[Federal Register Volume 77, Number 156 (Monday, August 13, 2012)]
[Rules and Regulations]
[Pages 48207-48366]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-18003]



[[Page 48207]]

Vol. 77

Monday,

No. 156

August 13, 2012

Part II





Commodity Futures Trading Commission





17 CFR Part 1





Securities and Exchange Commission





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17 CFR Parts 230, 240 and 241





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Further Definition of ``Swap,'' ``Security-Based Swap,'' and 
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping; Final Rule

Federal Register / Vol. 77, No. 156 / Monday, August 13, 2012 / Rules 
and Regulations

[[Page 48208]]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AD46

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 230, 240 and 241

[Release No. 33-9338; 34-67453; File No. S7-16-11]
RIN 3235-AK65


Further Definition of ``Swap,'' ``Security-Based Swap,'' and 
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping

AGENCY: Commodity Futures Trading Commission; Securities and Exchange 
Commission.

ACTION: Joint final rule; interpretations; request for comment on an 
interpretation.

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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 
adopting new rules and interpretations 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.'' The CFTC 
requests comment on its interpretation concerning forwards with 
embedded volumetric optionality, contained in Section II.B.2.(b)(ii) of 
this release.

DATES: Effective date: October 12, 2012.
    Compliance date: The applicable compliance dates are discussed in 
the section of the release titled ``IX. Effective Date and 
Implementation''.
    Comment date: Comments on the interpretation regarding forwards 
with embedded volumetric optionality must be received on or before 
October 12, 2012.

ADDRESSES: You may submit comments, identified by RIN number 3038-AD46, 
by any of the following methods:
     CFTC Web Site: via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments 
through the Web site.
     Mail: Address to David A. Stawick, Secretary of the 
Commission, 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.
    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 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 
Sec.  145.9 of the CFTC's Regulations.\1\
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    \1\ 17 CFR 145.9.
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    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 http://www.cftc.gov that it may deem to be 
inappropriate for publication, such as obscene language. All 
submissions that have been redacted or removed that contain comments on 
the merits of the interpretation 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.

FOR FURTHER INFORMATION CONTACT: CFTC: Julian E. Hammar, Assistant 
General Counsel, at 202-418-5118, jhammar@cftc.gov, Lee Ann Duffy, 
Assistant General Counsel, at 202-418-6763, lduffy@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: Donna M. 
Chambers, Special Counsel, at 202-551-5870, or John Guidroz, Attorney-
Adviser, at 202-551-5870, Division of Trading and Markets, or Andrew 
Schoeffler, Special Counsel, at 202-551-3860, Office of Capital Markets 
Trends, Division of Corporation Finance, or Wenchi Hu, Senior Special 
Counsel, at 202-551-5870, Office of Compliance, Inspections and 
Examinations, Securities and Exchange Commission, 100 F Street NE., 
Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
II. Scope of Definitions of Swap and Security-Based Swap
    A. Introduction
    B. Rules and Interpretations 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
    (c) Grandfather Provision for Existing Insurance Transactions
    (d) Alternative Tests
    (e) ``Safe Harbor''
    (f) Applicability of Insurance Exclusion to Security-Based Swaps
    (g) Guarantees
    2. The Forward Contract Exclusion
    (a) Forward Contracts in Nonfinancial Commodities
    (i) Forward Exclusion From the Swap and Future Delivery 
Definitions
    (ii) Nonfinancial Commodities
    (iii) Environmental Commodities
    (iv) Physical Exchange Transactions
    (v) Fuel Delivery Agreements
    (vi) Cleared/Exchange-Traded Forwards
    (b) Commodity Options and Commodity Options Embedded in Forward 
Contracts
    (i) Commodity Options
    (ii) Commodity Options Embedded in Forward Contracts
    (iii) Certain Physical Commercial Agreements, Contracts or 
Transactions
    (iv) Effect of Interpretation on Certain Agreements, Contracts 
and Transactions
    (v) Liquidated Damages Provisions
    (c) Security Forwards
    3. Consumer and Commercial Agreements, Contracts, and 
Transactions
    C. Final Rules and Interpretations 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
    (c) Interpretation Regarding Foreign Exchange Spot Transactions
    (d) Retail Foreign Currency Options
    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

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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) 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) Affiliation of Reference Entities and Issuers of Securities 
With Respect to Number and Concentration Criteria
    (iii) Public Information Availability Regarding Reference 
Entities and Securities
    (iv) Affiliation of Reference Entities and Issuers of Securities 
With Respect to Certain Criteria of the Public Information 
Availability Test
    (v) Application of the Public Information Availability 
Requirements to Indexes Compiled by a Third-Party Index Provider
    (vi) 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 Anti-Evasion Rules
    1. CFTC's Anti-Evasion Authority
    (a) Statutory Basis for the Anti-Evasion Rules
    2. Final Rules
    (a) Rule 1.3(xxx)(6)
    (b) Rule 1.6
    (c) Interpretation on the Final Rules
    3. Interpretation Contained in the Proposing Release
    (a) Business Purpose Test
    (b) Fraud, Deceit or Unlawful Activity
    B. SEC Position Regarding Anti-Evasion Rules
VIII. Miscellaneous Issues
    A. Distinguishing Futures and Options From Swaps
    B. Transactions Entered Into by Foreign Central Banks, Foreign 
Sovereigns, International Financial Institutions, and Similar 
Entities
    C. Definition of the Terms ``Swap'' and ``Security-Based Swap'' 
as Used in the Securities Act
IX. Effective Date and Implementation
X. Administrative Law Matters--CEA Revisions
    A. Paperwork Reduction Act
    B. Regulatory Flexibility Act
    C. Costs and Benefits Considerations
XI. Administrative Law Matters--Exchange Act Revisions
    A. Economic Analysis
    B. Paperwork Reduction Act
    C. Regulatory Flexibility Act Certification
XII. Statutory Basis and Rule Text

I. Backbround

    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.
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    \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.''
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    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

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evade the requirements of subtitles A and B, respectively, of Title 
VII.
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    \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.
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    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\
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    \5\ 7 U.S.C. 1 et seq.
    \6\ The CFTC has issued final rules regarding SDRs and, 
separately, swap data recordkeeping and reporting. See Swap Data 
Repositories: Registration Standards, Duties and Core Principles, 76 
FR 54538 (Sep. 1, 2011); Swap Data Recordkeeping and Reporting 
Requirements, 77 FR 2136 (Jan. 13, 2012). 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 final rules regarding recordkeeping 
requirements for swap dealers and major swap participants. See Swap 
Dealer and Major Swap Participant Recordkeeping, Reporting, and 
Duties Rules; Futures Commission Merchant and Introducing Broker 
Conflicts of Interest Rules; and Chief Compliance Officer Rules for 
Swap Dealers, Major Swap Participants, and Futures Commission 
Merchants, 77 FR 20128 (Apr. 3, 2012).
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    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\
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    \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.
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    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. Taking into account comments received 
on the ANPR, the Commissions published a notice of proposed rulemaking 
in the Federal Register on May 23, 2011.\15\ The comment period for the 
Proposing Release closed on July 22, 2011.\16\ Together, the 
Commissions received approximately 86 written comment letters in 
response to the Proposing Release.
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    \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 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,'' 77 FR 30596 
(May 23, 2012) (``Entity Definitions Release''). 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.
    \15\ See Further Definition of ``Swap,'' ``Security-Based 
Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps; 
Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23, 
2011) (``Proposing Release'').
    \16\ Id.
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    The Commissions have reviewed and considered the comments received, 
and the staffs of the Commissions have met with many market 
participants and other interested parties to discuss the 
definitions.\17\ 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.
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    \17\ 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.
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    Based on this review and consultation, the Commissions are adopting 
rules and interpretations regarding, among other things: (i) The 
regulatory treatment of insurance products; (ii) the exclusion of 
forward contracts from the swap and security-

[[Page 48211]]

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 monetary rates) 
and yields; (vi) total return swaps (``TRS''); (vii) Title VII 
instruments based on futures contracts; (viii) 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 (ix) the specification of certain swaps 
and security-based swaps that are, and are not, mixed swaps. In 
addition, the Commissions are adopting rules: (i) To clarify that there 
will not be additional books and records requirements applicable to 
SBSAs other than those required for swaps; (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 adopting rules to implement the anti-
evasion authority provided in the Dodd-Frank Act.
Overall Economic Considerations
    The Commissions are sensitive to the costs and benefits of their 
rules. In considering the adoption of the Product Definitions, the 
Commissions have been mindful of the costs and benefits associated with 
these rules, which provide fundamental building blocks for the Title 
VII regulatory regime. There are costs, as well as benefits, arising 
from subjecting certain agreements, contracts, or transactions to the 
regulatory regime of Title VII.\18\ Additionally, there are costs that 
parties will incur to assess whether certain agreements, contracts, or 
transactions are indeed subject to the Title VII regulatory regime, 
and, if so, the costs to assess whether such Title VII instrument is 
subject to the regulatory regime of the SEC or the CFTC.\19\
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    \18\ The Commissions refer to these costs and benefits as 
programmatic costs and benefits.
    \19\ The Commissions refer to these costs as assessment costs.
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    Title VII created a jurisdictional division between the CFTC and 
SEC. The costs and benefits flowing from an agreement, contract, or 
transaction being subject to the regulatory regime of the CFTC or the 
SEC may be impacted by similarities and differences in the Commissions' 
regulatory programs for swaps and security-based swaps. Title VII calls 
on the SEC and the CFTC to consult and coordinate for the purposes of 
assuring regulatory consistency and comparability to the extent 
possible.\20\ Title VII also calls on the agencies to treat 
functionally or economically similar products or entities in a similar 
manner, but does not require identical rules.\21\ Although the 
Commissions may differ on certain rulemakings, as the relevant 
products, entities and markets are different, the Commissions believe 
that, as the CFTC and SEC regulatory regimes share a statutory basis in 
Title VII, the costs and benefits of their respective regimes should be 
broadly similar and complementary.
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    \20\ See sections 712(a)(1) and (a)(2) of the Dodd-Frank Act.
    \21\ See sections 712(a)(7)(A) and (B) of the Dodd-Frank Act.
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    In acknowledging the economic consequences of the final rules, the 
Commissions recognize that the Product Definitions do not themselves 
establish the scope or nature of those substantive requirements or 
their related costs and benefits. In determining the appropriate scope 
of these rules, the Commissions consider the types of agreement, 
contract, or transaction that should be regulated as a swap, security-
based swap, or mixed swap under Title VII in light of the purposes of 
the Dodd-Frank Act. The Commissions have sought to further define the 
terms ``swap,'' ``security-based swap,'' and ``mixed swap'' to include 
agreements, contracts, and transactions only to the extent that 
capturing these agreements, contracts, and transactions is necessary 
and appropriate given the purposes of Title VII, and to exclude 
agreements, contracts, and transactions to the extent that the 
regulation of such agreements, contracts, and transactions does not 
serve the statutory purposes of Title VII, so as not to impose 
unnecessary burdens for agreements, contracts, and transactions whose 
regulation may not be necessary or appropriate to further the purposes 
of Title VII.

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.'' \22\ The 
statutory definition of the term ``swap'' also has various 
exclusions,\23\ rules of construction, and other provisions for the 
interpretation of the definition.\24\ One of the exclusions to the 
definition of the term ``swap'' is for security-based swaps.\25\ 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.\26\ Thus, the 
statutory definition of the term ``swap'' also determines the scope of 
agreements, contracts, and transactions that could be security-based 
swaps.
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    \22\ 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).
    \23\ See CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), clauses (i)-
(x).
    \24\ See CEA sections 1a(47)(C)-(F), 7 U.S.C. 1a(47)(C)-(F).
    \25\ See CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x).
    \26\ See section 3(a)(68) of the Exchange Act, 15 U.S.C. 
78c(a)(68).
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    The statutory definitions of the terms ``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, 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 
nothing in the legislative history of the Dodd-Frank Act appears to 
suggest that Congress intended such agreements, contracts, or 
transactions to be regulated as swaps or security-based swaps under 
Title VII. The Commissions thus believe that it is important to further 
clarify the treatment under the definitions of certain types of 
agreements, contracts, and transactions, such as insurance products and 
certain consumer and commercial contracts.
    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) under the definitions of the terms ``swap'' 
and ``security-based swap.'' Finally, the Commissions are providing

[[Page 48212]]

interpretations related to the definitions.\27\
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    \27\ In response to the ANPR, some commenters raised concerns 
regarding the treatment of inter-affiliate swaps and security-based 
swaps. See, e.g., Letter from Edward J. Rosen, Cleary Gottlieb Steen 
& Hamilton LLP, Sep. 21, 2010 (``Cleary ANPR Letter''); Letter from 
Coalition for Derivatives End Users, Sep. 20, 2010 (``CDEU ANPR 
Letter''); Letter from Robert Pickel, Executive Vice President, 
International Swaps and Derivatives Association, Inc. (``ISDA''), 
Sep. 20, 2010; Letter from Richard A. Miller, Vice President and 
Corporate Counsel, Prudential Financial Inc., Sep. 17, 2010; Letter 
from Richard M. Whiting, The Financial Services Roundtable, Sep. 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 ANPR Letter and CDEU ANPR 
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.
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B. Rules and Interpretations Regarding Certain Transactions Outside the 
Scope of the Definitions of the Terms ``Swap'' and ``Security-Based 
Swap''

1. Insurance Products
    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.'' \28\ As 
stated in the Proposing Release, 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 
definitions.\29\ The Commissions are aware of nothing in Title VII to 
suggest that Congress intended for traditional insurance products to be 
regulated as swaps or security-based swaps. Moreover, the fact 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.'' \30\ Accordingly, the 
Commissions believe that state or Federally regulated insurance 
products that are provided by persons that are subject to state or 
Federal insurance supervision, that otherwise could fall within the 
definitions should not be considered swaps or security-based swaps so 
long as they satisfy the requirements of the Insurance Safe Harbor (as 
defined below). At the same time, however, the Commissions are 
concerned that certain 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.
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    \28\ CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii).
    \29\ See Proposing Release at 29821. The Commissions continue to 
believe that 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 section 2(e) of the 
CEA, 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). 
Historically, insurance has not been regulated as such under the 
Federal securities laws or under the CEA. See infra note 1283.
    \30\ 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 V also addressed non-admitted insurance and 
reinsurance. 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).
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    Accordingly, the Commissions are adopting final rules that (i) 
clarify that certain agreements, contracts, or transactions that 
satisfy the requirements of the Insurance Safe Harbor will not be 
considered to be swaps or security-based swaps, and (ii) provide an 
Insurance Grandfather exclusion from the swap and security-based swap 
definitions for any agreement, contract, or transaction entered into on 
or before the effective date of the Product Definitions, provided that, 
when the parties entered into such agreement, contract, or transaction, 
it was provided in accordance with the Provider Test (as defined 
below), including a requirement that an agreement, contract or 
transaction that is provided in accordance with the first prong of the 
Provider Test must be regulated as insurance under applicable state law 
or the laws of the United States.
    The final rules contain four subparts: The first subpart addresses 
the agreement, contract, or transaction; the second subpart addresses 
the person \31\ providing that agreement, contract, or transaction; the 
third subpart includes a list of traditional insurance products that do 
not have to meet the requirements set out in the first subpart; and the 
fourth subpart contains the Insurance Grandfather exclusion (as defined 
below).
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    \31\ In response to commenters, the Commissions are changing the 
word ``company'' from the proposal to ``person.'' Each of the CEA, 
the Securities Act, and the Exchange Act contains a definition of a 
``person.'' See, e.g., Letter from Carl B. Wilkerson, Vice President 
& Chief Counsel, American Council of Life Insurers (``ACLI''), dated 
July 22, 2011 (``ACLI Letter'') and Letter from John P. Mulhern, 
Dewey & LeBoeuf LLP (``D&L''), dated July 22, 2011 (``D&L Letter'').
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    More specifically, with respect to the first subpart, the 
Commissions are adopting paragraph (i)(A) of rule 1.3(xxx)(4) under the 
CEA and paragraph (a)(1) of rule 3a69-1 under the Exchange Act (the 
``Product Test'') as proposed, with certain modifications to respond to 
commenters' concerns. As adopted, the Product Test provides that the 
terms ``swap'' and ``security-based swap'' will 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 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.
    The Commissions are also adopting paragraph (i)(B) of rule 
1.3(xxx)(4) under the CEA and paragraph (a)(2) of rule 3a69-1 under the 
Exchange Act (the ``Provider Test'') as proposed, with certain 
modifications to respond to commenters' concerns. As adopted, the 
Provider Test requires that an agreement, contract, or transaction that

[[Page 48213]]

satisfies the Product Test must be provided:
     By a person that is subject to supervision by the 
insurance commissioner (or similar official or agency) of any state 
\32\ or by the United States or an agency or instrumentality \33\ 
thereof, and such agreement, contract, or transaction is regulated as 
insurance under applicable state law \34\ or the laws of the United 
States (the ``first prong'');
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    \32\ The term ``State'' is defined in section 3(a)(16) of the 
Exchange Act, 15 U.S.C. 78c(a)(16), 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.'' The CFTC is 
incorporating this definition into rule 1.3(xxx)(4) for purposes of 
ensuring consistency between the CFTC and SEC rules further defining 
the terms ``swap'' and ``security-based swap.''
    \33\ For purposes of this release, the term ``instrumentality'' 
includes publicly supported, state operated or quasi-state operated 
insurance programs that may not be subject to state regulatory 
oversight, such as the Illinois Mine Subsidence Insurance Fund and 
the Florida Hurricane Catastrophe Fund.
    \34\ For purposes of this release, the Commissions anticipate 
that the parties to an agreement, contract, or transaction will 
evaluate which state law applies prior to entering into such 
agreement, contract, or transaction. The Commissions do not 
anticipate that the parties' analysis of which state law applies 
will change as a result of the adoption of the Insurance Safe 
Harbor. In addition, the Commissions will analyze which state law 
applies (if necessary, in consultation with state insurance 
regulatory authorities) if and when such issues arise that the 
Commissions determine to address. The Commissions note that courts 
routinely determine what is the ``applicable state law'' when 
adjudicating disputes involving insurance.
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     (i) Directly or indirectly by the United States, any state 
or any of their respective agencies or instrumentalities, or (ii) 
pursuant to a statutorily authorized program thereof ((i) and (ii) 
together, the ``second prong''); or
     In the case of reinsurance only \35\ by a person to 
another person that satisfies the Provider Test, provided that:
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    \35\ For purposes of this release, the term ``reinsurance'' 
means the assumption by an insurer of all or part of a risk 
undertaken originally by another insurer.
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    (i) Such person is not prohibited by applicable state law or the 
laws of the United States from offering such agreement, contract, or 
transaction to such person that satisfies the Provider Test;
    (ii) The agreement, contract, or transaction to be reinsured 
satisfies the Product Test or is one of the Enumerated Products (as 
defined below); and
    (iii) Except as otherwise permitted under applicable state law, the 
total amount reimbursable by all reinsurers \36\ for such agreement, 
contract, or transaction may not exceed the claims or losses paid by 
the cedant \37\ ((i), (ii), and (iii), collectively, the ``third 
prong''); or
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    \36\ For purposes of this release, the term ``reinsurer'' means 
any person who provides reinsurance.
    \37\ For purposes of this release, the term ``cedant'' means the 
person writing the risk being ceded or transferred to a reinsurer.
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     In the case of non-admitted insurance \38\ by a person 
who:
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    \38\ For purposes of this release, the term ``non-admitted 
insurance'' means any property and casualty insurance permitted to 
be placed directly or through a surplus lines broker with a non-
admitted insurer eligible to accept such insurance.
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    (i) Is located outside of the United States and listed on the 
Quarterly Listing of Alien Insurers as maintained by the International 
Insurers Department of the National Association of Insurance 
Commissioners; or
    (ii) Meets the eligibility criteria for non-admitted insurers \39\ 
under applicable state law ((i) and (ii) together, the ``fourth 
prong'').
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    \39\ For purposes of this release, the term ``non-admitted 
insurer'' means, with respect to any State, an insurer not licensed 
to engage in the business of insurance in such State, but does not 
include a risk retention group, as that term is defined in section 
2(a)(4) of the Liability Risk Retention Act of 1986, 15 U.S.C. 
3901(a)(4).
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    In response to commenters' requests that the Commissions codify the 
proposed interpretation regarding certain enumerated types of 
traditional insurance products in the final rules,\40\ the Commissions 
are also adopting paragraph (i)(C) of rule 1.3(xxx)(4) under the CEA 
and paragraph (a)(3) of rule 3a69-1 under the Exchange Act. In 
addition, in response to comments, the Commissions are expanding and 
revising the enumerated types of traditional insurance products. As 
adopted, the rule provides that the terms ``swap'' and ``security-based 
swap'' will not include an agreement, contract, or transaction that is 
provided in accordance with the Provider Test and is any one of the 
following (collectively, ``Enumerated Products''): Surety bonds; 
fidelity bonds; life insurance; health insurance; long-term care 
insurance; title insurance; property and casualty insurance; annuities; 
disability insurance; insurance against default on individual 
residential mortgages (commonly known as private mortgage insurance, as 
distinguished from financial guaranty of mortgage pools); and 
reinsurance (including retrocession) of any of the foregoing. The 
Commissions note that the inclusion of reinsurance (including 
retrocession) as an Enumerated Product is meant to apply to traditional 
reinsurance and retrocession contracts. Specifically, traditional 
reinsurance and retrocession contracts that reinsure risks ceded under 
traditional insurance products included in the Enumerated Product list 
and provided in accordance with the Provider test do not fall within 
the swap or security-based swap definitions. An agreement, contract, or 
transaction that is labeled as ``reinsurance'' or ``retrocession'', but 
is executed as a swap or security-based swap or otherwise is structured 
to evade Title VII of the Dodd-Frank Act, would not satisfy the 
Insurance Safe Harbor, and would be a swap or security-based swap.\41\
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    \40\ See infra notes 88, 89, and 90 and accompanying text.
    \41\ For example, if a person uses a weather derivative or 
catastrophe swap to assume all or part of the risks contained in a 
portfolio of property and casualty insurance policies, that weather 
derivative or catastrophe swap would be a Title VII instrument that 
is subject to regulation under Title VII.
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    In order for an agreement, contract, or transaction to qualify 
under the final rules as an insurance product that would not be a swap 
or security-based swap: (i) The agreement, contract, or transaction 
must satisfy the criteria in the Product Test or be one of the 
Enumerated Products and (ii) the person providing the agreement, 
contract or transaction must satisfy one prong of the Provider 
Test.\42\ The fact that an agreement, contract, or transaction 
satisfies the Product Test or is one of the Enumerated Products does 
not exclude it from the swap or security-based swap definitions if it 
is not provided by a person that satisfies the Provider Test; nor does 
the fact that a product is provided by a person that satisfies the 
Provider Test exclude the product from the swap or security-based swap 
definitions if the agreement, contract, or transaction does not satisfy 
the criteria set forth in the Product Test or is not one of the 
Enumerated Products.\43\
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    \42\ As was discussed in the Proposing Release, see Proposing 
Release at 29822 n. 31, certain variable life insurance products and 
annuities are securities and therefore are excluded from the swap 
and security-based swap definitions regardless of whether they meet 
the requirements under the final rules. See section 1a(47)(B)(v) of 
the CEA, 7 U.S.C. 1a(47)(B)(v). These securities would not be swaps 
or security-based swaps whether or not required to be registered 
under the Securities Act. See SEC v. United Benefit Life Ins. Co., 
387 U.S. 202 (1967) (holding that the accumulation provisions of a 
``flexible fund'' annuity contract were 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).
    \43\ For the purpose of determining whether an agreement, 
contract or transaction falls within the Insurance Safe Harbor, 
Title VII provides the Commissions with flexibility to address the 
facts and circumstances of new products that may be marketed or sold 
as insurance, through joint interpretations pursuant to section 
712(d)(4) of the Dodd-Frank Act.

