Treatment of Non-Dealing Transactions. As a general matter, to the extent that a particular swap or security-based swap transaction is not connected with dealer activity, that transaction will not count against the de minimis thresholds. Thus, the de minimis thresholds do not apply to: swaps or security-based swaps with a majority-owned affiliate; swaps covered by the exclusion for swaps entered into by IDIs in connection with the origination of loans to customers; swaps between a cooperative and its members; or swaps entered into for hedging physical positions as provided by the interim final rule. -12-

14 Two-Month Grace Period for Registration. If an entity that has relied on the de minimis exception no longer is able to rely on the exception because its dealing activity exceeds a relevant threshold, the entity would have two months, following the end of the month in which it no longer is able to take advantage of the exception, to submit a completed application to register as a swap dealer or security-based swap dealer. Withdrawal of Registration. A person registered as a swap dealer or security-based swap dealer may apply to withdraw that registration, while continuing to engage in a limited amount of dealing activity in reliance on the de minimis exception, if that person has been registered as a dealer for at least 12 months. D. LIMITED PURPOSE DESIGNATION AS A DEALER Under the Final Rules, a person who meets one of the dealer definitions will be deemed to be a dealer with regard to all of its swaps or security-based swaps activities, unless the CFTC or SEC exercises its authority to limit the person s designation as a dealer to specified categories of swaps or security-based swaps, or specified activities. A person may apply for a limited designation when it submits a registration application, or at a later time. 18 The practical availability of a limited purpose designation is very unclear since the Commissions indicate in the Adopting Release that regardless of the type of limited designation being requested, the Commissions will not designate a person as a limited purpose dealer unless it can demonstrate that it can fully comply with all of the Dodd-Frank requirements applicable to dealers. Among other things, this would require an entity seeking limited purpose designation to demonstrate the ability to comply with: the preparation and maintenance of trading records, documentation and confirmations; requirements related to registration, capital, risk management, supervision and chief compliance officers. The Adopting Release provides little clarity as to how compliance with these requirements, such as capital, would apply in the context of a separate business unit or desk. Thus, the practical availability of the limited purpose designation will be unclear until the CFTC and SEC actually begin analyzing specific applications for limited designations. The Adopting Release provides several examples of when a limited designation might be appropriate: When a commercial agricultural company is a dealer in swaps related to a thinly traded commodity, such as a particular fertilizer, but is not a dealer in, and does not wish to be subject to the swap dealer requirements with respect to, its swaps that relate to broadly traded commodities like corn or wheat; When a commercial energy company is a dealer in swaps involving a commodity to be delivered at a particular location and does not wish to be subject to the swap dealer requirements for its swaps involving that commodity to be delivered at other locations for which it is not a swap dealer; and -13-

15 For a particular business unit within a company or desk by applying the swap dealer requirements solely to the designee s limited activities involving swaps not entered into for the purpose of hedging a physical position. E. FLOOR TRADERS In the Final Rules, the CFTC adopted a separate exception for swaps entered into by floor traders in their capacity as floor traders. Historically, registration as a floor trader was required of those persons trading for their proprietary accounts on exchange floors (or, later, through exchange electronic trading systems). The CFTC has now extended this category to a completely different set of entities those engaged in proprietary trading of swaps that are active in the markets and perform some of the functions of dealers but are not conducting business as dealers. This category will likely apply to a variety of proprietary trading entities. Accordingly, the Final Rules provide that swaps entered into by a floor trader in its capacity as a floor trader will not be considered for purposes of the swap dealer analysis if the floor trader: is registered with the CFTC as a floor trader; enters into swaps only with proprietary funds for that trader s own account solely on or subject to the rules of a designated contract market ( DCM ) or swap execution facility ( SEF ), and submits each such swap for clearing to a designated clearing organization; is not an affiliated person ( AP ) of a registered swap dealer; does not directly, or through an AP, negotiate the terms of swap agreements (other than price and quantity or participate in a request for quote process subject to the rules of a DCM or SEF); does not directly, or through an AP, provide swap clearing services to third parties; does not directly, or through an AP, enter into swaps to hedge or mitigate physical or commercial risk (other than swaps that are executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction); does not participate in any market-making programs offered by a DCM or SEF; and complies with certain recordkeeping and risk management requirements. Given that the SEC does not have a regulatory category under the Exchange Act equivalent to floor trader, this provision only applies only to CFTC-registered floor traders engaging in swaps on DCMs or SEFs and does not apply to security-based swap dealers. Transactions that are entered into offexchange do not qualify for the floor trader exception. II. MAJOR SWAP PARTICIPANT AND MAJOR SECURITY-BASED SWAP PARTICIPANT Under Title VII of the Dodd-Frank Act, a major swap participant ( MSP ) is defined as a person, other than a swap dealer, that meets any of the following three tests: -14-