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[[Page 48214]]

    Further, in response to commenters' concerns,\44\ the Commissions 
are confirming that the Product Test, the Provider Test and the 
Enumerated Products represent a non-exclusive safe harbor. None of the 
Product Test, the Provider Test, or the Enumerated Products 
(collectively, the ``Insurance Safe Harbor'') implies or presumes that 
an agreement, contract, or transaction that does not meet any of their 
respective requirements is a swap or security-based swap. Such an 
agreement, contract, or transaction will require further analysis of 
the applicable facts and circumstances, including the form and 
substance of such agreement, contract, or transaction, to determine 
whether it is insurance, and thus not a swap or security-based swap.
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    \44\ See infra notes 178 and 179 and accompanying text.
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    However, future market conditions or other developments may prompt 
the Commissions to reconsider whether a particular product that 
satisfies the requirements of the Insurance Safe Harbor should instead 
fall within the swap or security-based swap definition. Because a 
determination that such a product is a swap or security-based swap 
could potentially have an unsettling effect on the domestic insurance 
or financial markets, the Commissions would only consider making a 
determination that such a product is a swap or security-based swap 
through a rulemaking \45\ process that would provide market 
participants with an opportunity to comment.\46\
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    \45\ The Commissions can engage in rulemakings in a variety of 
ways including an advanced notice of proposed rulemaking, a notice 
of proposed rulemaking, or an interim final rule.
    \46\ When determining whether a particular product is a swap or 
security-based swap instead of insurance, if such product does not 
meet the requirements set out in the Insurance Safe Harbor, the 
Commissions will consider prior regulation as an insurance contract 
as one factor in their respective facts and circumstances analysis.
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(a) Types of Insurance Products
Final Rules
Product Test
    The Commissions are adopting the Product Test as proposed, with 
certain modifications to respond to commenters' concerns. The Product 
Test sets forth four criteria for an agreement, contract, or 
transaction to be considered insurance. First, the final rules require 
that the beneficiary have an ``insurable interest'' underlying 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. 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 continuously 
throughout the duration of the agreement, contract, or transaction will 
ensure that an insurance contract beneficiary has a stake in the 
interest on which the agreement, contract, or transaction is 
written.\47\ Similarly, the requirement that the beneficiary have the 
insurable interest continuously throughout the duration 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 insurance, a credit default swap (``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.\48\ One commenter identified the 
existence of an insurable interest as a material element to the 
existence of an insurance contract.\49\ Because neither swaps nor 
security-based swaps require the presence of an insurable interest at 
all (although an insurable interest may sometimes be present 
coincidentally), the Commissions continue to believe that whether an 
insurable interest is present continuously throughout the duration of 
the agreement, contract, or transaction is a meaningful way to 
distinguish insurance from swaps and security-based swaps.
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    \47\ 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.
    \48\ 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., ISDA, 2003 ISDA Credit Derivatives Definitions, 
art. 9.1(b)(i) (2003) (``2003 Definitions'') (stating that ``the 
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'').
    \49\ See D&L Letter.
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    Second, the requirement that a loss occur and be proved similarly 
ensures 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 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.\50\
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    \50\ 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.
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    Third, the final rules require that the insurance product not be 
traded, separately from the insured interest, on an organized market or 
over the counter. As the Commissions observed in the Proposing Release, 
with limited exceptions,\51\ insurance products traditionally have not 
been 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). While 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 all or 
part of swaps and security-based swaps are novated or assigned to third 
parties, usually pursuant to industry standard terms and documents.\52\ 
In response to commenter concerns,\53\ the Commissions are clarifying 
when assignments of insurance contracts and trading on ``insurances 
exchanges'' do not constitute trading the contract separately from the 
related insurable interest, and thus would not violate the Product 
Test. The Commissions do not interpret the assignment of an insurance 
contract as described by commenters \54\

[[Page 48215]]

to be ``trading'' as that term is used in the Product Test.\55\ Nor do 
the Commissions find that the examples of exchanges offered by 
commenters,\56\ such as Federal Patient Protection and Affordable Care 
Act ``exchanges,'' \57\ are exchanges as that term is used in the 
Product Test, e.g., a national securities exchange or designated 
contract market. Mandated insurance exchanges are more like 
marketplaces for the purchase of insurance, and there is no trading of 
insurance policies separately from the insured interest on these 
insurance exchanges. Thus, the assignment of an insurance contract as 
permitted or required by state law, or the purchase or assignment of an 
insurance contract on an insurance exchange or otherwise, does not 
constitute trading an agreement, contract, or transaction separately 
from the insured interest and would not violate the trading restriction 
in the Product Test. For the foregoing reasons as clarified, the 
Commissions continue to 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.
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    \51\ 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).
    \52\ See, e.g., ISDA, 2005 Novation Protocol, available at 
http://www.isda.org/2005novationprot/docs/NovationProtocol.pdf 
(2005); ISDA, ISDA Novation Protocol II, available at http://www.isda.org/isdanovationprotII/docs/NPII.pdf (2005); 2003 
Definitions, Exhibits E (Novation Agreement) and F (Novation 
Confirmation).
    \53\ See infra notes 74 and 75 and accompanying text.
    \54\ See, e.g., Letter from Kim O'Brien, President & CEO, 
National Association for Fixed Annuities (``NAFA''), dated July 21, 
2011 (``NAFA Letter''); Letter from Robert Pickel, Executive Vice 
Chairman, ISDA, dated July 22, 2011 (``ISDA Letter''); ACLI Letter; 
and Letter from Letter from Stephen E. Roth, Frederick R. Bellamy 
and James M. Cain, Sutherland Asbill & Brennan LLP on behalf of the 
Committee of Annuity Insurers (``CAI''), dated July 22, 2011 (``CAI 
Letter'').
    \55\ The assignment of the benefits or proceeds of an insurance 
contract by an owner or beneficiary does not violate the trading 
restriction in the Product Test. This interpretation does not extend 
to ``stranger originated'' products. The transfer of obligations for 
policyholder benefits between two insurance companies, such as would 
occur in connection with an insurance company merger or acquisition, 
also does not violate the trading restriction contained in the 
Product Test.
    \56\ See Letter from Susan E. Voss, Commissioner Iowa Insurance 
Division & National Association of Insurance Commissioners 
(``NAIC'') President, and Therese M. Vaughan, NAIC Chief Executive 
Officer, dated July 22, 2011 (``NAIC Letter'').
    \57\ See Patient Protection and Affordable Care Act; 
Establishment of Exchanges and Qualified Health Plans, 76 FR 41866 
(Jul. 15, 2011) (proposed).
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    Fourth, the final rules provide that in the case of financial 
guaranty insurance policies, also known as bond insurance or bond 
wraps, any acceleration of payment under the policy must be at the sole 
discretion of the provider of the financial guaranty insurance policy 
in order to satisfy the Product Test.\58\ 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.\59\ For example, under a financial guaranty 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 guaranty policy, the indenture, related documentation, and/or 
the financial guaranty 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.\60\
---------------------------------------------------------------------------

    \58\ 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 for Securities Guaranteed by Banks and 
the Use of Insurance Policies to Guarantee Debt Securities'' (Aug. 
28, 1987).
    \59\ See, e.g., Letter from Sean W. McCarthy, Chairman, 
Association of Financial Guaranty Insurers on the ANPR, dated Sept. 
20, 2010 (explaining the differences between financial guaranty 
policies and CDS); Letter from James M. Michener, General Counsel, 
Assured Guaranty on the ANPR, dated Dec. 14, 2010 (noting that the 
Financial Accounting Standards Board has issued separate guidance on 
accounting for financial guaranty insurance and CDS); Letter from 
Ernest C. Goodrich, Jr., Managing Director--Legal Department, 
Deutsche Bank AG on the ANPR, dated Sept. 20, 2010 (noting that 
financial guaranty policies require the incurrence of loss for 
payment, whereas CDS do not).
    \60\ 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.
---------------------------------------------------------------------------

    As noted in the Proposing Release, the Commissions do not believe 
that financial guaranty policies, in general, should be regulated as 
swaps or security-based swaps. However, because of the close economic 
similarity of financial guaranty insurance policies guaranteeing 
payment on debt securities to CDS, in addition to the criteria noted 
above with respect to insurance generally, the final rules require 
that, in order to satisfy the Product Test, financial guaranty policies 
also must 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 further distinguishes financial 
guaranty 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.
    Finally, in response to comments,\61\ the Commissions are 
clarifying that reinsurance and retrocession transactions fall within 
the scope of the Product Test. The Commissions find that these 
transactions have insurable interests, as the Commissions interpret 
such interests in this context, if they have issued insurance policies 
covering the risks that they wish to insure (and reinsure). Moreover, 
the Commissions find that retrocession transactions are encompassed 
within the Product Test and the Provider Test because retrocession is 
reinsurance of reinsurance (provided the retrocession satisfies the 
other requirements of both tests). In addition, reinsurance (including 
retrocession) of certain types of insurance products is included in the 
list of Enumerated Products.\62\
---------------------------------------------------------------------------

    \61\ See infra note 105 and accompanying text.
    \62\ See supra note 41 and accompany text.
---------------------------------------------------------------------------

    Requiring all of the criteria in the Product Test will help to 
limit the application of the final rules to agreements, contracts, and 
transactions that are appropriately regulated as insurance, and help to 
assure that agreements, contracts, and transactions 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 will help prevent the final 
rules from being used to circumvent the applicability of the swap and 
security-based swap regulatory regimes under Title VII.
Enumerated Products
    In the Proposing Release, the Commissions proposed an 
interpretation that certain enumerated types of insurance products 
would be outside the scope of the statutory definitions of swap and 
security-based swap under the Dodd-Frank Act if provided in accordance 
with the Provider Test and regulated as insurance. Based on comments 
received,\63\ the Commissions are adding three products to the list of 
products as proposed (fidelity bonds, disability insurance and 
insurance against default on individual residential mortgages), adding 
reinsurance (including retrocession) of any of the traditional 
insurance products included in the list, deleting a requirement 
applicable to annuities, and codifying the Enumerated Products in the 
final rules. The revised list of Enumerated Products is: Surety bonds, 
fidelity bonds, life insurance, health insurance, long-term

[[Page 48216]]

care insurance, title insurance, property and casualty insurance, 
annuities, disability insurance, insurance against default on 
individual residential mortgages (commonly known as private mortgage 
insurance, as distinguished from financial guaranty of mortgage pools), 
and reinsurance (including retrocession) of any of the foregoing.\64\ 
The Commissions believe that the Enumerated Products, as traditional 
insurance products, are not the types of agreements, contracts, or 
transactions that Congress intended to subject to the regulatory regime 
for swaps and security-based swaps under the Dodd-Frank Act. Codifying 
the Enumerated Products in the final rules appropriately places 
traditional insurance products outside the scope of the swap and 
security-based swap definition so long as such Enumerated Products are 
provided in accordance with the Provider Test, including a requirement 
that an Enumerated Product that is provided in accordance with the 
first prong of the Provider Test must be regulated as insurance under 
applicable state law or the laws of the United States.
---------------------------------------------------------------------------

    \63\ See infra notes 93 and 94 and accompanying text.
    \64\ See supra note 41 and accompanying text.
---------------------------------------------------------------------------

Comments
Insurable Interest
    Six commenters objected to the requirement in the Product Test that 
the beneficiary have an insurable interest continuously throughout the 
duration of the contract.\65\ These commenters noted that, under state 
law, an insurable interest may not always be required to be present 
continuously throughout the duration of the policy. For example, 
commenters noted that life insurance may only require an insurable 
interest at the time the policy is executed; \66\ and some property and 
casualty or liability insurance may only require an insurable interest 
at the time a loss occurs.\67\ Commenters also noted that annuities and 
health insurance do not require the existence of an insurable interest 
at all.\68\ Another commenter suggested that the Commissions modify the 
Product Test to indicate that annuities would not need to satisfy the 
``insurable interest'' component, or to use terminology other than 
insurable interest to make clear that annuities are not swaps.\69\
---------------------------------------------------------------------------

    \65\ See ACLI Letter; CAI Letter; ISDA Letter (objecting to the 
requirement that the risk of loss be held continuously throughout 
the contact); NAFA Letter; NAIC Letter; and Letter from Kenneth F. 
Spence III, Executive Vice President & General Counsel, The 
Travelers Companies, Inc. (``Travelers''), dated Nov. 14, 2011 
(``Travelers Letter'').
    \66\ See ACLI Letter; CAI Letter; ISDA Letter; NAIC Letter; and 
Travelers Letter. The Commissions understand that some states may 
define what constitutes an insurable interest with reference to 
personal or emotional consequence in addition to the financial, 
economic, or commercial consequence mentioned in the statutory swap 
definition.
    \67\ See NAIC Letter and Travelers Letter. However, one 
commenter noted that the Product and Provider Tests, as proposed, 
should be an effective means of helping to distinguish between those 
contracts that qualify for exclusion from the definition of swap and 
security-based swap from those contracts that will not. See Letter 
from Michael A. Bell, Senior Counsel, Financial Policy, The Property 
Casualty Insurers Association of America, dated July 22, 2011.
    \68\ See CAI Letter; ISDA Letter; NAFA Letter; and NAIC Letter.
    \69\ See Letter from Nicholas D. Latrenta, Executive Vice 
President and General Counsel, Metropolitan Life Insurance Companies 
and its insurance affiliates (``MetLife''), dated July 22, 2011 
(``MetLife Letter'').
---------------------------------------------------------------------------

    As discussed above, the Commissions are retaining the insurable 
interest requirement of the Product Test. The Commissions continue to 
believe that this requirement is a useful tool to distinguish insurance 
from swaps and security-based swaps, because swaps and security-based 
swaps do not require the presence of an insurable interest (or require 
either counterparty to bear any risk of loss) at any time during the 
term of the agreement, contract, or transaction. While the Commissions 
acknowledge commenters who argued that products such as life insurance, 
property and casualty insurance, and annuities may fail the Product 
Test because of the insurable interest requirement, the Commissions do 
not interpret any such failure to mean that life insurance, property 
and casualty insurance, and annuities are not insurance products. To 
the contrary, as discussed above, these products are included in the 
list of Enumerated Products that are excluded from the swap and 
security-based swap definitions so long as they are provided in 
accordance with the Provider Test. If a life insurance, property and 
casualty insurance, or annuity is provided in accordance with the 
Provider Test, such product is not a swap or security-based swap, 
whether or not an insurable interest is present at all times during the 
term of the contract.
Indemnification for Loss
    Five commenters objected to the requirement in the Product Test 
that a loss occur and be proven, and that any payment be limited to the 
value of the insurable interest, because payment under many insurance 
products may not be directly based upon actual losses incurred.\70\ Two 
commenters argued that annuities do not provide indemnification for 
loss and that life insurance products are not constrained by the value 
of the insurable interest.\71\ Another argued that many insurance 
policies pay fixed amounts upon the occurrence of a loss without a 
requirement that the loss be tied to the value of an insurable 
interest.\72\ Disability insurance and long-term care insurance are 
other products that commenters indicate would not be able to satisfy 
this requirement of the Product Test.\73\
---------------------------------------------------------------------------

    \70\ See ACLI Letter; CAI Letter; ISDA Letter; NAFA Letter; and 
Travelers Letter.
    \71\ See ACLI Letter and Travelers Letter.
    \72\ See Travelers Letter.
    \73\ See, e.g., ACLI Letter and CAI Letter.
---------------------------------------------------------------------------

    As discussed above, the Commissions are retaining the requirement 
in the Product Test that a loss occur and be proven and that any 
payment for such loss be limited to the value of the insurable 
interest. The Commissions continue to believe that this requirement is 
a useful tool to distinguish insurance from swaps and security-based 
swaps, because payments under swaps and security-based swaps may be 
required when neither party incurs a loss, nor is the amount of payment 
limited by any such loss. While the Commissions acknowledge commenters 
who identified various products that may fail this part of the Product 
Test, the Commissions do not interpret any such failure to mean that 
products such as annuities, disability insurance, and long-term care 
insurance are not insurance products. To the contrary, as discussed 
above, these products are included in the list of Enumerated Products 
that are excluded from the swap and security-based swap definitions so 
long as they are provided in accordance with the Provider Test. If 
long-term care insurance, disability insurance, or an annuity is 
provided in accordance with the Provider Test, such product is not a 
swap or a security-based swap, whether or not a loss occurs, is proven, 
or indemnification for loss is limited to the value of the insurable 
interest.
Not Traded Separately
    Six commenters stated that the proposed requirement that the 
agreement, contract, or transaction not be traded, separately from the 
insured interest, on an organized market or over the counter, is not an 
effective criterion in determining whether a product is insurance.\74\ 
According to commenters, this criterion is ineffective and should be 
deleted from the Product Test because many conventional insurance

[[Page 48217]]

products, such as annuities, are assignable (and therefore tradable), 
which may violate the trading restriction.\75\ Two commenters observed 
that the trading of insurance policies has already occurred and is 
expected to increase.\76\ One commenter stated that a number of states 
have ``insurance exchanges'' that sell reinsurance and excess or 
surplus lines, and that the Patient Protection and Affordable Care Act 
requires states or the Federal government to establish health benefit 
``insurance exchanges'' through which insurers will sell health 
insurance to individuals and small groups.\77\ One commenter 
recommended that the trading restriction apply only to trading by the 
policyholder or beneficiary of an insurance policy.\78\
---------------------------------------------------------------------------

    \74\ See ACLI Letter; Letter from Chris Barnard (``Barnard''), 
dated June 28, 2011 (``Barnard Letter''); CAI Letter; NAFA Letter; 
NAIC Letter; and ISDA Letter.
    \75\ Id. ACLI stated that many conventional insurance products, 
particularly annuities, can be assigned by the owner, and often 
state insurance law requires such assignability as a condition for 
approval of the product for sale under applicable insurance law. 
ACLI also stated that insurance policies are frequently assigned 
among family members, to third parties as collateral for loans, and 
in a host of other situations, and does not believe that these 
common kinds of assignment should cause an insurance product to be 
characterized as a swap.
    \76\ See Barnard Letter and NAIC Letter.
    \77\ See NAIC Letter. The commenter explained that the 
``insurance exchanges'' mandated by the Patient Protection and 
Affordable Care Act would be marketplaces for insurance policies. 
The commenter described them as ``cooperatives'' where people could 
go to buy insurance policies with standardized terms/actuaries. The 
commenter noted that the insurable interest would not ``trade'' 
separately from the insurance policy in these cooperatives.
    \78\ See Travelers Letter.
---------------------------------------------------------------------------

    The Commissions are retaining the requirement in the Product Test 
that the agreement, contract, or transaction not be traded separately 
from the insured interest, on an organized market or over the counter, 
and as discussed above have provided a clarification regarding 
assignments and trading on insurance exchanges. The Commissions 
continue to believe that using this criterion is an effective way to 
distinguish insurance from swaps and security-based swaps because swaps 
and security-based swaps are traded on organized markets and over the 
counter.
    As stated above, the Commissions do not interpret the assignment of 
an insurance contract as described by commenters to be ``trading'' as 
that term is used in the Product Test.\79\ Nor do the Commissions find 
that the examples of exchanges offered by commenters, such as Federal 
Patient Protection and Affordable Care Act ``exchanges,'' are exchanges 
as that term is used in the Product Test, e.g., a national securities 
exchange or designated contract market.\80\ Mandated insurance 
exchanges are more like marketplaces for the purchase of insurance, and 
there is no trading of insurance policies separately from the insured 
interest on these insurance exchanges. Thus, the assignment of an 
insurance contract as permitted or required by state law, or the 
purchase or assignment of an insurance contract on an insurance 
exchange or otherwise, does not constitute trading an agreement, 
contract, or transaction separately from the insured interest and would 
not violate the trading restriction in the Product Test.
---------------------------------------------------------------------------

    \79\ See supra notes 54 and 55.
    \80\ See supra notes 56 and 57.
---------------------------------------------------------------------------

Acceleration
    Three commenters believed that the proposed requirement that, in 
the event of payment default or insolvency of the obligor, any 
acceleration of payments under a financial guaranty insurance policy be 
at the sole discretion of the insurer, is not an effective criterion in 
determining whether financial guaranty insurance falls outside the swap 
and security-based swap definitions and should be deleted from the 
Product Test.\81\ However, one commenter supported its inclusion, 
observing that the proposed requirement is ``firmly based on 
substantive business realities.'' \82\ Two commenters believed that the 
acceleration of payments requirement is not useful in distinguishing 
between financial guaranty insurance and swaps or security-based swaps 
because it is designed to protect financial guaranty insurers from 
insolvency.\83\ They noted that the criterion is a regulatory 
requirement imposed by state insurance commissioners that is subject to 
change, and that a state could not change this regulatory requirement 
without converting the financial guaranty policy into a swap or 
security-based swap.\84\ One commenter stated that the acceleration of 
payments criterion has been the subject of significant analysis and 
interpretation by state insurance regulators, and including the 
requirement in the rules could result in conflicting interpretations 
and additional legal uncertainty.\85\ This commenter also stated that 
this uncertainty will impose significant burdens on financial guaranty 
insurers that insure municipal bonds.\86\
---------------------------------------------------------------------------

    \81\ See Letter from Bruce E. Stern, Chairman, Association of 
Financial Guaranty Insurers (``AFGI''), dated July 20, 2011 (``AFGI 
Letter''); ISDA Letter; and Letter from Kimberly M. Welsh, Vice 
President and Assistant General Counsel, Reinsurance Association of 
America (``RAA''), dated July 22, 2011 (``RAA Letter'').
    \82\ See Letter from Dennis M. Kelleher, President & CEO, Better 
Markets Inc., dated July 22, 2011 (``Better Markets Letter'').
    \83\ See ISDA Letter and RAA Letter.
    \84\ Id.
    \85\ See AFGI Letter.
    \86\ Id. The commenter argued that these burdens would (a) 
increase instability in the currently fragile municipal bond market 
and (b) decrease the availability or attractiveness of bond 
insurance to municipal issuers that would otherwise save money by 
employing bond insurance. The Commissions understand that only one 
member of AFGI is currently active in the municipal bond insurance 
market.
---------------------------------------------------------------------------

    The Commissions are retaining the requirement that acceleration be 
at the sole option of the provider of the financial guaranty insurance 
policy in the Product Test. In response to commenter concerns, the 
Commissions are clarifying that they plan to interpret the acceleration 
limitation in accordance with applicable state law to the extent that 
it does not contradict the Commissions' rules, interpretations and/or 
guidance regarding what is a swap or security-based swap.\87\ The 
Commissions continue to believe that, for purposes of further defining 
swaps and security-based swaps, this criterion is useful to distinguish 
between financial guaranty insurance on the one hand, and swaps and 
security-based swaps, such as CDS, on the other because, as discussed 
above, the latter generally requires payment of the relevant settlement 
amount on the CDS after demand by the protection buyer.
---------------------------------------------------------------------------

    \87\ One commenter noted that ``financial guarantors, for some 
time and in full compliance with state insurance laws, have issued 
insurance policies that contemplate acceleration upon events 
unrelated to an issuer default, e.g., upon the downgrade of the 
insurer.'' See AFGI Letter. In response to this comment, the 
Commissions note that the acceleration requirement in the Product 
Test refers only to ``payment default or insolvency of the obligor'' 
(emphasis added), without precluding other triggers.
---------------------------------------------------------------------------

Enumerated Products
    The Commissions proposed an interpretation that certain enumerated 
types of insurance products would be outside the scope of the statutory 
definitions of swap and security-based swap. Several commenters stated 
that the list of enumerated insurance products should be codified in 
order to enhance legal certainty.\88\ In particular, one commenter 
stated that it is important for the Commissions to codify the 
interpretation because the traditional insurance products included in 
the enumerated list may not satisfy the Product Test.\89\ The commenter 
also expressed concern that insurance companies and state insurance

[[Page 48218]]

regulators would face the possibility that the Commissions could revise 
or withdraw the interpretation in the future, with or without 
undergoing a formal rulemaking process.\90\ As noted above, in response 
to commenters' concerns, the Commissions are codifying the Enumerated 
Products in the final rules.
---------------------------------------------------------------------------

    \88\ See ACLI Letter; NAIC Letter; RAA Letter; AIA Letter; NAFA 
Letter; and Letter from Mark R. Thresher, Executive Vice President, 
Nationwide, dated July 19, 2011 (``Nationwide Letter'').
    \89\ See Travelers Letter.
    \90\ Id.
---------------------------------------------------------------------------

    One commenter further argued that the enumerated types of insurance 
products included in the list should not have to additionally satisfy 
the requirements that the person offering such product be a U.S. 
domiciled insurer and that the product be regulated in the U.S. as 
insurance.\91\ The commenter argued that this additional requirement 
would result in the Insurance Safe Harbor not applying to traditional 
insurance products offered by insurers domiciled outside of the U.S. or 
by insurers that are not organized as insurance companies. The 
Commissions are retaining the requirement that the Enumerated Products 
be provided in accordance with the Provider Test. The Commissions also 
note that, in response to commenters' concerns, the Commissions have 
revised the first prong of the Provider Test so that it is not limited 
to insurance companies or to entities that are domiciled in the U.S. A 
product that need not satisfy the Product Test must be provided in 
accordance with the Provider Test, including a requirement that 
products provided in accordance with the first prong of the Provider 
Test must be regulated as insurance.\92\
---------------------------------------------------------------------------

    \91\ See D&L Letter.
    \92\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------

    Five commenters addressed the treatment of annuities in the 
proposed interpretive guidance, with all recommending that all 
annuities be excluded from the swap and security-based definitions 
regardless of their status under the tax laws.\93\ In response to the 
comments, the Commissions are eliminating the proposed requirement that 
annuities comply with section 72 of the Internal Revenue Code in order 
to qualify as an Enumerated Product. The Commissions are persuaded that 
the proposed reference to the Internal Revenue Code is unnecessarily 
limiting and does not help to distinguish insurance from swaps and 
security-based swaps.
---------------------------------------------------------------------------

    \93\ See ACLI Letter; CAI Letter; MetLife Letter; Nationwide 
Letter; and RAA Letter.
---------------------------------------------------------------------------

    Other commenters suggested adding other products to the list of 
enumerated types of insurance products,\94\ with one suggesting that 
the Commissions' interpretation cover all transactions currently 
reportable as insurance in the provider's regulatory and financial 
reports under a state's or a foreign jurisdiction's insurance laws.\95\ 
One commenter noted that the list of enumerated types of insurance 
products does not include other state-regulated products such as 
service contracts, that may not satisfy the Product Test.\96\ In 
response to requests to expand the list of enumerated products, the 
Commissions are adding fidelity bonds,\97\ disability insurance, and 
insurance against default on individual residential mortgages (commonly 
known as private mortgage insurance, as distinguished from financial 
guaranty of mortgage pools) to the list of Enumerated Products. The 
Commissions agree that these are traditional insurance products, and 
thus their inclusion in the list of Enumerated Products is appropriate. 
The Commissions have also added reinsurance (including retrocession) of 
any of the traditional insurance products to the list of Enumerated 
Products.\98\ However, the Commissions decline at this time to expand 
the list of Enumerated Products to include other types of contracts 
such as, guaranteed investment contracts (``GICs''), synthetic GICs, 
funding agreements, structured settlements, deposit administration 
contracts, immediate participation guaranty contracts, industry loss 
warrants, and catastrophe bonds.\99\ These products do not receive the 
benefit of state insurance guaranty funds; their providers are not 
limited to insurance companies. The Commissions received little detail 
on sales of these other products, and do not believe it is appropriate 
to determine whether particular complex, novel or still evolving 
products are swaps or security-based swaps in the context of a general 
definitional rulemaking. Rather these products should be considered in 
a facts and circumstances analysis. With respect to GICs, the 
Commissions have published a request for comment regarding the study of 
stable value contracts. \100\
---------------------------------------------------------------------------

    \94\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; NAIC 
Letter; Letter from Michael A. Bell, Senior Counsel, Financial 
Policy, RAA Letter; and Letter from Robert J. Duke, The Surety & 
Fidelity Association of America (``SFAA''), dated July 13, 2011 
(``SFAA Letter''). ACLI, CAI and RAA requested the addition of other 
types of annuity and pension plan products, such as group annuity 
contracts, guaranteed investment contracts, funding agreements, 
structured settlements, deposit administration contracts, and 
immediate participation guarantee contracts. D&L requested the 
addition of reinsurance of any of the enumerated types of 
traditional insurance products. NAIC requested the addition of 
mortgage guaranty, accident, and disability insurance. SFAA request 
the addition of surety and fidelity bonds.
    \95\ See Letter from J. Stephen Zielezienski, Senior Vice 
President & General Counsel, American Insurance Association 
(``AIA''), dated July 22, 2011 (``AIA Letter'').
    \96\ See NAIC Letter. The Commissions note that service 
contracts, although regulated as insurance in some states, comprise 
consumer warranties, extended service plans, and buyer protection 
plans of the sort purchased with major appliances, electronics, and 
the like. The Commissions are addressing these contracts in their 
interpretation regarding consumer/commercial transactions. See infra 
part II.B.3.
    \97\ SFAA requested that the Commissions issue specific guidance 
that surety and fidelity bonds are insurance products rather than 
swaps, noting that all states include surety and fidelity bonds as 
lines of insurance subject to state oversight. Surety bonds were 
already included in the list of enumerated insurance products 
contained in the Proposing Release.
    \98\ See supra note 41 and accompanying text.
    \99\ See, e.g., RAA Letter; CAI Letter; Letter from Ian K. 
Shepherd, Managing Director, Alice Corp. Pty Ltd (``Alice Corp.''), 
dated July 22, 2011. Alice Corp. stated that industry loss warrants 
are a contingent instrument with a somewhat illiquid secondary 
market but ``are currently treated as a reinsurance product and 
require an insurable interest.'' Alice Corp. also stated that 
``[c]atastrophe bonds may reference a specific insured portfolio or 
a set of parameters and may be traded in a secondary market and 
behave like a coupon bond if there is no triggering event but have a 
contingent element since some or all of the principal may be lost if 
the referenced event or loss occurs.'' Id. The Commissions note that 
catastrophe bonds are ``securities'' under the Federal securities 
laws and decline to provide an interpretation regarding industry 
loss warrants because it is inappropriate to determine whether a 
complex and novel product is a swap or a security-based swap in a 
general definitional rulemaking.
    \100\ See Acceptance of Public Submissions Regarding the Study 
of Stable Value Contracts, 76 FR 53162 (Aug. 25, 2011).
---------------------------------------------------------------------------

Reliance on State Law Concepts
    Two commenters noted that the Product Test relies on concepts 
derived from state law, such as ``insurable interest'' and 
``indemnification for loss,'' which do not have uniform 
definitions.\101\ This would require the

[[Page 48219]]

Commissions to analyze state insurance law, as well as to determine 
which state law should apply.\102\ One of these commenters also 
requested that such concepts be applied consistently with the 
historical interpretation by the applicable state.\103\
---------------------------------------------------------------------------

    \101\ See ACLI Letter and AFGI Letter. Some states define 
concepts such as ``insurable interest'' in statute; in other states 
definitions have developed through common law. The Commissions 
recognize that the terms denoting such concepts may vary from state 
to state; for instance, what one state calls an ``insurable 
interest'' may be referred to as a ``material interest'' in another. 
See, e.g., New York Insurance Law Section 1101 (``material 
interest''). The Commissions believe, however, that both the 
concepts and their labels are well understood by insurance 
professionals and that any such variations would not impede market 
participants from interpreting or applying the final rules. Indeed, 
one commenter acknowledged this and applied the concepts, labeled 
differently, to particular products. ``The terms used in the rule's 
criteria are different from the terms used with respect to a surety 
bond. For example, the bond is generally not referred to as a 
`policy.' In addition, the beneficiary of a bond typically is known 
as the `obligee.' Further, the bond's limit is referred to as the 
`penal sum.' Nevertheless, the criteria can be applied to surety 
bonds and fidelity bonds, and such application would exclude bonds 
from the statutory definition of swaps.'' See SFAA Letter.
    \102\ See ACLI Letter and AFGI Letter.
    \103\ See AFGI Letter.
---------------------------------------------------------------------------

    State law differences regarding these concepts should not impede 
the ability of market participants from interpreting or applying the 
final rules to distinguishing between insurance and swaps or security-
based swaps, and thus the Commissions are retaining these concepts in 
the Product Test. The Commissions intend to interpret these concepts 
consistently with the existing and developing laws of the relevant 
state(s) governing the agreement, contract, or transaction in question. 
However, the Commissions note their authority to diverge from state law 
if the Commissions become aware of evasive conduct.\104\
---------------------------------------------------------------------------

    \104\ The Commissions may also diverge from interpretations or 
determinations of state law based on an analysis of applicable facts 
and circumstances when determining whether a particular product is a 
swap or security-based swap.
---------------------------------------------------------------------------

Inclusion of Reinsurance and Retrocession Transactions
    Several commenters suggested that the Commissions amend the Product 
Test to explicitly address reinsurance and retrocession (i.e., 
reinsurance of reinsurance) transactions.\105\
---------------------------------------------------------------------------

    \105\ See ACLI Letter; CAI Letter; D&L Letter; ISDA Letter; NAFA 
Letter; Nationwide Letter; and RAA Letter. ACLI noted that the 
Product Test does not include a reference to reinsurance and that 
the ``insurable interest'' requirement under state insurance law 
generally does not apply to reinsurance products which, therefore, 
would not satisfy the Product Test. ACLI and CAI state that 
reinsurance in a chain of reinsurance also should not be considered 
a swap or security-based swap. In addition to expressly referencing 
reinsurance and retrocession transactions, ACLI believes that the 
Product Test should be expanded to include reinsurance and 
retrocession of insurance risks ceded by non-U.S. insurance 
companies to domestic insurance companies. RAA recommended adding a 
new clause to the Product Test to provide that ``[a]ny agreement, 
contract, or transaction which reinsures any agreement, contract, or 
transaction meeting the criteria of paragraph (xxx)(4)(i)(A)-(C) of 
this section is also an insurance product.''
---------------------------------------------------------------------------

    In response to these comments, the Commissions are clarifying that 
reinsurance and retrocession transactions may fall within the Insurance 
Safe Harbor, thus, it is unnecessary for the Product Test to be 
modified as suggested by these commenters. In addition, the Commissions 
have modified the final rules to include reinsurance (including 
retrocession) of certain types of insurance products in the list of 
Enumerated Products. Reinsurance or retrocession of these Enumerated 
Products will fall within the Insurance Safe Harbor so long as such 
reinsurance or retrocession is provided in accordance with the Provider 
Test.\106\
---------------------------------------------------------------------------

    \106\ See supra note 41 and accompanying text.
---------------------------------------------------------------------------

Payment Based on the Price, Rate, or Level of a Financial Instrument
    In the Proposing Release, the Commissions requested comment on 
whether, in order for an agreement, contract, or transaction to be 
considered insurance under the Product Test, 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. The 
Commissions also requested comment on whether variable annuity 
contracts (where the income is subject to tax treatment under section 
72 of the Internal Revenue Code) and variable life insurance should be 
excepted from such a requirement, if adopted.\107\
---------------------------------------------------------------------------

    \107\ See Proposing Release at 29824. See also id. at 29825, 
Request for Comment 7.
---------------------------------------------------------------------------

    Eight commenters stated that it is inappropriate to include such a 
requirement in the final rules because a number of traditional 
insurance products would not satisfy the requirement and suggested that 
the Commissions should instead consider whether the agreement, 
contract, or transaction transfers risk and argued that such a 
requirement is not a useful marker for distinguishing insurance from 
swaps and security-based swaps.\108\ Several commenters also believed 
that the addition to the Product Test of the criterion that payment not 
be based on the price, rate, or level of a financial instrument, asset, 
or interest or any commodity would contribute to greater legal 
uncertainty.\109\
---------------------------------------------------------------------------

    \108\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter; ISDA 
Letter; NAFA Letter; NAIC Letter; and Nationwide Letter (concurring 
with ACLI's comments).
    Commenters cited several examples of products that would fail a 
requirement that payment not be based on the price, rate, or level 
of a financial instrument, asset, or interest or any commodity. 
ACLI, CAI and NAFA cited registered and unregistered variable 
annuities and variable life insurance, and certain fixed annuities 
and equity indexed annuities, stating that these could be construed 
as being based on, or related to, a price, rate or level of a 
financial asset. ACLI also cited financial guaranty insurance, and 
replacement value property and casualty insurance, where the 
insurer's payment obligation may be based on the current price of 
the insured property or adjusted to reflect inflation. ACLI and ISDA 
cited crop insurance, because it could call for payment to be based 
in some way on the market price of the covered crop on the date of 
loss. ISDA and RAA cited ``dual trigger'' insurance (such as 
replacement power insurance); property and casualty policies 
purchased by some commodity producers (e.g., oil refineries, copper 
mines) with deductibles that increase or decrease based on the price 
of the commodity that the company produces; event cancellation 
insurance that uses commodity indices to determine claims; and 
weather insurance and malpractice insurance. NAIC cited guaranteed 
investment contracts, financial guaranty insurance, and mortgage 
guaranty insurance
    \109\ See AIA Letter and AFGI Letter.
---------------------------------------------------------------------------