16 maintains a substantial position in swaps for any of the major swap categories as determined by the CFTC (excluding positions held for hedging or mitigating commercial risk and positions maintained by any employee benefit plan (or any contract held by such a plan) as defined in paragraphs (3) and (32) of Section 3 of ERISA ( ERISA Plans ) for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan); or has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or is a financial entity that is not subject to capital requirements imposed by any federal banking agency, is highly leveraged relative to the amount of capital it holds, and maintains a substantial position in outstanding swaps in any major swap category. Title VII defines a major security-based swap participant ( SMSP ) in substantially the same manner as MSP, replacing swap dealer, swap and CFTC in the tests above with security-based swap dealer, security-based swap and SEC, respectively. MSPs and SMSPs (together, major participants ) will be subject to registration, capital, reporting, recordkeeping and other regulatory requirements of the CFTC and SEC, as applicable. Those requirements are not addressed in the Final Rules or Adopting Release. The Final Rules include definitions that will be used to determine whether a person qualifies as a major participant. Notably, the CFTC anticipates that only six market participants will be covered by the MSP definition, and the SEC estimates that fewer than five (and perhaps zero) participants will qualify as SMSPs. Unlike the dealer definitions and the related interpretive analyses, the major participant calculations and analyses remain relatively unchanged from the Proposed Rules. However, in response to concerns raised by commenters, the Commissions have included three safe harbors from the major participant designations, which are discussed in Section II.G below, Calculation Safe Harbors. For additional information regarding the various calculations of the major participant definitions, please see our prior Memorandum to Clients regarding the CFTC and SEC Proposed Rules and Guidance to Further Define the Terms Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant, dated December 14, A. MAJOR CATEGORIES OF SWAPS AND SECURITY-BASED SWAPS Two of the three tests for qualifying as a major participant require a determination of whether an entity has a substantial position in a major category of swaps or security-based swaps. Major categories of swaps. Consistent with the Proposed Rules, the Final Rules create the following four major categories of swaps for purposes of the MSP definition: Rate swaps. This category would include any swap that is primarily based on one or more reference rates, such as fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates, any foreign exchange swap and any foreign exchange option other than an option to deliver currency. Credit swaps. This category would include any swap that is primarily based on instruments of indebtedness, including but not limited to any swap primarily based on one or more broadbased indices related to debt instruments or loans, or any swap that is an index credit default swap or total return swap on one or more indices of debt instruments. -15-