    Two commenters agreed that such a requirement should be included in 
the final rules.\110\ One commenter argued that any insurance 
instrument that provides for payment based on the price, rate, or level 
of a financial instrument, asset, or interest in any commodity is in 
substance a swap or security-based, regardless of its label, and should 
be regulated as such.\111\ One of these commenters further recommended 
that the Commissions exclude annuity and variable universal life 
insurance from this requirement because these products were investments 
with some minimal level of life insurance cover or investment guarantee 
rider on top.\112\
---------------------------------------------------------------------------

    \110\ See Barnard Letter and Better Markets Letter.
    \111\ See Better Markets Letter.
    \112\ See Barnard Letter.
---------------------------------------------------------------------------

    The Commissions are not adopting an additional requirement for the 
Product Test that payment not be based on the price, rate, or level of 
a financial instrument, asset, or interest or any commodity because the 
Commissions find the requirement to be unsuitable for distinguishing 
insurance from swaps and security-based swaps. While the provision 
might work for property and casualty insurance, as many commenters 
noted, it is not an effective distinction for a number of other 
traditional insurance products.
Accounting Standards
    In the Proposing Release, the Commissions requested comment on 
whether the proposed rules relating to insurance should 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.\113\
---------------------------------------------------------------------------

    \113\ See Proposing Release at 29827, Request for Comment 17.
---------------------------------------------------------------------------

    Three commenters argued that the proposed rules should not include 
a provision that an insurance product is recognized at fair value under 
generally accepted accounting principles.\114\ One commenter argued 
that the determinants of what is an insurance product should be the 
existence of an insurable interest, transfer of risk, and 
indemnification of covered loss.\115\ Another argued that factoring 
accounting standards into the analysis of whether a product is a swap

[[Page 48220]]

or insurance will introduce unnecessary complexity in most cases but 
that the examination of accounting standards would be useful in cases 
where the classification of a product as insurance or swap is 
unclear.\116\
---------------------------------------------------------------------------

    \114\ See AFGI Letter; D&L Letter; and ISDA Letter.
    \115\ See D&L Letter.
    \116\ See ISDA Letter.
---------------------------------------------------------------------------

    After considering these comments, the Commissions are not including 
a reference to accounting standards in the Product Test.
(b) Providers of Insurance Products
    Under the first prong of the Provider Test, the agreement, 
contract, or transaction must be provided by a person that is subject 
to supervision by the insurance commissioner (or similar official or 
agency) of any state\117\ or by the United States.\118\ In addition, 
such agreement, contract, or transaction also must be regulated as 
insurance under applicable state law\119\ or the laws of the United 
States.
---------------------------------------------------------------------------

    \117\ See supra note 32, regarding the definition of ``State'' 
contained in the Proposing Release.
    \118\ This requirement in the final rules is substantially 
similar to the requirement included in section 3(a)(8) of the 
Securities Act, 15 U.S.C. 77c(a)(8).
    \119\ See supra note 34.
---------------------------------------------------------------------------

    The Commissions have revised the first prong of the Provider Test 
from the proposal. As proposed, the first prong of the Provider Test 
could only be satisfied by a company that was organized as an insurance 
company whose primary and predominant business activity was the writing 
of insurance or the reinsuring of risks underwritten by insurance 
companies.\120\ The Commissions have revised this prong of the Provider 
Test to address commenters' concerns that the proposed rules would 
exclude insurers that were not organized as ``insurance companies,'' as 
well as insurers that were domiciled outside of the United States.\121\ 
As adopted, the first prong of the Provider Test can be satisfied by 
any person that is subject to state or Federal insurance supervision, 
regardless of that person's corporate structure or domicile. The 
Commissions understand that, with the exception of non-admitted 
insurers,\122\ foreign insurers are subject to supervision in the 
states in which they offer insurance products. The treatment of non-
admitted insurers is addressed in the fourth prong of the Provider 
Test.
---------------------------------------------------------------------------

    \120\ See Proposing Release at 29824.
    \121\ See infra notes 139, 140, and 141 and accompanying text.
    \122\ The Commissions understand that the surplus lines brokers 
who place insurance on behalf of non-admitted insurers are subject 
to supervision in the states in which they offer non-admitted 
insurance products.
---------------------------------------------------------------------------

    The Commissions believe that the requirement that the agreement, 
contract, or transaction be provided by a person that is subject to 
state or Federal insurance supervision should help prevent regulatory 
gaps that otherwise might exist between insurance regulation and the 
regulation of swaps and security-based swaps by ensuring that products 
provided by persons that are not subject to state or Federal insurance 
supervision are not able to be offered by persons that avoid regulation 
under Title VII of the Dodd-Frank Act as well.
    The first prong of the Provider Test also requires that the 
agreement, contract, or transaction being provided is ``regulated as 
insurance'' under applicable state law or the laws of the United 
States. As stated in the Proposing Release, the purpose of this 
requirement is that an agreement, contract, or transaction that 
satisfies the other conditions of the final rules must be subject to 
regulatory oversight as an insurance product. The Commissions believe 
that this condition will help prevent products that are not regulated 
as insurance in the states in which they are offered, and 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. As noted by commenters,\123\ the Commissions recognize 
that the ``regulated as insurance'' limitation means that it is 
possible that a particular product that may not be regulated as 
insurance in a particular state may not qualify for the Insurance Safe 
Harbor.\124\
---------------------------------------------------------------------------

    \123\ See infra notes 145 and 146 and accompanying text.
    \124\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions believe that it 
is appropriate to exclude, from regulation under Title VII, 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.\125\ Such 
insurance includes, for example, Federal insurance of funds held in 
banks, savings associations, and credit unions; catastrophic crop 
insurance; flood insurance; Federal insurance of certain pension 
obligations; and terrorism risk insurance. At the request of 
commenters,\126\ the Commissions are persuaded that it is also 
appropriate to provide a similar exclusion to insurance that is issued 
by a state or any of its agencies or instrumentalities, or pursuant to 
a statutorily authorized program thereof. Accordingly, the Commissions 
have revised the second prong of the Provider Test to provide that 
products meeting the Product Test are excluded from the swap and 
security-based swap definitions if they are provided (i) directly or 
indirectly by the Federal government or a state or (ii) pursuant to a 
statutorily authorized program of either.\127\
---------------------------------------------------------------------------

    \125\ See Proposing Release at 29824.
    \126\ See Ex Parte Communication between NAIC and CFTC and SEC 
Staff on October 5, 2011, at http://sec.gov/comments/s7-16-11/s71611-61.pdf.
    \127\ The Commissions understand that certain types of Federal 
and State insurance programs, including crop insurance, are 
administered by third parties; as a result, the Commissions have 
added ``directly or indirectly'' to the second prong of the Provider 
Test to clarify that it can be satisfied even if the agreement, 
contract, or transaction is not provided directly by the federal 
government or a state. See Id.
---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions believe that 
where an agreement, contract, or transaction qualifies for the safe 
harbor and therefore is considered insurance excluded from the swap and 
security-based swap definitions, the lawful reinsurance of that 
agreement, contract, or transaction similarly should be excluded.\128\ 
Accordingly, the Commissions are adopting the third prong of the 
Provider Test as proposed, with certain modifications, to provide that 
an agreement, contract, or transaction of reinsurance will be excluded 
from the swap and security-based swap definitions, provided that: (i) 
The person offering such reinsurance is not prohibited by applicable 
state law or the laws of the United States from offering such 
reinsurance to a person that satisfies the Provider Test; (ii) the 
agreement, contract, or transaction to be reinsured meets the 
requirements under the Product Test or is one of the Enumerated 
Products; and (iii) except as otherwise permitted under applicable 
state law, the total amount reimbursable by all reinsurers for such 
insurance product cannot exceed the claims or losses paid by the 
cedant.
---------------------------------------------------------------------------

    \128\ See Proposing Release at 29825.
---------------------------------------------------------------------------

    In response to commenters' concerns,\129\ the Commissions have 
revised the third prong of the Provider Test from that contained in the 
Proposing Release. As adopted, the third prong of the Provider Test 
encompasses all reinsurers wherever incorporated or organized, and not 
just those based outside of the United States. The Commissions also 
have revised the third prong of the Provider Test to clarify that the 
total amount reimbursable by all reinsurers may not exceed the claims 
or losses paid by the cedant, unless otherwise permitted by applicable 
state law. It is not the Commissions' intent to

[[Page 48221]]

impose requirements that conflict with state law regarding the 
calculation of amounts reimbursable under reinsurance contracts.
---------------------------------------------------------------------------

    \129\ See infra notes 150, 151, 152, and 153 and accompanying 
text.
---------------------------------------------------------------------------

    The Commissions have added a fourth prong to the Provider Test to 
address commenters' concerns that the proposed Provider Test excluded 
entities issuing insurance products on a non-admitted basis through 
surplus lines brokers.\130\ Non-admitted insurance is typically 
property and casualty insurance that is permitted to be placed through 
a surplus lines broker \131\ by an insurer that is not licensed to do 
business in the state where the product is offered.\132\ In practice, a 
provider of non-admitted insurance may not satisfy the first prong of 
the Provider Test because it may not be subject to state or Federal 
insurance supervision. The Commissions understand that non-admitted 
insurance plays a very important role in the insurance marketplace. In 
addition, Congress has explicitly recognized non-admitted insurance 
products as insurance and specified that a state cannot prohibit 
certain types of entities from offering non-admitted insurance 
products.\133\ Because Congress recognized that certain persons qualify 
as non-admitted insurers, the Commissions find that it is appropriate 
to add the fourth prong to the Provider Test.
---------------------------------------------------------------------------

    \130\ See infra note 146 and accompanying text.
    \131\ For the purposes of this release, the term ``surplus lines 
broker'' means an individual, firm, or corporation that is licensed 
in a state to sell, solicit, or negotiate insurance on properties, 
risks, or exposures located or to be performed in a state with non-
admitted insurers.
    \132\ See supra note 39. With respect to domestic reinsurance, 
state insurance regulators do retain the authority to prevent or 
allow a non-admitted company from participating in a state market. 
Some states compile a list of companies that may sell as non-
admitteds; other states list non-admitted companies that may not 
sell.
    \133\ See Subtitle B of Title V of the Dodd-Frank Act.
---------------------------------------------------------------------------

    A person will qualify under the fourth prong of the Provider Test 
if it satisfies any one of the following two requirements:
     It is located outside of the United States and listed on 
the Quarterly Listing of Alien Insurers that is compiled and maintained 
by the International Insurers Department of the National Association of 
Insurance Commissioners;\134\ or
---------------------------------------------------------------------------

    \134\ Section 524 of the Nonadmitted and Reinsurance Reform Act 
of 2010 (15 U.S.C. 8204) provides that a state cannot prohibit a 
surplus lines broker from placing non-admitted insurance with a non-
admitted insurer that is listed on the Quarterly Listing of Alien 
Insurers. According to the NAIC the non-admitted alien insurers 
whose names appear in the Quarterly Listing of Alien Insurers have 
filed financial statements, copies of auditors' reports, the names 
of their U.S. attorneys or other representatives, and details of 
U.S. trust accounts with the NAIC's International Insurers 
Department and, based upon those documents and other information, 
appear to fulfill the criteria set forth in the International 
Insurers Department Plan of Operation for Listing of Alien 
Nonadmitted Insurers.
---------------------------------------------------------------------------

     It meets the eligibility criteria for non-admitted 
insurers under applicable state law.
Comments
General
    The Commissions received ten comment letters that addressed the 
Provider Test.\135\ A few commenters recommended that the Commissions 
retract the Provider Test.\136\ These commenters argued that if a 
product is subject to regulation as insurance in the United States, the 
regulated status of the insurer is irrelevant.\137\ The Commissions are 
retaining the Provider Test with modifications as discussed above. The 
Commissions believe that insurance products should fall outside the 
swap or security-based swap definitions only if they are offered by 
persons subject to state or Federal insurance supervision or by certain 
reinsurers.\138\ The Provider Test will help to prevent products that 
are swaps or security-based swaps from being characterized as insurance 
in order to evade the regulatory regime under Title VII of the Dodd-
Frank Act. Other commenters suggested various modifications to the 
Provider Test and those comments are discussed in more detail below.
---------------------------------------------------------------------------

    \135\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; ISDA 
Letter; NAIC Letter; NAFA Letter; Nationwide Letter; RAA Letter; and 
Travelers Letter.
    \136\ See AIA Letter; D&L Letter; and ISDA Letter.
    \137\ Id.
    \138\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------

``Insurance Company'' Limitation
    Several commenters recommended that the Commissions expand the 
first prong of the Provider Test so that it is not limited to 
``insurance companies,'' but to all insurers because not all insurers 
are organized as ``insurance companies,''\139\ to accommodate insurers 
and reinsurers that are domiciled outside of the United States,\140\ 
and to cover domestic and foreign insurance companies and other 
entities that issue insurance products on a non-admitted basis through 
surplus lines brokers.\141\
---------------------------------------------------------------------------

    \139\ See AIA Letter; D&L Letter; ISDA Letter; RAA Letter; NAIC 
Letter; and Travelers Letter.
    \140\ See AIA Letter; D&L Letter; RAA Letter; and Travelers 
Letter.
    \141\ See RAA Letter and Travelers Letter.
---------------------------------------------------------------------------

    The Commissions have revised the first prong of the Provider Test 
to remove the ``insurance company'' limitation and to clarify that any 
person that is subject to state or Federal insurance supervision will 
qualify under the first prong of the Provider Test. As noted above, the 
Commissions also believe that this revision should address commenters' 
concerns that the proposed rules could have excluded some foreign 
insurers since the revised test does not require that a person be 
domiciled in the United States; it only requires that the person be 
subject to state or Federal insurance supervision.
    Several commenters suggested that the proposed Provider Test would 
permit an insurer that is not organized as an insurance company to 
evade state insurance oversight by deliberately failing the exemption 
for insurance products (that is, by issuing a contract that would fail 
the proposed rules because it would not be issued by an insurance 
company).\142\ These commenters were concerned that if a product were 
to be considered a swap merely because it was not issued by an 
insurance company, this would render the regulation of such products 
outside of the scope of state insurance laws due to the Federal 
preemption of swaps regulation.\143\ Commenters noted that a likely 
consequence of this preemption would be that the same product would be 
subject to substantially different regulation within a state's 
jurisdiction based solely on the nature of the issuing person.\144\
---------------------------------------------------------------------------

    \142\ See ACLI Letter; CAI Letter; NAFA Letter; Nationwide 
Letter; RAA Letter; and Travelers Letter.
    \143\ Id.
    \144\ Id.
---------------------------------------------------------------------------

    The Commissions have revised the first prong of Provider Test to 
address commenters' concerns that providers of insurance products could 
evade state insurance regulation by intentionally failing the Provider 
Test, i.e., marketing the insurance products as swaps or security-based 
swaps in order to avoid state insurance supervision. As adopted, any 
person that provides insurance products (and therefore should be 
subject to state or Federal insurance supervision) must, in fact, be 
subject to state or Federal insurance supervision in order to satisfy 
the first prong of the Provider Test. Persons that are organized as 
insurance companies or whose business activity is predominantly 
insurance or reinsurance, but who are not in fact subject to state or 
Federal insurance supervision, would not satisfy the first prong of the 
Provider Test.
    Finally, as discussed below, the Commissions have added a fourth 
prong

[[Page 48222]]

to the Provider Test to provide relief for persons that provide 
insurance products on a non-admitted basis through surplus lines 
brokers.
``Regulated as Insurance'' Limitation
    Two commenters recommended that the Commissions remove the 
provision in the first prong of the Provider Test that states ``and 
such agreement, contract, or transaction is regulated as insurance 
under the laws of such state or of the United States.''\145\ These 
commenters argued that the provision should be deleted because it was 
redundant with the Product Test and may exclude certain reinsurers and 
non-admitted insurers, as well as products that may not be specifically 
``regulated as insurance'' in all states.\146\
---------------------------------------------------------------------------

    \145\ See RAA Letter and Travelers Letter.
    \146\ Id. These commenters also recommended the addition of a 
new prong to the Provider Test to cover domestic or foreign entities 
that issue insurance products on a non-admitted basis through 
surplus lines brokers. See discussion below. The Commissions note 
that the first prong of the Provider Test does not apply to 
reinsurance contracts and the third prong of the Provider Test, 
which does apply to reinsurance contracts, does not contain the 
``regulated as insurance'' limitation.
---------------------------------------------------------------------------

    The Commissions have retained the requirement in the first prong of 
the Provider Test that an insurance product must be regulated as 
insurance, but have revised the provision to clarify that an insurance 
product must be regulated as insurance under applicable state law or 
the laws of the United States. As discussed above, the Commissions 
believe that this condition will help prevent products that are not 
regulated as insurance and are swaps or security-based swaps from being 
characterized as insurance products in order to evade the regulatory 
regime under the Dodd-Frank Act.
    The Commissions have received conflicting comments regarding 
whether surety bonds are currently offered by persons who do not 
satisfy the Provider Test, in particular the ``regulated as insurance'' 
requirement.\147\ If a person who does not satisfy the Provider Test 
sells a surety bond incidental to other business activity and is not 
subject to state or Federal insurance supervision, it does not mean 
that such surety bond is a swap or security-based swap. The surety bond 
may not satisfy the Insurance Safe Harbor, but it would be subject to a 
facts and circumstances analysis. Similarly, one commenter indicated 
that title insurance is not always subject to state insurance 
regulation.\148\ Title insurance sold in a state that does not regulate 
title insurance as insurance would be in the list of Enumerated 
Products but would not satisfy the Provider Test and, thus would not 
qualify for the Insurance Safe Harbor. However, this does not mean that 
title insurance sold in a state that does not regulate title insurance 
as insurance is a swap or security-based swap. The title insurance may 
not satisfy the Insurance Safe Harbor, but it would be subject to a 
facts and circumstances analysis. The Commissions anticipate that many 
factors would militate against a determination that such a surety bond 
or title insurance that fails the Provider Test, because it cannot meet 
the ``regulated as insurance'' requirement, is a swap or security-based 
swap rather than insurance.
---------------------------------------------------------------------------

    \147\ See SFAA Letter. SFAA stated that all states include 
surety and fidelity bonds as lines of insurance subject to state 
oversight. However, Travelers stated that surety bonds may not be 
``specifically'' regulated as insurance. See Travelers Letter.
    \148\ See ACLI Letter.
---------------------------------------------------------------------------

    The Commissions agree that the inclusion of the ``regulated as 
insurance'' requirement in the first prong of the Provider Test will 
have the effect of causing non-admitted insurance products to fall 
within the swap and security-based swap definitions. In response to 
commenters' concerns about the ability of non-admitted insurers to 
qualify under the Provider Test, the Commissions have added a fourth 
prong to the Provider Test to address providers of non-admitted 
insurance products.\149\
---------------------------------------------------------------------------

    \149\ See supra notes 130, 131, and 132 and accompanying text.
---------------------------------------------------------------------------

Providers of Reinsurance
    Several commenters recommended that the Commissions expand the 
third prong of the Provider Test to include domestic reinsurers.\150\ 
One commenter requested that the Commissions remove the third prong of 
the Provider Test from the final rules because it appears to prohibit a 
reinsurer from offering a product in a state where it is permitted if 
any other state prohibits that product.\151\ Two commenters requested 
revisions to the portion of the third prong of the Provider Test that 
addresses a cedant's reimbursable losses.\152\ One commenter argued 
this portion of the third prong of the Provider Test may conflict with 
the state-based insurance receivership law.\153\
---------------------------------------------------------------------------

    \150\ See ACLI Letter; CAI Letter; NAIC Letter; and RAA Letter.
    \151\ See RAA Letter. The commenter argued that one state's 
prohibition on a reinsurance product should not affect the ability 
of the reinsurer to offer the product in a state where it is 
permitted.
    \152\ See RAA Letter and Travelers Letter. Both commenters 
suggested specific edits to the proposed rules.
    \153\ See RAA Letter. RAA stated that in an insurance 
receivership reinsurers are required to comply with the reinsurance 
contract and pay all amounts due and owing to the estate of the 
insolvent cedant even if the estate of the cedant may not 
necessarily pay the full amount of the underlying claims to the 
applicable policyholders.
---------------------------------------------------------------------------

    As noted above, the Commissions have revised the third prong of the 
Provider Test to remove the limitation that a reinsurance provider has 
to be located outside of the United States, and thereby address 
commenters' concerns that domestic reinsurers would not qualify under 
the reinsurance prong. In addition, in response to commenters' 
concerns, the Commissions have clarified the third prong of the 
Provider Test so that it does not prohibit a reinsurer from offering a 
product in a state where it is permitted, even if that product is 
prohibited in another state, and have revised the portion of the third 
prong of the Provider Test that addresses a cedant's reimbursable 
losses to make it subject to applicable state law so that it does not 
conflict with state-based insurance receivership law.
(c) Grandfather Provision for Existing Insurance Transactions
    In the Proposing Release, the Commissions asked whether the 
proposed rules should include a provision similar to section 302(c)(1) 
of the Gramm-Leach-Bliley Act that any product regulated as insurance 
before the date the Dodd-Frank Act was signed into law and provided in 
accordance with the Provider Test would be considered insurance and not 
fall within the swap or security-based swap definitions.
    In response to comments,\154\ the Commissions are adding a new 
paragraph (ii) to rule 1.3(xxx)(4) under the CEA and new paragraph (b) 
to rule 3a69-1 under the Exchange Act that provides that an agreement, 
contract, or transaction entered into on or before the effective date 
of the Product Definitions will be considered insurance and not fall 
within the swap and security-based swap definitions, provided that, at 
such time it was entered into, such agreement, contract, or transaction 
was provided in accordance with the Provider Test (the ``Insurance 
Grandfather'').
---------------------------------------------------------------------------

    \154\ See infra notes 157, 158, 159, and 160 and accompanying 
text.
---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions are aware of 
nothing in Title VII to suggest that Congress intended for traditional 
insurance products to be regulated as swaps or security-based 
swaps.\155\ The

[[Page 48223]]

Commissions have designed the Insurance Safe Harbor to provide greater 
assurance to market participants that traditional insurance products 
that were regulated as insurance prior to the Dodd-Frank Act will fall 
outside the swap and security-based swap definitions. Nevertheless, 
after considering comments received, the Commissions believe that it is 
appropriate to adopt the Insurance Grandfather in order to assure 
market participants that those agreements, contracts, or transactions 
that meet the conditions set out in the Insurance Grandfather will not 
fall within the swap or security-based swap definitions.
---------------------------------------------------------------------------

    \155\ See Proposing Release at 29821.
---------------------------------------------------------------------------

    In order to qualify for the Insurance Grandfather an agreement, 
contract, or transaction must meet two requirements. First, it must be 
entered into on or before the effective date of the Product 
Definitions. The Commissions are linking the Insurance Grandfather to 
the effective date of the Product Definitions, rather than the date 
that the Dodd-Frank Act was signed into law, in order to avoid 
unnecessary market disruption.\156\ Second, such agreement, contract, 
or transaction must be provided in accordance with the Provider Test. 
In other words, the provider must be subject to state or Federal 
insurance supervision or be a non-admitted insurer or a reinsurer that 
satisfies the conditions for non-admitted insurers and reinsurers that 
are set out in the Provider Test. The Commissions note that an 
agreement, contract or transaction that is provided in accordance with 
the first prong of the Provider Test must also be regulated as 
insurance under applicable state law or the laws of the United States.
---------------------------------------------------------------------------

    \156\ The Commissions believe that 60 days after publication of 
this release should be sufficient time for market participants to 
enter into pending agreements, contracts, or transactions for which 
the Insurance Grandfather may provide relief.
---------------------------------------------------------------------------

    By adopting the Insurance Grandfather and the Insurance Safe 
Harbor, the Commissions are excluding agreements, contracts, and 
transactions for which the Commissions have found no evidence that 
Congress intended them to be regulated as swaps or security-based 
swaps, and are providing greater certainty regarding the treatment of 
agreements, contracts, and transactions currently regulated as 
insurance.
Comments
    Four commenters addressed whether the final rules should include a 
grandfather provision that would exclude certain insurance products 
from the swap or security-based swap definitions.\157\ Two commenters 
suggested that a grandfather provision for all products that were 
regulated as insurance before the Dodd-Frank Act was signed into law 
would be appropriate, stating that it would reduce confusion and 
uncertainty in applying the swap and security-based swap definitions to 
products that are traditionally regulated as insurance while addressing 
the Commissions' stated concern that products might be structured as 
insurance products to evade Dodd-Frank Act requirements.\158\ These 
commenters also stated that it is necessary to add an effective date-
based grandfather provision to the final rule providing that any 
contract or transaction subject to state insurance regulation and 
entered into prior to any final rules necessary to implement Title VII, 
including the Product Definitions, are not swaps or security-based 
swaps.\159\ These commenters noted that a grandfather provision based 
on effective date of all the Title VII rules was needed to address 
product development and variation that occurred between the date the 
Dodd-Frank Act was enacted and the effective date of the rules mandated 
under that statute.\160\
---------------------------------------------------------------------------

    \157\ See ACLI Letter; AFGI Letter; CAI Letter; and D&L Letter.
    \158\ See ACLI Letter and CAI Letter. ACLI and CAI argued that 
products that were regulated as insurance prior to the effective 
date of the Dodd-Frank Act clearly were not characterized as 
insurance to avoid the Title VII regulatory regime. See also AFGI 
Letter; AFGI argued that all insurance contracts issued by state-
regulated insurance companies should be excluded from the swap 
definition but in the alternative, all insurance products regulated 
as insurance before July 21, 2010 should be grandfathered. See also 
D&L Letter. D&L stated that prior regulation of insurance products 
before July 21, 2010 could be a consideration, but not an absolute 
determinant for exclusion from the swap or security-based swap 
definitions.
    \159\ See ACLI Letter and CAI Letter.
    \160\ Id.
---------------------------------------------------------------------------

    The Commissions believe that the combination of the Insurance 
Grandfather along with the Insurance Safe Harbor provides market 
participants with increased legal certainty with respect to existing 
agreements, contracts, transactions, and products. In addition, the 
fact that the Commissions are linking the Insurance Grandfather to the 
effective date of the Product Definitions, rather than the date that 
the Dodd-Frank Act was signed into law, takes into account product 
development and innovation that may have occurred between the date the 
Dodd-Frank Act was signed into law at the effective date of the Product 
Definitions. Further, the Commissions believe that a grandfather 
provision that would exclude all products regulated as insurance before 
the Dodd-Frank Act was signed into law, as recommended by some 
commenters,\161\ is unnecessary because non-grandfathered regulated 
insurance transactions generally should fall within the Insurance Safe 
Harbor. The Commissions believe that market participants could be 
incentivized to use such a broader grandfather provision to create new 
swap or security-based swap products with characteristics similar to 
those of existing categories of regulated insurance contracts for the 
purpose of evading the Dodd-Frank Act regulatory regime. The 
Commissions also believe that a broader grandfather provision would be 
contrary to the explicit direction of sections 722(b) and 767 of the 
Dodd-Frank Act which provide that swaps and security-based swaps may 
not be regulated as insurance contracts by any state.\162\
---------------------------------------------------------------------------

    \161\ See ACLI Letter; AGFI Letter; and CAI Letter.
    \162\ Section 722(b) of the Dodd-Frank Act provides, (B) 
Regulation of Swaps Under Federal and State Law.--Section 12 of the 
Commodity Exchange Act (7 U.S.C. 16) is amended by adding at the end 
the following: ``(h) Regulation of Swaps as Insurance Under Federal 
and State Law.--A swap--(1) Shall not be considered to be insurance; 
and (2) may not be regulated as an insurance contract under the law 
of any State.'' Section 767 of the Dodd-Frank Act amended section 
28(a) of the Exchange Act, 15 U.S.C. 78bb(a), to provide, ``A 
security-based swap may not be regulated as an insurance contract 
under any provision of State law.''
---------------------------------------------------------------------------

    One commenter argued that the Provider Test should not apply to 
grandfathered contracts. The commenter stated that it should be enough 
that the product is regulated as insurance.\163\ As described above, 
the grandfather provision will apply only to agreements, contracts, and 
transactions that are entered into prior to the effective date of the 
Product Definitions if they were provided in accordance with the 
Provider Test, including a requirement that an agreement, contract or 
transaction that is provided in accordance with the first prong of the 
Provider Test must be regulated as insurance under applicable State law 
or the laws of the United States. As the Commissions discussed in the 
Proposing Release, and above in describing the Provider Test, the 
Commissions believe the requirement that the agreement, contract, or 
transaction be provided in accordance with the Provider Test should 
help ensure that persons who are not subject to state or Federal 
insurance supervision are not able to avoid the oversight

[[Page 48224]]

provided for under Title VII of the Dodd-Frank Act.
---------------------------------------------------------------------------

    \163\ See CAI Letter. CAI suggested that for a product to be 
regulated as insurance it means that it was provided by an insurance 
company. See supra part II.B.1.b) for a discussion of the need for 
the Provider Test portion of the Insurance Safe Harbor.
---------------------------------------------------------------------------

(d) Alternative Tests
    A number of commenters proposed that the Commissions adopt 
alternative tests to distinguish insurance from swaps and security-
based swaps.\164\ After considering each of these alternatives, the 
Commissions are not adopting them.
---------------------------------------------------------------------------

    \164\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter; 
MetLife Letter; NAFA Letter; NAIC Letter; Nationwide Letter; and 
Travelers Letter.
---------------------------------------------------------------------------

    Several commenters suggested that the sole test for determining 
whether an agreement, contract, or transaction is insurance should be 
whether it is subject to regulation as insurance by the insurance 
commissioner of the applicable state(s).\165\ The Commissions find this 
alternative to be unworkable because it does not provide a sufficient 
means to distinguish agreements, contracts and transactions that are 
insurance from those that are swaps or security-based swaps. Section 
712(d) of the Dodd-Frank Act directs the Commissions to ``further 
define'' the terms swap and security-based swap. Neither swaps nor 
security-based swaps may be regulated as insurance contracts under the 
laws of any state.\166\ While insurance contracts have long been 
subject to state regulation, swaps and security-based swaps were 
largely unregulated. Since the Dodd-Frank Act created a new regulatory 
regime for swaps and specifically provides that ``swaps may not be 
regulated as an insurance contract under the law of any state,\167\ the 
Commissions believe that it is important to have a test that 
distinguishes insurance from swaps and security-based swaps without 
relying entirely on the regulatory environment prior to the enactment 
of the Dodd-Frank Act. The Product Test is an important element of the 
Insurance Safe Harbor.
---------------------------------------------------------------------------

    \165\ See ACLI Letter; AIA Letter; AFGI Letter; MetLife Letter; 
and Travelers Letter.
    \166\ See section 12(h) of the CEA, 7 U.S.C. 16(h) (regarding 
swaps) and section 28(a)(4) of the Exchange Act, 15 U.S.C. 
78bb(a)(4) (regarding security-based swaps).
    \167\ See section 12(h)(2) of the CEA, 7 U.S.C. 16(h)(2).
---------------------------------------------------------------------------

    Several commenters suggested an approach in which insurance 
products that qualify for the exclusion contained in section 3(a)(8) of 
the Securities Act\168\ would be excluded from the swap 
definition.\169\ One commenter argued that ``Section 3(a)(8) has long 
been recognized as the definitive provision as to where Congress 
intends to separate securities products that are subject to SEC 
regulation from `insurance' and `annuity' products that are to be left 
to state insurance regulation'' and that the section 3(a)(8) criteria 
are well understood and have a long history of interpretation by the 
SEC and the courts.\170\ Other commenters suggest that because section 
3(a)(8) includes both a product and a provider requirement, if the 
Commissions include it in their final rules, it should be a requirement 
separate from the Product Test and the Provider Test, and should extend 
to insurance products that are securities.\171\
---------------------------------------------------------------------------

    \168\ Section 3(a)(8) of the Securities Act excludes the 
following from all provisions of the Securities Act: Any insurance 
or endowment policy or annuity contract or optional annuity 
contract, issued by a corporation subject to the supervision of the 
insurance commissioner, bank commissioner, or any agency or officer 
performing like functions, of any State or Territory of the United 
States or the District of Columbia.
    See infra note 1283 and accompanying text.
    \169\ See ACLI Letter; CAI Letter; NAFA Letter; and Nationwide 
Letter.
    \170\ See NAFA Letter.
    \171\ See ACLI Letter and CAI Letter.
---------------------------------------------------------------------------

    While the Commissions agree that the section 3(a)(8) criteria have 
a long history of interpretations by the SEC and the courts, the 
Commissions find that it is inappropriate to apply the section 3(a)(8) 
criteria in this context. Although section 3(a)(8) contains some 
conditions applicable to insurance providers that are similar to the 
prongs of the Provider Test, it does not contain any conditions that 
are similar to the prongs of the Product Test. Moreover, section 
3(a)(8) provides an exclusion from the Securities Act and the CFTC has 
no jurisdiction under the Federal securities laws. Congress directed 
both agencies to further define the terms ``swap'' and ``security-based 
swap.'' As such, the Commissions find that it is more appropriate to 
have a standalone rule that incorporates features that distinguish 
insurance products from swaps and security-based swaps and over which 
both Commissions will have joint interpretative authority.
    One commenter suggested yet another approach, recommending that 
insurance be defined as an agreement, contract, or transaction that by 
its terms:
     Exists for a specified period of time;
     Where the party (the ``insured'') to the contract promises 
to make one or more payments such as money, goods or services;
     In exchange for another party's promise to provide a 
benefit of pecuniary value for the loss, damage, injury, or impairment 
of an identified interest of the insured as a result of the occurrence 
of a specified event or contingency outside of the parties' control; 
and
     Where such payment is related to a loss occurring as a 
result of a contingency or specified event.\172\
---------------------------------------------------------------------------

    \172\ See NAIC Letter.
---------------------------------------------------------------------------

    The Commissions do not find this alternative preferable to the 
Commissions' proposal for two reasons. First, the requirements of a 
specified term and the promise to make payments are present in both 
insurance products and in agreements, contracts, or transactions that 
are swaps or security-based swaps and therefore do not help to 
distinguish between them. A test based solely on these requirements, 
then, could be over-inclusive and exclude from the Dodd-Frank Act 
regulatory regime agreements, contracts, and transactions that have not 
traditionally been considered insurance. Further, the third and fourth 
requirements of this alternative test collapse into the Product Test's 
requirement that the loss must occur and be proved, and any payment or 
indemnification therefor must be limited to the value of the insurable 
interest.
    One commenter suggested a three-part test in lieu of the Product 
and Provider Tests. Under this test, the terms ``swap'' and ``security-
based swap'' would exclude any agreement, contract, or transaction 
that:
     Is issued by a person who is or is required to be 
organized as an insurance company and subject to state insurance 
regulation;
     Is the type of contract issued by insurance companies; and
     Is not of the type that the Commissions determine to 
regulate. \173\
---------------------------------------------------------------------------

    \173\ See ACLI Letter (Appendix 1). See also CAI Letter. CAI 
stated that it believes that the approach and test recommended by 
ACLI is a fundamentally sound method for determining those insurance 
products that are not swaps or security-based swaps and that should 
remain subject to state regulation, and is more appropriate than the 
Commissions' proposals. Nationwide suggested a three-part test to 
differentiate insurance products from swaps and security-based swaps 
similar to the test proposed by ACLI. See also Nationwide Letter.
---------------------------------------------------------------------------

    This commenter stated that its approach does not contain a 
definition of insurance, and believes that is preferable to the 
Commissions' approach, which it believes creates legal uncertainty 
because any attempted definition of insurance has the potential to be 
over- or under- inclusive.\174\ As discussed above, the Commissions' 
rules and interpretations are not intended to define insurance. Rather, 
they provide a safe harbor for certain types of traditional insurance 
products by reference to factors that may be used to distinguish 
insurance from swaps and security-based swaps, and a list of

[[Page 48225]]

products that do not have to satisfy a portion of the safe harbor 
factors. Agreements, contracts, and transactions that do not qualify 
for the Insurance Safe Harbor may or may not be insurance, depending 
upon the facts and circumstances regarding such agreements, contracts 
and transactions. The Commissions find the first two requirements of 
the commenter's three-part test to be tautologous, and the third 
provides no greater certainty than the Commissions' facts and 
circumstances approach. In addition, the Commissions find that this 
alternative test could exclude from the Dodd-Frank Act regulatory 
regime agreements, contracts, and transactions that have not 
traditionally been considered insurance.
---------------------------------------------------------------------------

    \174\ See ACLI Letter.
---------------------------------------------------------------------------

    Another commenter proposed different approaches for existing 
products and new products.\175\ Specifically, if an existing type of 
agreement, contract or transaction is currently reportable as insurance 
in the provider's regulatory and financial reports under a state or 
foreign jurisdiction's insurance laws, then that agreement, contract, 
or transaction would be insurance rather than a swap or security-based 
swap. On the other hand, for new products, if this approach were 
inconclusive, this commenter recommended that the Commissions use the 
Product Test of the Commissions' rules only.\176\ As discussed above, 
rather than treating existing products and new products differently, 
the Commissions are providing ``grandfather'' protection for 
agreements, contracts, and transactions entered into prior to the 
effective date of the Products Definitions.\177\ Moreover, this 
commenter's test would eliminate the Provider Test for new products, 
which the Commissions believe is important to help prevent products 
that are swaps or security-based swaps from being characterized as 
insurance.
---------------------------------------------------------------------------

    \175\ See AIA Letter.
    \176\ Id.
    \177\ See supra part II.B.1.c)
---------------------------------------------------------------------------

    In sum, the Commissions find that each of the alternatives proposed 
by commenters could exclude from the Dodd-Frank Act regulatory regime 
agreements, contracts, and transactions that have not historically been 
considered insurance, and that should, in appropriate circumstances, be 
regulated as swaps or security-based swaps. Accordingly, the 
Commissions do not find these alternatives to be appropriate for 
delineating the scope of the Insurance Safe Harbor from the swap and 
security-based swap definitions.
(e) ``Safe Harbor''
    Five commenters recommended that the Product Test, the Provider 
Test, and related interpretations should be structured as a ``safe 
harbor'' so that they do not raise any presumption or inference that 
products that do not meet the Product Test, Provider Test and related 
interpretations are necessarily swaps or security-based swaps.\178\ One 
commenter suggested that this safe harbor approach could be modeled 
after Rule 151 under the Securities Act.\179\
---------------------------------------------------------------------------

    \178\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with 
ACLI and CAI); Nationwide Letter; and Travelers Letter.
    \179\ See ACLI Letter.
---------------------------------------------------------------------------

    As discussed above, the Commissions do not intend to create a 
presumption that agreements, contracts, or transactions that do not 
fall within the Insurance Safe Harbor are necessarily swaps or 
security-based swaps. As stated above, the Commissions are instead 
adopting final rules that clarify that certain agreements, contracts, 
or transactions meeting the requirements of a non-exclusive ``safe 
harbor'' established by such rules will not be considered to be swaps 
or security-based swaps. An agreement, contract, or transaction that 
does not fall within the Insurance Safe Harbor will require further 
analysis of the applicable facts and circumstances to determine whether 
it is insurance, and thus not a swap or security-based swap.
(f) Applicability of Insurance Exclusion to Security-Based Swaps
    Four commenters expressed concerns that the proposed rules were 
unclear in their application to both swaps and security-based 
swaps.\180\ These commenters argued that the proposed rules do not 
directly exclude insurance products from the term ``security-based 
swap'' because the rules explicitly state that ``[t]he term `swap' does 
not include'' the products that meet the Product and Provider Tests, 
but do not make the same statement as to the term ``security-based 
swap.'' \181\
---------------------------------------------------------------------------

    \180\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with 
ACLI and CAI); and Nationwide Letter (concurring the ACLI and CAI).
    \181\ Id. The commenters suggested that this ambiguity could be 
resolved by making it clear in the final rules that an excluded 
product is neither a swap nor a security-based swap.
---------------------------------------------------------------------------

    The Commissions have revised rule 1.3(xxx)(4) under the CEA and 
rule 3a69-1 under the Exchange Act to clarify that the exclusion 
contained therein applies to both swaps and security-based swaps.
(g) Guarantees
    In the Proposing Release, the Commissions requested comment on 
whether insurance of an agreement, contract, or transaction that falls 
within the swap or security-based swap definitions should itself be 
included in the swap or security-based swap definition. The Commissions 
also requested comment on whether the Commissions should provide 
guidance as to whether swap or security-based swap guarantees offered 
by non-insurance companies should be considered swaps or security-based 
swaps.\182\
---------------------------------------------------------------------------

    \182\ See Proposing Release at 29827.
---------------------------------------------------------------------------

Guarantees of Swaps.\183\
---------------------------------------------------------------------------