17 Equity swaps. This category would include any swap that is primarily based on equity securities, including any swap primarily based on one or more broad-based indices of equity securities, or any total return swap on one or more equity indices. Other commodity swaps. This category would include any swap that is not included in any of the first three categories, such as any swap for which the primary underlying item is a physical commodity or the price or any other aspect of a physical commodity. Major categories of security-based swaps. The Final Rules would create the following two major categories of security-based swaps for purposes of the SMSP definition: Debt security-based swaps. This category would include any security-based swap that is based, in whole or in part, on one or more instruments of indebtedness (including loans) or on a credit event relating to one or more issuers or securities. This would include, for example, any security-based swap that is a credit default swap, total return swap on one or more debt instruments, debt swap, debt index swap, or credit spread. In the Proposing Release, the SEC indicated that this category would not include a security-based swap that is based on a debt instrument solely in connection with the swap s financing leg; this was not repeated in the Adopting Release. Other security-based swaps. This category would include any other security-based swap not included in the first category (for example, an equity swap). The Commissions expect that mixed swaps 19 would be placed in the swap and security-based swap categories that are consistent with the underlying attributes that cause such instrument to be a mixed swap. 20 In addition, swaps or security-based swaps based on more than one item, instrument or risk should be placed in the category that most closely describes the primary underlying item, instrument or risk. Debt securities that are convertible into equity should be categorized as debt or equity based on their status at the time of evaluation. B. SUBSTANTIAL POSITION Under the first major participant test, any person that maintains a substantial position in any of the major categories of swaps or security-based swaps will qualify as a major participant, subject to certain exceptions discussed below. A person will qualify as maintaining a substantial position if it meets either of two tests. The first substantial position test: measures a person s current uncollateralized outward exposure by marking to market swap or security-based swap positions with a negative value, using industry standard practice; allows the deduction of the value of collateral that is posted with respect to the swap or security-based swap positions; and calculates exposure on a net basis, according to the terms of any master netting agreement that applies. The thresholds adopted for the first test are the daily average current uncollateralized outward exposure of $1 billion in the applicable major category of swaps or security-based swaps, except that the threshold for the rate swap category would be $3 billion. -16-

18 The second test adopted accounts for both current uncollateralized outward exposure and the potential outward exposure associated with a person s swap or security-based swap positions. substantial position test determines potential outward exposure by adding: The second if the swaps or security-based swaps are not cleared by a registered or exempt clearing agency or a derivatives clearing organization ( DCO ) and are not subject to daily mark-tomarket margining, multiplying the total notional principal amount of the person s swap or security-based swap positions by specified risk factor percentages based on the type of swap or security-based swap and the duration of the position 21 ; and if the swaps or security-based swaps are cleared by a registered or exempt clearing agency or a DCO or subject to daily mark-to-market margining, further discounting the amount of the potential future exposure associated with the positions by 90% (for positions that are cleared) or 80% (for positions subject to daily mark-to-market margining but not cleared). The thresholds adopted for the second test are $2 billion in daily average aggregate uncollateralized outward exposure plus daily average aggregate potential outward exposure in the applicable major swap category, except that the threshold for the rate swap category would be $6 billion. 1. Exclusion for Hedging or Mitigating Commercial Risk The first test of the major participant definitions under Dodd-Frank excludes any position that is held for hedging or mitigating commercial risk or is maintained by an ERISA Plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the Plan. The Final Rules define hedging or mitigating commercial risk for purposes of this exclusion and include hedging or mitigating financial risk by financial entities. Exclusion for MSPs. Under the Final Rules, the determination as to whether a swap hedges or mitigates commercial risk is made by analyzing the facts and circumstances at the time the swap is entered into, and by taking into account the person s overall hedging and risk mitigation strategies. The hedging exclusion would extend to any swap that: is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise (or a majority-owned affiliate of the enterprise), where the risks arise from: a potential change in the value of (i) assets that a person owns, produces, manufactures, processes or merchandises or reasonably anticipates owning, producing, manufacturing, processing or merchandising, (ii) assets, services, inputs, products or commodities that a person owns, produces, manufactures, processes, merchandises, leases or sells or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing or selling, (iii) liabilities that a person incurs or reasonably anticipates incurring or (iv) services that a person provides or purchases or reasonably anticipates producing or purchasing, each in the ordinary course of business; or a potential change in value related to any of the foregoing arising from interest, currency or foreign exchange rate movements; or a fluctuation in interest, currency, or foreign exchange rate exposures arising from a person s assets or liabilities; or -17-