    \183\ The discussion in this subsection relates only to swaps 
that are not security-based swaps or mixed swaps and has no effect 
on the laws or regulations applicable to security-based swaps or 
mixed swaps.
---------------------------------------------------------------------------

    No commenter identified any product that insures swaps (that are 
not security-based swaps or mixed swaps) other than financial guaranty 
insurance. The CFTC finds that insurance of an agreement, contract, or 
transaction that falls within the swap definition (and is not a 
security-based swap or mixed swap) is functionally or economically 
similar to a guarantee of a swap (that is not a security-based swap or 
mixed swap) offered by a non-insurance company.\184\ Therefore, the 
CFTC is treating financial guaranty insurance of swaps (that are not 
security-based swaps or mixed swaps) the same way it is treating all 
other guarantees of swaps (that are not security-based swaps or mixed 
swaps), as discussed below.\185\
---------------------------------------------------------------------------

    \184\ The Commissions did not express a view regarding whether 
financial guaranty insurance is a swap or security-based swap in the 
Entities Release. See Entities Release at 30689, n.1132.
    \185\ Subsequent references to ``guarantees'' in this discussion 
shall thus be deemed to include ``financial guaranty insurance 
policies.''
---------------------------------------------------------------------------

    The CFTC is persuaded that when a swap has the benefit of a 
guarantee,\186\ the guarantee is an integral part of that swap. The 
CFTC finds that a guarantee of a swap (that is not a security-based 
swap or mixed swap) is a term of that swap that affects the price or 
pricing attributes of that swap.\187\ When a swap

[[Page 48226]]

counterparty typically provides a guarantee as credit support for its 
swap obligations, the market will not trade with that counterparty at 
the same price, on the same terms, or at all without the guarantee. The 
guarantor's resources are added to the analysis of the swap; if the 
guarantor is financially more capable than the swap counterparty, the 
analysis of the swap becomes more dependent on the creditworthiness of 
the guarantor. Therefore, the CFTC is interpreting the term ``swap'' 
(that is not a security-based swap or mixed swap) to include a 
guarantee of such swap, to the extent that a counterparty to a swap 
position would have recourse to the guarantor in connection with the 
position.\188\ The CFTC anticipates that a ``full recourse'' guarantee 
would have a greater effect on the price of a swap than a ``limited'' 
or ``partial recourse'' guarantee; nevertheless, the CFTC is 
determining that the presence of any guarantee with recourse, no matter 
how robust, is price forming and an integral part of a guaranteed swap.
---------------------------------------------------------------------------

    \186\ For purposes of this release, the CFTC views a guarantee 
of a swap to be a collateral promise by a guarantor to answer for 
the debt or obligation of a counterparty obligor under a swap. A 
guarantee of a swap does not include for purposes of this release: 
(i) A ``guarantee agreement'' as defined in CFTC regulation Sec.  
1.3(nn), 17 CFR 1.3(nn); (ii) any assumption by a clearing member of 
financial or performance responsibility to a derivatives clearing 
organization (``DCO'') for swaps cleared by a DCO; or (iii) any 
guarantee by a DCO with respect to a swap that it clears.
    \187\ E.g., a swap counterparty may specify that a guarantee is 
a Credit Support Document under an ISDA Master Agreement. If the 
guarantor fails to comply with or perform under such guarantee, such 
guarantee expires or terminates, or if such guarantee ceases to be 
in full force and effect, the ``Credit Support Default'' Event of 
Default under the ISDA Master Agreement would generally be 
triggered, potentially bringing down the entire swap trading 
relationship between the parties to the ISDA Master Agreement. See 
generally the standard 1992 ISDA Master Agreement and 2002 ISDA 
Master Agreement. However, the CFTC finds the presence of a 
guarantee to be an integral part of a swap and that affects the 
price or pricing attributes of a swap whether or not such guarantee 
is a Credit Support Document under an ISDA Master Agreement.
    \188\ This interpretation is consistent with the interpretations 
of the Commissions in the Entity Definitions Release. See, e.g., 
Entity Definitions Release at 30689 (``[A]n entity's swap or 
security-based swap positions in general would be attributed to a 
parent, other affiliate or guarantor for purposes of major 
participant analysis to the extent that counterparties to those 
positions would have recourse to that other entity in connection 
with the position. Positions would not be attributed in the absence 
of recourse.''). A swap backed by a partial or limited recourse 
guarantee will include the guarantee to the extent of such partial 
or limited recourse; a blanket guarantee that supports both swap and 
non-swap obligations will be treated as part of the guaranteed swap 
only to the extent that such guarantee backstops obligations under a 
swap or swaps.
    In the Entity Definitions Release, the Commissions stated, ``we 
do not believe that it is necessary to attribute a person's swap or 
security-based swap positions to a parent or other guarantor if the 
person is already subject to capital regulation by the CFTC or SEC 
(i.e., swap dealers, security-based swap dealers, major swap 
participants, major security-based swap participants, FCMs and 
broker-dealers) or if the person is a U.S. entity regulated as a 
bank in the United States. Positions of those regulated entities 
already will be subject to capital and other requirements, making it 
unnecessary to separately address, via major participant 
regulations, the risks associated with guarantees of those 
positions.'' Id. In a footnote, the Commissions continued, ``As a 
result of this interpretation, holding companies will not be deemed 
to be major swap participants as a result of guarantees to certain 
U.S. entities that are already subject to capital regulation.'' Id.
    As a result of interpreting the term ``swap'' (that is not a 
security-based swap or mixed swap) to include a guarantee of such 
swap, to the extent that a counterparty to a swap position would 
have recourse to the guarantor in connection with the position, and 
based on the reasoning set forth above from the Entity Definitions 
Release in connection with major swap participants, the CFTC will 
not deem holding companies to be swap dealers as a result of 
guarantees to certain U.S. entities that are already subject to 
capital regulation. It may, however, be appropriate to regulate as a 
swap dealer a parent or other guarantor who guarantees swap 
positions of persons who are not already subject to capital 
regulation by the CFTC (i.e., who are not swap dealers, major swap 
participants or FCMs). The CFTC is addressing guarantees provided to 
non-U.S. entities, and guarantees by non-U.S. holding companies, in 
its proposed interpretive guidance and policy statement regarding 
the cross-border application of the swaps provisions of the CEA, 77 
FR 41214 (Jul. 12, 2012).
---------------------------------------------------------------------------

    The CFTC's interpretation of the term ``swap'' to include 
guarantees of swaps does not limit or otherwise affect in any way the 
relief provided by the Insurance Grandfather. In a separate release, 
the CFTC will address the practical implications of interpreting the 
term ``swap'' to include guarantees of swaps (the ``separate CFTC 
release'').\189\
---------------------------------------------------------------------------

    \189\ Briefly, in the separate CFTC release the CFTC anticipates 
proposing reporting requirements with respect to guarantees of swaps 
under Parts 43 and 45 of the CFTC's regulations and explaining the 
extent to which the duties and obligations of swap dealers and major 
swap participants pertaining to guarantees of swaps, as an integral 
part of swaps, are already satisfied to the extent such obligations 
are satisfied with respect to the related guaranteed swaps. The CFTC 
also anticipates addressing in the separate CFTC release the effect, 
if any, of the interpretation regarding guarantees of swaps on 
position limits and large trader reporting requirements.
---------------------------------------------------------------------------

Comments
    Three commenters provided comments regarding the treatment of 
guarantees. Two commenters \190\ opposed treating insurance or 
guarantees of swaps as swaps. Suggesting that the products are not 
economically similar, one commented that insurance wraps of swaps do 
not ``necessarily replicate the economics of the underlying swap, and 
only following default could the wrap provider end up with the same 
payment obligations as a wrapped defaulting swap counterparty.'' \191\ 
This commenter also stated that the non-insurance guarantees are not 
swaps because the result of most guarantees is that the guarantor is 
responsible for monetary claims against the defaulting party, which in 
this commenter's view is a different obligation than the arrangement 
provided by the underlying swap itself.\192\
---------------------------------------------------------------------------

    \190\ See AFGI Letter and ISDA Letter.
    \191\ ISDA Letter.
    \192\ Id.
---------------------------------------------------------------------------

    One commenter supported treating financial guaranty insurance of a 
swap or security-based swap as itself a swap or a security-based swap. 
This commenter argued that financial guaranty insurance of a swap or 
security-based swap transfers the risk of counterparty non-performance 
to the guarantor, making it an embedded and essential feature of the 
insured swap or security-based swap. This commenter further argued that 
the value of such swap or security-based swap is largely determined by 
the likelihood that the proceeds from the financial guaranty insurance 
policy will be available if the counterparty does not meet its 
obligations.\193\ This commenter maintained that financial guaranty 
insurance of swaps and security-based swaps serves a very similar 
function to credit default swaps in hedging counterparty default 
risk.\194\
---------------------------------------------------------------------------

    \193\ See Better Markets Letter.
    \194\ See Better Markets Letter.
---------------------------------------------------------------------------

    The CFTC is persuaded that when a swap (that is not a security-
based swap or mixed swap) has the benefit of a guarantee, the guarantee 
and related guaranteed swap must be analyzed together. The events 
surrounding the failure of AIG Financial Products (``AIGFP'') highlight 
how guarantees can cause major risks to flow to the guarantor.\195\ The 
CFTC finds that the regulation of swaps and the risk exposures 
associated with them, which is an essential concern of the Dodd-Frank 
Act, would be less effective if the CFTC did not interpret the term 
``swap'' to include a guarantee of a swap.
---------------------------------------------------------------------------

    \195\ ``AIGFP's obligations were guaranteed by its highly rated 
parent company * * * an arrangement that facilitated easy money via 
much lower interest rates from the public markets, but ultimately 
made it difficult to isolate AIGFP from its parent, with disastrous 
consequences.'' Congressional Oversight Panel, The AIG Rescue, Its 
Impact on Markets, and the Government's Exit Strategy 20 (2010).
---------------------------------------------------------------------------

    Two commenters cautioned against unnecessary and duplicative 
regulation. One commented that, because the underlying swap, and the 
parties to it, will be regulated and reported to the extent required by 
Title VII, there is no need for regulation of non-insurance 
guarantees.\196\ The other commented that an insurance policy on a swap 
would be subject to state regulation; without addressing non-insurance 
guarantees, this commenter stated that additional Federal regulation 
would be duplicative.\197\ The CFTC disagrees with these arguments. As 
stated above, the CFTC is treating financial guaranty insurance of 
swaps and all other guarantees of swaps in a similar manner because 
they are functionally or

[[Page 48227]]

economically similar products. If a guarantee of a swap is not treated 
as an integral part of the underlying swap, price forming terms of 
swaps and the risk exposures associated with the guarantees may remain 
hidden from regulators and may not be regulated appropriately. 
Moreover, treating guarantees of swaps as part of the underlying swaps 
ensures that the CFTC will be able to take appropriate action if, after 
evaluating information collected with respect to the guarantees and the 
underlying swaps, such guarantees of swaps are revealed to pose 
particular problems in connection with the swaps markets. In the 
separate CFTC release, the CFTC will clarify the limited practical 
effects of the CFTC's interpretation, which should address concerns 
regarding duplicative regulation.
---------------------------------------------------------------------------

    \196\ See ISDA Letter.
    \197\ See AFGI Letter.
---------------------------------------------------------------------------

    One commenter also argued that regulating financial guaranty of 
swaps as swaps would cause monoline insurers to withdraw from the 
market, which could adversely affect the U.S. and international public 
finance, infrastructure and structured finance markets, given that 
insuring a related swap often is integral to the insurance of municipal 
bonds and other securities.\198\ The CFTC finds this argument 
unpersuasive. The CFTC understands that the 2008 global financial 
crisis severely affected most monolines and only one remains active in 
U.S. municipal markets. Thus, it appears that the monolines have, for 
the most part, already exited these markets. In addition, as stated 
above, the CFTC will clarify in the separate CFTC release the limited 
practical effects of the CFTC's interpretation, which should address 
these concerns.
---------------------------------------------------------------------------

    \198\ See AFGI Letter. Of the members of AFGI, only Assured 
Guaranty (or its affiliates) is currently writing financial guaranty 
insurance policies on U.S. municipal obligations.
---------------------------------------------------------------------------

Guarantees of Security-Based Swaps
    The SEC believes that a guarantee of an obligation under a 
security-based swap, including financial guaranty insurance of a 
security-based swap, is not a separate security-based swap. Further, 
the SEC is not adopting an interpretation that a guarantee of a 
security-based swap is part of the security-based swap. Instead, the 
SEC will consider requiring, as part of its rulemaking relating to the 
reporting of security-based swaps,\199\ the reporting of information 
about any guarantees and the guarantors of obligations under security-
based swaps in connection with the reporting of the security-based swap 
transaction itself. In addition, the SEC will consider issues involving 
cross-border guarantees of security-based swaps in a separate release 
addressing the cross-border application of Title VII. The SEC notes 
that security-based swaps are included in the definition of 
``security'' contained in the Securities Act and the Exchange Act.\200\ 
Under the Securities Act, a guarantee of a security also is a 
``security.'' \201\ Therefore, a guarantee of a security-based swap is 
a security subject to Federal securities law regulation.\202\
---------------------------------------------------------------------------

    \199\ See Regulation SBSR Proposing Release infra note 1231.
    \200\ See sections 768(a)(1) and 761(a)(2) of the Dodd-Frank Act 
(amending sections 2(a)(1) of the Securities Act, 15 U.S.C. 
77b(a)(1), and 3(a)(10) of the Exchange Act, 15 U.S.C. 78c(a)(10), 
respectively).
    \201\ See section 2(a)(1) of the Securities Act, 15 U.S.C. 
77b(a)(1).
    \202\ The SEC has previously addressed the treatment of 
financial guaranty insurance under the Federal securities laws. See 
supra note 58.
---------------------------------------------------------------------------

2. The Forward Contract Exclusion
    As the Commissions explained in the Proposing Release, the 
definitions of the terms ``swap'' and ``security-based swap'' do not 
include forward contracts.\203\ These definitions 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.'' 
\204\ The Commissions provided an interpretation in the Proposing 
Release regarding the applicability of the exclusion from the swap and 
security-based swap definition for forward contracts with respect to 
nonfinancial commodities \205\ and securities. The Commissions are 
restating this interpretation as set forth in the Proposing Release 
with certain modifications in response to commenters.
(a) Forward Contracts in Nonfinancial Commodities
---------------------------------------------------------------------------

    \203\ See Proposing Release at 29827.
    \204\ CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).
    \205\ 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 CEA.
---------------------------------------------------------------------------

    The CFTC provided an interpretation in the Proposing Release 
regarding the forward contract exclusion for nonfinancial commodities 
and is restating this interpretation with certain modifications in 
response to commenters. These clarifications include that the CFTC will 
interpret the forward contract exclusion consistent with the entire 
body of CFTC precedent.\206\ The CFTC is also clarifying what 
``commercial participant'' means under the ``Brent Interpretation.'' 
\207\ In addition, while the CFTC is withdrawing its 1993 ``Energy 
Exemption'' \208\ as proposed, it is clarifying that certain 
alternative delivery procedures will not disqualify a transaction from 
the forward contract exclusion. In response to comments, the CFTC is 
providing a new interpretation regarding book-out documentation, as 
well as additional factors that may be considered in its ``facts and 
circumstances'' analysis of whether a particular contract is a forward.
---------------------------------------------------------------------------

    \206\ See infra part II.B.2(a)(i)(F).
    \207\ Statutory Interpretation Concerning Forward Transactions, 
55 FR 39188 (Sep. 25, 1990) (``Brent Interpretation'').
    \208\ Exemption for Certain Contracts Involving Energy Products, 
58 FR 21286-02 (Apr. 20, 1993) (``Energy Exemption'').
---------------------------------------------------------------------------

(i) Forward Exclusion From the Swap and Future Delivery Definitions
(A) Consistent Interpretation
    The wording of the forward contract exclusion from the swap 
definition with respect to nonfinancial commodities is similar, but not 
identical, to the forward exclusion from the definition of the term 
``future delivery'' that applies to futures contracts, which excludes 
``any sale of any cash commodity for deferred shipment or delivery.'' 
\209\
---------------------------------------------------------------------------

    \209\ CEA section 1a(27), 7 U.S.C. 1a(27).
---------------------------------------------------------------------------

    In the Proposing Release, the CFTC proposed an interpretation 
clarifying the scope of the exclusion of forward contracts for 
nonfinancial commodities from the swap definition and from the ``future 
delivery'' definition in a number of respects. After considering the 
comments received, the CFTC is restating substantially all of its 
interpretation regarding these forward exclusions set forth in the 
Proposing Release, but with several clarifications in response to 
commenters.
    The CFTC is restating from the Proposing Release that the forward 
exclusion for nonfinancial commodities in the swap definition will be 
interpreted in a manner consistent with the CFTC's historical 
interpretation of the existing forward exclusion with respect to 
futures contracts, consistent with the Dodd-Frank Act's legislative 
history.\210\ In addition, in response to a

[[Page 48228]]

commenter, the CFTC is clarifying that the entire body of CFTC 
precedent regarding forwards should apply to the forward exclusions 
from the swap and future delivery definitions.\211\
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    \210\ See 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.''). See also 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.'').
    \211\ See Letter from Craig Donahue, Chief Executive Officer, 
CME Group Inc. (``CME''), dated July 22, 2011 (``CME Letter'') 
(requesting this clarification). But see below regarding the CFTC's 
response to CME's comment concerning the Brent Interpretation that 
it may be inconsistent, in CME's view, with more recent CFTC 
adjudicatory decisions.
---------------------------------------------------------------------------

    The CFTC's historical interpretation has been that forward 
contracts with respect to nonfinancial commodities are ``commercial 
merchandising transactions.'' \212\ The primary purpose of a forward 
contract is to transfer ownership of the commodity and not to transfer 
solely its price risk. As the CFTC has noted and reaffirms today:

    \212\ See, e.g., Brent Interpretation, supra note 207.
---------------------------------------------------------------------------

    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.\213\

    \213\ See Brent Interpretation, supra note 207. 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).
---------------------------------------------------------------------------

    As noted in the Proposing Release, 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.\214\ In assessing the parties' 
expectations or intent regarding delivery, the CFTC consistently has 
applied a ``facts and circumstances'' test.\215\ 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.
---------------------------------------------------------------------------

    \214\ The CFTC observed in its decision 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 207). 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 
(Jul. 21, 1989) (``Swap Policy Statement'') (citations and internal 
quotations omitted)).
    \215\ In 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, note 214, supra, 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 213; Competitive Strategies for Agric., supra note 
213.
---------------------------------------------------------------------------

(B) Brent Interpretation
    In this interpretation, the CFTC is restating, with certain 
clarifications in response to commenters, its interpretation from the 
Proposing Release that the principles underlying the CFTC's ``Brent 
Interpretation'' regarding book-outs developed in connection with the 
forward exclusion from futures apply to the forward exclusion from the 
swap definition as well. Book-out transactions meeting the requirements 
specified in the Brent Interpretation that are effectuated through a 
subsequent, separately negotiated agreement qualify for the safe harbor 
under the forward exclusions.
    As was noted in the Proposing Release, the issue of book-outs first 
arose in 1990 in the Brent Interpretation \216\ because the parties to 
the crude oil contracts in that case could individually negotiate 
cancellation agreements, or ``book-outs,'' with other parties.\217\ In 
describing these transactions, the CFTC stated:
---------------------------------------------------------------------------

    \216\ See Brent Interpretation, supra note 207. 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 207.
    \217\ 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 207, 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.\218\
---------------------------------------------------------------------------

    \218\ 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.'' \219\
---------------------------------------------------------------------------

    \219\ 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

[[Page 48229]]

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.\220\
---------------------------------------------------------------------------

    \220\ 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 also is clarifying that commercial market participants 
that regularly make or take delivery of the referenced commodity in the 
ordinary course of their business meet the commercial participant 
standard of the Brent Interpretation.\221\ The CFTC notes that the 
Brent Interpretation applies to ``commercial participants in connection 
with their business.'' \222\ The CFTC intends that the interpretation 
in this release be consistent with the Brent Interpretation, and 
accordingly is adding ``commercial'' before ``market participants'' in 
this final interpretation. Such entities qualify for the forward 
exclusion from both the future delivery and swap definitions for their 
forward transactions in nonfinancial commodities under the Brent 
Interpretation even if they enter into a subsequent transaction to 
``book out'' the contract rather than make or take delivery. Intent to 
make or take delivery can be inferred from the binding delivery 
obligation for the commodity referenced 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 ordinary course of their 
business.
---------------------------------------------------------------------------

    \221\ See CME Letter (noting that, although the Brent 
Interpretation applies to ``commercial market participants,'' the 
proposed guidance in the Proposing Release was described as applying 
to ``market participants'' (omitting the word ``commercial'') who 
``regularly make or take delivery of the referenced commodities * * 
* in the ordinary course of business.'' See also Proposing Release 
at 29829.
    \222\ Brent Interpretation, supra note 207, at 39192.
---------------------------------------------------------------------------

    Further, in this final interpretation, the CFTC clarifies, in 
response to a comment received, that an investment vehicle taking 
delivery of gold as part of its investment strategy would not be 
engaging in a commercial activity within the meaning of the Brent 
Interpretation.\223\ By contrast, were the investment vehicle, for 
example, to own a gold mine and sell the output of the gold mine for 
forward delivery, or own a chain of jewelry stores that produces its 
own jewelry from raw materials and purchase a supply of gold from 
another entity's gold mine in order to provide raw materials for its 
jewelry stores, such contracts could qualify as forward contracts under 
the Brent Interpretation--provided that such contracts otherwise 
satisfy the terms thereof.
---------------------------------------------------------------------------

    \223\ See CME Letter. In connection with its comment regarding 
``market participants'' described above, see supra note 221, the CME 
further requests confirmation that the CFTC intends to apply the 
Brent Interpretation to market participants who can demonstrate that 
they meet the standard in the guidance as proposed, but are not 
themselves commercial actors:
    Because the Commission`s interpretation does not explicitly 
refer to commercial market participants, it would seem to cover 
financial players as long as those entities regularly make or take 
delivery of the underlying commodity in connection with their 
business. Examples of such entities would be hedge funds or other 
investment vehicles that regularly make or take delivery of 
commodities (e.g. gold) in conjunction with their line of business--
that is, as part of their investment strategies. [CME] asks that the 
[CFTC] confirm that the Brent safe harbor would be available to 
these types of market participants that technically are not 
``commercial'' actors.
    See CME Letter.
---------------------------------------------------------------------------

    In sum, the CFTC is interpreting the term ``commercial'' in the 
context of the Brent Interpretation in the same way it has done since 
1990: ``related to the business of a producer, processor, fabricator, 
refiner or merchandiser.'' \224\ While a market participant need not be 
solely engaged in ``commercial'' activity to be a ``commercial market 
participant'' within the meaning of the Brent Interpretation under this 
interpretation, the business activity in which it makes or takes 
delivery must be commercial activity for it to be a commercial market 
participant. A hedge fund's investment activity is not commercial 
activity within the CFTC's longstanding view of the Brent 
Interpretation.
---------------------------------------------------------------------------

    \224\ Brent Interpretation, supra note 207, at 39191. See also 
dissent of Commissioner Fowler West (stating that commercial means 
``in the traditional sense of those who produce, process, use or * * 
* handle the underlying commodity.''). Note that being a commercial 
market participant with respect to an agreement, contract or 
transaction in one commodity, or grade of a commodity, neither makes 
an entity, nor precludes an entity from being, a commercial market 
participant with respect to an agreement, contract or transaction in 
a different grade of the commodity or a different commodity. For 
example, a West Texas Intermediate oil producer may or may not also 
be a commercial with respect to Brent. Similarly, that same West 
Texas Intermediate oil producer may or may not have commercial corn 
operations. In determining whether an entity is a commercial market 
participant with respect to an agreement, contract or transaction in 
a commodity, the CFTC will consider the facts and circumstances, 
though it is not unlikely that an entity that is a commercial market 
participant with respect to one commodity may also be a commercial 
market participant with respect to either a different grade of the 
commodity or a closely related commodity.
---------------------------------------------------------------------------

    In addition, the CFTC is expanding the Brent Interpretation, which 
applied only to oil, to all nonfinancial commodities, as proposed.\225\ 
As a result, book-outs are permissible (where the conditions of the 
Brent Interpretation are satisfied) for all nonfinancial commodities 
with respect to the exclusions from the definition of the term ``swap'' 
and the definition of the term ``future delivery'' under the CEA.\226\
---------------------------------------------------------------------------

    \225\ See infra part II.B.2(a)(ii), with respect to the CFTC's 
interpretation concerning nonfinancial commodities.
    \226\ The CFTC reminds market participants that this does not 
mean, as was noted in the Brent Interpretation, that these 
transactions or persons who engage in them are wholly outside the 
reach of the CEA for all purposes. See, e.g., CEA section 8(d), 7 
U.S.C. 12(d), which directs the CFTC to investigate the marketing 
conditions of commodities and commodity products and byproducts, 
including supply and demand for these commodities, cost to the 
consumer, and handling and transportation charges; CEA sections 
6(c), 6(d), and 9(a)(2), 7 U.S.C. 9, 13b, and 13(a)(2), which 
proscribe any manipulation or attempt to manipulate the price of any 
commodity in interstate commerce; and CEA section 6(c) as amended by 
section 753 of the Dodd-Frank Act, which contains prohibitions 
regarding manipulation and false reporting with respect to any 
commodity in interstate commerce, including prohibiting any person 
to (i) ``use or employ, or attempt to use or employ * * * any 
manipulative or deceptive device or contrivance'' (section 6(c)(1)); 
(ii) ``to make any false or misleading statement of material fact'' 
to the CFTC or ``omit to state in any such statement any material 
fact that is necessary to make any statement of material fact made 
not misleading in any material respect'' (section 6(c)(2)); and 
(iii) ``manipulate or attempt to manipulate the price of any swap, 
or of any commodity in interstate commerce * * * (section 6(c)(3)). 
See also Rule 180.1(a) under the CEA, 17 CFR 180.1(a) (broadly 
prohibiting in connection with a commodity in interstate commerce 
manipulation, false or misleading statements or omissions of 
material fact to the Commission, fraud or deceptive practices or 
courses of business, and false reporting).
---------------------------------------------------------------------------

(C) Withdrawal of the Energy Exemption
    Because the CFTC has expanded the Brent Interpretation to 
nonfinancial commodities in this final interpretation, the CFTC also 
has determined to withdraw the Energy Exemption as proposed. In 
response to comments received, the CFTC is clarifying that certain 
alternative delivery procedures discussed in the Energy Exemption \227\ 
will not disqualify a transaction from the Brent Interpretation safe 
harbor.
---------------------------------------------------------------------------

    \227\ These include pre-transaction netting agreements that 
result in offsetting physical delivery obligations, ``bona fide 
termination rights,'' and certain other methods by which parties may 
settle their delivery obligations. See Energy Exemption, supra note 
208, at 21293.
---------------------------------------------------------------------------

    In the Proposing Release, the CFTC proposed to withdraw the Energy 
Exemption, which, among other things,

[[Page 48230]]

expanded the Brent Interpretation to energy commodities other than oil, 
on the basis that the exemption was no longer necessary in light of the 
extension of the Brent Interpretation to nonfinancial commodities.\228\ 
The Energy Exemption, like the Brent Interpretation, requires binding 
delivery obligations at the outset, with no right to cash settle or 
offset transactions.\229\ Each requires that book-outs be undertaken 
pursuant to a subsequent, separately negotiated agreement.
---------------------------------------------------------------------------

    \228\ See Proposing Release at 29829. The CFTC also noted that, 
to avoid any uncertainty, the Dodd-Frank Act supersedes the Swap 
Policy Statement. Id. at 29829 n. 74. The CFTC reaffirms that such 
is the case.
    \229\ Compare Energy Exemption, supra note 208, at 21293 with 
Brent Interpretation, supra note 207, at 39192.
---------------------------------------------------------------------------

    As discussed above, the CFTC is extending the Brent Interpretation 
to the swap definition and applying it to all nonfinancial commodities 
for both the swap and future delivery definitions, but is withdrawing 
the Energy Exemption. With regard to netting agreements that were 
expressly permitted by the Energy Exemption,\230\ the CFTC clarifies 
that a physical netting agreement (such as, for example, the Edison 
Electric Institute Master Power Purchase and Sale Agreement) that 
contains a provision contemplating the reduction to a net delivery 
amount of future, unintentionally offsetting delivery obligations, is 
consistent with the intent of the book out provision in the Brent 
Interpretation--provided that the parties had a bona fide intent, when 
entering into the transactions, to make or take delivery (as 
applicable) of the commodity covered by those transactions.
---------------------------------------------------------------------------

    \230\ See Energy Exemption, supra note 208, at 21293.
---------------------------------------------------------------------------

    The CFTC also has determined that, notwithstanding the withdrawal 
of the Energy Exemption, a failure to deliver as a result of the 
exercise by a party of a ``bona fide termination right'' does not 
render an otherwise binding delivery obligation as non-binding.\231\ In 
the Energy Exemption, the CFTC provided the following examples of bona 
fide termination rights: force majeure provisions and termination 
rights triggered by events of default, such as counterparty insolvency, 
default or other inability to perform.\232\ The CFTC confirms that 
market participants who otherwise qualify for the forward exclusion may 
continue to rely on the bona fide termination right concept as set 
forth in this interpretation, although, as was stated in the Energy 
Exemption, such right must be bona fide and not for the purpose of 
evasion. In this regard, the CFTC further clarifies, consistent with 
the Energy Exemption, that a bona fide termination right must be 
triggered by something not expected by the parties at the time the 
contract is entered into.\233\
---------------------------------------------------------------------------

    \231\ See also infra part II.B.2(b)(v) for a discussion of 
liquidated damages.
    \232\ Energy Exemption, supra note 208, at 21293.
    \233\ Id.
---------------------------------------------------------------------------

    The Energy Exemption also discussed a number of methods by which 
parties to energy contracts settle their obligations, including: The 
seller's passage of title and the buyer's payment and acceptance of the 
underlying commodity; taking delivery of the commodity in some 
instances and in others instead passing title to another intermediate 
purchaser in a chain; and physically exchanging (i.e., delivering) one 
quality, grade or type of physical commodity for another quality, grade 
or type of physical commodity.\234\ The CFTC clarifies that these 
settlement methods generally \235\ are not inconsistent with the Brent 
Interpretation.\236\
---------------------------------------------------------------------------

    \234\ Id.
    \235\ The CFTC will carefully scrutinize whether market 
participants are legitimately relying on the Brent Interpretation 
safe harbor. For example, if non-commercial market participants are 
intermediate purchasers in a delivery chain, then the transaction is 
not actually a commercial merchandising transaction, and the parties 
cannot rely on the Brent Interpretation safe harbor.
    \236\ By definition, if two parties exchange (i.e., physically 
deliver) one physical commodity for another physical commodity in 
settlement of the parties' delivery obligations, each seller has 
delivered the commodity that is the subject of its delivery 
obligation under the relevant agreement, contract or transaction. 
Depending on the settlement timing, such transactions, which 
resemble barter transactions, would be spot transactions or forward 
transactions. While the most common forward transaction involves an 
exchange of a physical commodity for cash, neither the Brent 
Interpretation nor any other CFTC authority requires payment for a 
forward delivery to be made in cash. Thus, a physical exchange of 
one quality, grade or type of physical commodity for another 
quality, grade, or type of physical commodity does not affect the 
characterization of the transaction as a spot or forward 
transaction. As for the sellers passing title and buyers, instead of 
taking delivery of the commodity, passing title to another 
intermediate purchaser in a chain, this is consistent with the 
description of Brent transactions in the Brent Interpretation, 
provided that, as set forth therein, delivery is required and ``the 
delivery obligations create substantial economic risk of a 
commercial nature to the parties required to make or take delivery * 
* * includ[ing, without limitation,] demurrage, damage, theft or 
deterioration.'' That description was based on the industry delivery 
structure as it existed prior to the Brent Interpretation. To the 
extent other industries are similarly structured for commercial 
reasons, the delivery-by-title-and-related-bill-of-lading-transfer 
delivery method would be able to rely on the Brent Interpretation if 
it otherwise satisfied the terms thereof. However, to the extent 
persons seek to establish such a delivery structure for new products 
and markets (e.g., not actually delivering the commodity to most of 
the participants in a chain), that could, depending on the 
applicable facts and circumstances, be viewed as outside the Brent 
Interpretation safe harbor or evasion. The CFTC expects that the 
limitation of counterparties eligible to rely on the Brent 
Interpretation to those with a commercial purpose for entering into 
the transaction should limit the development of such markets to 
those with commercial reasons for such a delivery structure.
---------------------------------------------------------------------------

(D) Book-Out Documentation
    The CFTC has taken into consideration comments regarding the 
documentation of book-outs.\237\ Under the Brent Interpretation, what 
is relevant is that the book out occur through a subsequent, separately 
negotiated agreement. While the CFTC is sensitive to existing 
recordkeeping practices for book-outs, in order to prevent abuse of the 
safe harbor, the CFTC clarifies that in the event of an oral agreement, 
such agreement must be followed in a commercially reasonable timeframe 
by a confirmation in some type of written or electronic form.
---------------------------------------------------------------------------

    \237\ See Letter from R. Michael Sweeney, Jr., Hunton & Williams 
LLP, on behalf of the Working Group of Commercial Energy Firms 
(``WGCEF''), dated July 22, 2011 (``WGCEF Letter'').
---------------------------------------------------------------------------

(E) Minimum Contract Size and Other Contextual Factors
    In the Proposing Release, the CFTC requested comment about 
potentially imposing additional conditions (such as, for example, a 
minimum contract size) in order for a transaction to qualify as a 
forward contract under the Brent Interpretation with respect to the 
future delivery and swap definitions.\238\ The CFTC has determined that 
a minimum contract size should not be required in order for a contract 
to qualify as a forward contract under the Brent Interpretation.\239\ 
However, as suggested

[[Page 48231]]

by a commenter, the CFTC may consider contract size as a contextual 
factor in determining whether a particular contract is a forward.\240\ 
Moreover, the CFTC may consider other contextual factors when 
determining whether a contract qualifies as a forward, such as a 
demonstrable commercial need for the product, the underlying purpose of 
the contract (e.g. whether the purpose of the claimed forward was to 
sell physical commodities, hedge risk, or speculate), the regular 
practices of the commercial entity with respect to its general 
commercial business and its forward and swap transactions more 
specifically, or whether the absence of physical settlement is based on 
a change in commercial circumstances. These contextual factors are 
consistent with the CFTC's historical facts-and-circumstances approach 
to the forward contract exclusion outside of the Brent Interpretation 
safe harbor.
---------------------------------------------------------------------------

    \238\ See Proposing Release at 29831, Request for Comment 27.
    \239\ Most commenters opposed adding a minimum contract size or 
other conditions to the CFTC's interpretation of the forward 
exclusion. One commenter argued that such an approach would be 
inconsistent with CFTC precedent, citing the fact that neither the 
Brent Interpretation nor subsequent CFTC precedent interpreting the 
forward exclusion mention contract size. See CME Letter. Another 
commenter pointed out that Congress did not impose such a 
requirement, and thus believes that the CFTC should not do so. See 
Letter from David M. Perlman, Partner, Bracewell & Giuliani LLP, 
Counsel to the Coalition of Physical Energy Companies (``COPE''), 
dated July 22, 2011 (``COPE Letter''). Similarly, a third commenter 
argued that the only condition Congress placed on the forward 
exclusion is intent to physically settle, and contract size is not 
relevant to such intent. See Letter from Natural Gas Supply 
Association/National Corn Growers Association (``NGSA/NCGA''), dated 
July 22, 2011 (``NGSA/NCGA Letter'').
    Two commenters questioned the reasonableness in instituting a 
minimum contract size below which a transaction would become 
regulated, but otherwise would not. See Letter from Craig G. 
Goodman, Esq., President, The National Energy Marketers Association 
(``NEMA''), dated July 21, 2011, (``NEMA Letter'') and Letter from 
Phillip G. Lookadoo on behalf of the International Energy Credit 
Association (``IECA''), dated July 28, 2011 (``IECA Letter''). Two 
commenters believed that such an approach would be contrary to the 
purposes of Dodd-Frank in regulating transactions that would affect 
systemic risk. See NEMA Letter and Letter from Dan Gilligan and 
Michael Trunzo, Petroleum Marketers Association of America and New 
England Fuel Institute (``PMAA/NEFI''), dated July 22, 2011 (``PMAA/
NEFI Letter''). One commenter urged that the Brent Interpretation be 
applied with minimal restrictive overlay. It believed that contract 
size is a ``contextual factor'' that may be considered in evaluating 
the existence of intent to deliver, but should not be viewed as an 
independent determinant. See ISDA Letter.
    One commenter argued that the forward exclusion should be 
strengthened with additional conditions to preclude evasion. Its 
suggested conditions include defining the required regularity of 
delivery (such as a predominance, or ``more often than not'' 
standard); providing a quantitative test of bona fide intent to 
deliver (such as a demonstrable commercial need for the product and 
justifying non-physical settlement based on a change in commercial 
circumstances); and re-evaluating the book-outs aspect of the Brent 
Interpretation. See Better Markets Letter.
    \240\ See ISDA Letter.
---------------------------------------------------------------------------

Comments
    Several commenters believed that the CFTC should codify its 
proposed interpretation regarding the Brent Interpretation in rule text 
to provide greater legal certainty.\241\ One commenter further 
commented that the Dodd-Frank Act's legislative history expressly 
directed the CFTC to clarify through rulemaking that the nonfinancial 
commodity forward contract exclusion from the swap definition is 
intended to be consistent with the forward contract exclusion from the 
term ``future delivery.''\242\ The commenter also stated its view that 
the interpretation as proposed does not provide notice to the 
electricity industry as to how to determine whether a nonfinancial 
commodity agreement is a swap or a nonfinancial commodity forward 
contract, nor as to which factors the CFTC would consider in 
distinguishing between swaps and nonfinancial forward contracts.\243\ 
Moreover, another commenter suggested that the CFTC should include in 
regulatory text a representative, non-exhaustive list of the kinds of 
contracts that are excluded from the swap definition.\244\
---------------------------------------------------------------------------

    \241\ See Letter from Lisa Yoho, Director, Regulatory Affairs, 
BGA, dated July 22, 2011) (``BGA Letter''); COPE Letter; Letter from 
Michael Bardee, General Counsel, Federal Energy Regulatory 
Commission (``FERC''), dated July 22, 2011 (``FERC Staff Letter''); 
Letter from Stephanie Bird, Chief Financial Officer, Just Energy, 
dated July 22, 2011 (``Just Energy Letter''); Letter from the 
Electric Trade Associations (the Electric Power Supply Association, 
National Rural Electric Cooperative Association, Large Public Power 
Council, Edison Electric Institute and American Power Association) 
(``ETA Letter''), dated July 22, 2011.
    \242\ See ETA Letter (citing the ``Lincoln-Dodd Letter'' printed 
at 156 Cong. Rec. H5248-249).
    \243\ See ETA Letter. The commenter requests that the CFTC 
``further define the statutory term `swap' by defining relevant 
terms in the Dodd-Frank Act, reconciling the wording used in the 
various provisions in the CEA as amended by the Dodd-Frank Act, and 
setting forth in the [CFTC's] rules the factors that are 
determinative in drawing the distinction between a `swap' and a 
`nonfinancial commodity forward contract.''' The commenter suggests 
rule text to codify the CFTC's interpretation regarding the 
exclusion of nonfinancial commodity forward contracts. Id.
    \244\ See FERC Staff Letter.
---------------------------------------------------------------------------

    The CFTC has determined not to codify its interpretation in rule 
text. The CFTC has never codified its prior interpretations of the 
forward contract exclusion with respect to the future delivery 
definition as a rule or regulation;\245\ thus, providing an 
interpretation is consistent with the manner in which the CFTC has 
interpreted the forward exclusion in the past, which in turn is 
consistent with the Dodd-Frank Act legislative history.\246\ Moreover, 
Congress did not direct the CFTC to write rules regarding the forward 
exclusion. The Dodd-Lincoln letter, cited by a commenter in support of 
its argument, ``encourages'' the CFTC to clarify the forward exclusion 
``through rulemaking'' in the generic sense of that term (i.e., through 
the rulemaking process of notice and comment), not specifically through 
rule text.\247\ Similarly, the CFTC is not providing in rule text a 
representative list of contracts in nonfinancial commodities that are 
excluded from the swap definition as forwards.
---------------------------------------------------------------------------

    \245\ See, e.g. Brent Interpretation, supra note 207; Energy 
Exemption, supra note 208; Characteristics Distinguishing Cash and 
Forward Contracts and ``Trade'' Options, 50 FR 39656 (Sep. 30, 1985) 
(``1985 CFTC OGC Interpretation'').
    \246\ See supra note 210 and accompanying text.
    \247\ See 156 Cong. Rec. H5248-49 (June 30, 2010).
---------------------------------------------------------------------------

    The CFTC believes that its interpretation provides sufficient 
clarity with respect to the forward contract exclusion from the swap 
and future delivery definitions.\248\ The CFTC also believes that the 
interpretation provides sufficient notice to the public regarding how 
the forward exclusions from the swap and future delivery definitions 
will be interpreted. As noted above, the CFTC's historical approach to 
the forward contract exclusion from the future delivery definition 
developed on a case-by-case basis, not by rule.
---------------------------------------------------------------------------

    \248\ This is particularly true given that the CFTC intends to 
interpret the forward exclusion from the swap definition 
consistently with its interpretation of the forward exclusion from 
the term ``future delivery,'' with which market participants have 
had decades of experience.
---------------------------------------------------------------------------

    Commenters generally supported applying the Brent Interpretation to 
the forward exclusion from the swap definition and expanding it to all 
nonfinancial commodities for purposes of the forward exclusion from 
both the definitions of the terms ``future delivery'' and ``swap.'' 
\249\ However, in addition to the requests for clarification to which 
the CFTC has responded in its final interpretation provided above, 
commenters raise other requests for clarification. One commenter,\250\ 
for example, believed that the CFTC's adjudicatory decisions in Grain 
Land \251\ and Wright \252\ should be construed to have expanded the 
Brent Interpretation's safe harbor. This commenter stated its view that 
in Grain Land, the CFTC recognized that cancellation provisions or an 
option to roll the delivery date within flexible hedge-to-arrive 
contracts did not render the transactions futures contracts, as opposed 
to forwards. As such, this commenter believed this case may be at odds 
with the literal terms of the Brent Interpretation regarding book-outs, 
which required that, to be a forward contract, any cancellation of 
delivery must be effected through a subsequent, separately negotiated 
agreement. The commenter argued that cases subsequent to the Brent 
Interpretation, such as Grain Land and Wright, recognized the need for 
flexibility and innovation in the commercial merchandising transactions 
that are eligible for the forward exclusion. Therefore, this commenter 
requested that the CFTC consider the body of

[[Page 48232]]

forward contract precedent as a whole and extend the Brent 
Interpretation's safe harbor to situations like those presented in 
Grain Land, notwithstanding the absence of a subsequent, separately-
negotiated agreement.\253\
---------------------------------------------------------------------------

    \249\ See BGA Letter; COPE Letter; ISDA Letter; IECA Letter; 
Letter from Stuart J. Kaswell, Executive Vice President & Managing 
Director, Managed Funds Association (``MFA''), dated July 22, 2011 
(``MFA Letter''); NGSA/NCGA Letter; Letter from Charles F. Conner, 
President and CEO, National Council of Farmer Cooperatives 
(``NCFC''), dated July 22, 2011 (``NCFC Letter''); NEMA Letter; 
PMAA/NEFI Letter; WGCEF Letter.
    \250\ See CME Letter.
    \251\ Grain Land, supra note 213.
    \252\ Wright, supra note 214.
    \253\ See CME Letter.
---------------------------------------------------------------------------

    While, as noted above, the CFTC has clarified that the entire body 
of its precedent applies to its interpretation of the forward exclusion 
for nonfinancial commodities in the swap definition, the CFTC does not 
believe that there is a conflict between the Brent Interpretation and 
the Grain Land or Wright cases. In Grain Land, the CFTC concluded that 
the fact that a contract includes a termination right, standing alone, 
is not determinative of whether the contract is a forward. Rather, as 
the CFTC has always interpreted the forward exclusion, it looks to the 
facts and circumstances of the transaction. Similarly in Wright, which 
cited Grain Land with approval, the CFTC stated that ``[i]n assessing 
the parties' expectations or intent regarding delivery, the Commission 
applies a `facts and circumstances' test rather than a bright-line test 
focused on the contract's terms * * * .'' In contrast, the Brent 
Interpretation is a safe harbor that assures commercial parties that 
book-out their contracts through a subsequent, separately negotiated 
agreement that their contracts will not fall out of the forward 
exclusion. The CFTC's conclusion that application of its facts-and-
circumstances approach demonstrated that the particular contracts at 
issue in Grain Land and Wright were forwards did not expand the scope 
of the safe harbor afforded by the Brent Interpretation.\254\
---------------------------------------------------------------------------

    \254\ As described above in the interpretation, the CFTC has 
addressed CME's other comments on the forward exclusion, including 
the interpretation's applicability to commercial market participants 
and CME's hedge fund example.
---------------------------------------------------------------------------

    Several commenters suggested that the Energy Exemption should not 
be withdrawn. One commenter noted that the Energy Exemption, along with 
the Brent Interpretation, should inform the CFTC's interpretation of 
the forward exclusion.\255\ Another commenter believed that the Energy 
Exemption appears entirely consistent with the Dodd-Frank Act and 
should be included in the rules as a non-exclusive exemption to ensure 
continued clarity.\256\ A third commenter requested clarification that 
revoking the Energy Exemption will not harm market participants, 
stating that the Proposing Release did not sufficiently explain the 
rationale for withdrawing the Energy Exemption or the possible 
consequences for energy market participants. This commenter sought 
confirmation that, despite the withdrawal of the Energy Exemption, 
market participants will be permitted to rely on the Brent 
Interpretation, as expanded by the Energy Exemption, particularly as it 
relates to alternative delivery procedures.\257\ This commenter 
expressed concern that by withdrawing the Energy Exemption, the CFTC 
would be revoking the ability of market participants to rely on pre-
transaction netting agreements to offset physical delivery obligations 
as an alternative to separately negotiating book-outs after entering 
into the transactions.\258\ As discussed above, the CFTC has determined 
to withdraw the Energy Exemption as proposed, but has provided certain 
clarifications to address commenters' concerns.
---------------------------------------------------------------------------

    \255\ See COPE Letter Appendix.
    \256\ See IECA Letter.
    \257\ See MFA Letter.
    \258\ Ex Parte Communication between MFA and CFTC Staff on 
September 15, 2011, at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=387&SearchText= .
---------------------------------------------------------------------------

    One commenter suggested the deletion of ``commercial merchandising 
transaction'' as a descriptive term in the interpretation. Although 
recognizing its provenance from the Brent Interpretation, this 
commenter believed that the phrase was anachronistic at that time, and 
that it is misleading and narrow in the current evolving commercial 
environment.\259\ Contrary to this commenter's suggestion, the CFTC has 
determined to retain the phrase ``commercial merchandising 
transaction'' in its final interpretation regarding forward contracts. 
The CFTC characterized forward transactions in this manner in the Brent 
Interpretation, as well as in its subsequent adjudications. Courts also 
have characterized forwards as commercial merchandising transactions or 
cited the CFTC's characterization with approval.\260\ Accordingly, the 
CFTC believes that ``commercial merchandising transaction'' continues 
to be an accurate descriptive term for characterizing forward 
transactions.
---------------------------------------------------------------------------

    \259\ See ISDA Letter.
    \260\ See, e.g., In re Bybee, 945 F.2d 309, 315 (9th Cir. 1991).
---------------------------------------------------------------------------

    Another commenter requested that the CFTC clarify that a 
subsequent, separately-negotiated agreement to effectuate a book-out 
under the Brent Interpretation may be oral or written. This commenter 
noted that the pace at which certain energy markets transact and the 
frequency with which book-outs may sometimes occur, makes formal 
written documentation of all book-outs impracticable.\261\ The CFTC has 
provided an interpretation above regarding the documentation of book-
outs in response to this commenter's concerns.
(ii) Nonfinancial Commodities
---------------------------------------------------------------------------

    \261\ See WGCEF Letter.
---------------------------------------------------------------------------

    In response to commenters,\262\ the CFTC is providing an 
interpretation regarding the scope of the term ``nonfinancial 
commodity'' in the forward exclusion from the swap definition.\263\
---------------------------------------------------------------------------

    \262\ The Commissions requested comment in the Proposing Release 
on whether they should provide guidance regarding the scope of the 
term ``nonfinancial commodity'' and, if so, how and where the line 
should be drawn between financial and nonfinancial commodities. See 
Proposing Release at 29832.
    \263\ As noted above, the CEA definition of the term ``swap'' 
excludes ``any sale of a nonfinancial commodity or security for 
deferred shipment or delivery, so long as the transaction is 
intended to be physically settled.'' CEA section 1a(47)(B)(ii), 7 
U.S.C. 1a(47)(B)(ii). Thus, the forward exclusion from the swap 
definition is limited to transactions in nonfinancial commodities. 
To the extent the CFTC uses the term ``nonfinancial commodity'' in 
other contexts in this release, such as in connection with the Brent 
Interpretation (including as it applies with respect to the ``future 
delivery'' definition), the term will have the same meaning as 
discussed in this section in those contexts.
---------------------------------------------------------------------------

    The CFTC interprets the term ``nonfinancial commodity'' to mean a 
commodity that can be physically delivered and that is an exempt 
commodity \264\ or an agricultural commodity.\265\ Unlike excluded 
commodities, which generally are financial,\266\ exempt and 
agricultural commodities by their nature generally are nonfinancial. 
The requirement that the commodity be able to be physically delivered 
is designed to prevent market participants from relying on the forward 
exclusion to enter into swaps based on indexes of exempt or 
agricultural commodities outside of the Dodd-Frank Act and settling 
them in cash, which would be inconsistent with the historical 
limitation of the forward exclusion to commercial merchandising 
transactions. However, to the extent that a transaction is intended to 
be physically settled, otherwise meets the terms of the forward 
contract exclusion and uses an index merely to determine the price to 
be paid for the nonfinancial commodity intended to be delivered,

[[Page 48233]]

the transaction may qualify for the forward exclusion from the swap 
definition.
---------------------------------------------------------------------------

    \264\ The CEA defines an ``exempt commodity'' as ``a commodity 
that is not an excluded commodity or an agricultural commodity.'' 
CEA section 1a(20), 7 U.S.C. 1a(20). A security is an excluded 
commodity as discussed below, and therefore is not an exempt 
commodity.
    \265\ The CFTC has defined the term ``agricultural commodity'' 
in its regulations at Rule 1.3(zz) under the CEA, 17 CFR 1.3(zz). 
See Agricultural Commodity Definition, 76 FR 41048 (Jul. 13, 2011).
    \266\ The CEA defines an ``excluded commodity'' at CEA section 
1a(19), 7 U.S.C. 1a(19).
---------------------------------------------------------------------------

    In addition, the CFTC is providing an interpretation that an 
intangible commodity (that is not an excluded commodity) which can be 
physically delivered qualifies as a nonfinancial commodity if ownership 
of the commodity can be conveyed in some manner and the commodity can 
be consumed. One example of an intangible nonfinancial commodity that 
qualifies under this interpretation, as discussed in greater detail 
below, is an environmental commodity, such as an emission allowance, 
that can be physically delivered and consumed (e.g., by emitting the 
amount of pollutant specified in the allowance).\267\ The 
interpretation provided herein recognizes that transactions in 
intangible commodities can, in appropriate circumstances, qualify as 
forwards, while setting forth certain conditions to assure that the 
forward exclusion may not be abused with respect to intangible 
commodities.
---------------------------------------------------------------------------

    \267\ See supra part II.B.2.a)iii), regarding environmental 
commodities. An emission allowance buyer also can consume the 
allowance by retiring it without emitting the permitted amount of 
pollutant.
---------------------------------------------------------------------------

Comments
    Several commenters believed that the CFTC should provide an 
interpretation regarding the meaning of the term ``nonfinancial 
commodity'' to provide clarity to market participants on the 
applicability of the forward exclusion.\268\ The CFTC is providing the 
interpretation discussed above to address these commenters' concerns 
but, contrary to one commenter's request, declines to adopt a 
regulation.\269\
(iii) Environmental Commodities
---------------------------------------------------------------------------

    \268\ See Letter from Steven J. Mickelsen, Counsel, 3Degrees 
Group, Inc., dated July 22, 2011 (``3Degrees Letter''); ETA Letter; 
and Letter from Kari S. Larsen, General Counsel, Chief Regulatory 
Officer, Green Exchange LLC, dated July 22, 2011 (``GreenX 
Letter''). Each of these commenters proposed its own definition of 
``nonfinancial commodity.'' The interpretation above incorporates 
many of their suggestions.
    \269\ See ETA Letter. This is consistent with CFTC practice in 
providing an interpretation rather than regulations where warranted. 
In this context, the CFTC is providing an interpretation rather than 
rule text because the CFTC is not limiting the definition of 
``nonfinancial commodity'' to exempt and agricultural commodities 
(the latter category includes agricultural commodity indexes (see 17 
CFR 1.3(zz)(4))). The definition also requires physical 
deliverability and, with respect to intangible commodities, 
ownership transferability and consumability. Whether a commodity has 
these features may require interpretation. In any case, courts can 
rely on agency interpretations.
---------------------------------------------------------------------------

    The Commissions requested comment on whether environmental 
commodities should fall within the forward exclusion from the swap 
definition and, if so, subject to what parameters.\270\ In response to 
commenters, the CFTC is providing an interpretation regarding the 
circumstances under which agreements, contracts or transactions in 
environmental commodities will satisfy the forward exclusion from the 
swap definition.\271\ The CFTC did not propose a definition of the term 
``environmental commodity'' in the Proposing Release and is not doing 
so in this release.\272\ The CFTC believes it is not necessary to 
define the term ``environmental commodity'' because any intangible 
commodity--environmental or otherwise--that satisfies the terms of the 
interpretation provided herein is a nonfinancial commodity, and thus an 
agreement, contract or transaction in such a commodity is eligible for 
the forward exclusion from the swap definition.\273\ The forward 
exclusion from the swap definition does not apply to commodities 
themselves, but to certain types of agreements, contracts or 
transactions in a specified type of commodity (i.e., a ``nonfinancial'' 
commodity).\274\ Environmental commodities that meet the interpretation 
regarding nonfinancial commodities discussed in subsection (ii) above 
are nonfinancial commodities and, therefore, a sale for deferred 
shipment or delivery in such a commodity, so long as the transaction is 
intended to be physically settled, may qualify for the forward 
exclusion from the swap definition.
---------------------------------------------------------------------------

    \270\ See Proposing Release at 29832, Request for Comment 32, 
asked: 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?
    \271\ Because the CFTC has determined, as discussed elsewhere in 
this release, to interpret the forward exclusion from the swap 
definition consistently with the forward exclusion from the ``future 
delivery'' definition, the discussion in this section applies 
equally to the forward exclusion from future delivery.
    \272\ See also Letter from Gene Grace, Senior Counsel, American 
Wind Energy Association (``AWEA''), dated July 22, 2011 (``AWEA 
Letter'') (providing a general description of renewable energy 
credits (``RECs''), emission allowances, and offsets, which the 
commenter collectively termed ``environmental commodities'' for 
purposes of its letter).
    \273\ Thus, market participants should apply the interpretation 
to their facts to determine whether their specific circumstances 
support reliance on the forward exclusion from the swap definition.
    \274\ Several commenters appear to have confused these concepts. 
The term ``commodity'' is defined in CEA section 1a(9), 7 U.S.C. 
1a(9). The forward exclusion in CEA section 1a(47)(B)(ii), 7 U.S.C. 
1a(47)(B)(ii), excludes from the swap definition ``any sale of a 
nonfinancial commodity or security for deferred shipment or 
delivery, so long as the transaction is intended to be physically 
settled.''
---------------------------------------------------------------------------

    The intangible nature of environmental, or other, commodities does 
not disqualify contracts based on such commodities from the forward 
exclusion from the swap definition, notwithstanding that the core of 
the forward exclusion is intent to deliver the underlying 
commodity.\275\ As commenters noted, securities are intangible (with 
the exception of the rare certificated security) and yet they are 
expressly permitted by CEA section 1a(47)(B)(ii) \276\ to be the 
subject of the forward exclusion; this reflects recognition by Congress 
that the forward exclusion can apply to intangible commodities.\277\
---------------------------------------------------------------------------

    \275\ See supra part II.B.2.a)i)(A).
    \276\ 7 U.S.C. 1a(47)(B)(ii).
    \277\ As commenters also note, each Commission or its staff has 
previously indicated that environmental commodities, in the CFTC's 
case, and securities, in the SEC's case, can be physically settled. 
See Letter from Kyle Danish, Van Ness Feldman, P.C., on behalf of 
Coalition for Emission Reduction Policy (``CERP''), dated July 18, 
2011 (``CERP Letter'') and 3Degrees Letter. Also, the recent Carbon 
Report suggested that the forward exclusion could apply to 
agreements, contracts or transactions in environmental commodities. 
See Interagency Working Group for the Study on Oversight of Carbon 
Markets (``Interagency Working Group''), Report on the Oversight of 
Existing and Prospective Carbon Markets (January 2011) (``Carbon 
Report''). The Carbon Report specifically stated that--[n]o set of 
laws currently exist that apply a comprehensive regulatory regime--
such as that which exists for derivatives--specifically to secondary 
market trading of carbon allowances and offsets. Thus, for the most 
part, absent specific action by Congress, a secondary market for 
carbon allowances and offsets may operate outside the routine 
oversight of any market regulator.
---------------------------------------------------------------------------

    The CFTC understands that market participants often engage in 
environmental commodity transactions in order to transfer ownership 
\278\ of the environmental commodity (and not solely price risk),\279\ 
so that the buyer

[[Page 48234]]

can consume the commodity in order to comply with the terms of 
mandatory or voluntary environmental programs.\280\ Those two 
features--ownership transfer and consumption--distinguish such 
environmental commodity transactions from other types of intangible 
commodity transactions that cannot be delivered, such as temperatures 
and interest rates. The ownership transfer and consumption features 
render such environmental commodity transactions similar to tangible 
commodity transactions that clearly can be delivered, such as wheat and 
gold.\281\
---------------------------------------------------------------------------

    \278\ One commenter maintains that a transaction in an 
environmental allowance represents a physically-settled transaction 
because its primary purpose is to transfer ownership of the right to 
emit a specified unit of pollution. See Letter from Andrew K. Soto, 
American Gas Association (``AGA''), dated July 22, 2011 (``AGA 
Letter''). Compare to Proposing Release at 29828 (stating that 
``[t]he primary purpose of the contract is to transfer ownership of 
the commodity'').
    \279\ Another commenter states that, from a practical 
standpoint, the buyer must take delivery to satisfy a compliance 
obligation, which typically requires surrender of allowances and 
offset credits, and likens such transactions to forward sales of 
more tangible commodities, noting they are not devices for 
transferring price risk. See CERP Letter. Compare to Proposing 
Release at 29828 (stating that ``[t]he primary purpose of the 
contract is * * * not to transfer solely * * * price risk''). This 
commenter also advises that delivery of RECs and offsets is 
typically deferred for commercial convenience, consistent with the 
Brent Interpretation, because ``not all of the purchased RECs and 
offsets are generated at the time of the transaction'' and ``long-
term contracts with deferred delivery are important for renewable 
energy projects to ensure a consistent revenue stream over a long 
period of time.'' See CERP Letter.
    \280\ Consumption also can be part of a commercial merchandising 
transaction in the chain of commerce. See, e.g., Brent 
Interpretation, supra note 207 (dissent of Commissioner Fowler West) 
(citing the 1985 CFTC OGC Interpretation and cases cited therein for 
the proposition that ``parties to forward contracts * * * seek to 
profit in their businesses from producing, processing, distributing, 
storing, or consuming the commodity'').
    \281\ Similarly, the settlement method for the types of 
environmental commodity transactions described by commenters such as 
RECs, emission allowances, and offsets are equivalent to that of 
physical commodities where ownership is transferred by delivering a 
warehouse receipt from the seller to the buyer, thereby indicating 
the presence in the warehouse of the contracted for commodity 
volume. See GreenXLetter. See also REMA letter (averring that ``[i]n 
effect, the REC is an intangible contract right or interest in that 
specific quantity of energy; thus, it is quite analogous to a 
warehouse receipt that represents title to a physical commodity''). 
Another similarity between these environmental commodity 
transactions and tangible commodities is that it is possible to 
manipulate the deliverable supply of an environmental commodity just 
as it is for a tangible commodity. The CFTC reminds market 
participants of its continuing authority over forwards under the 
CEA's anti-manipulation provisions prohibiting manipulation, making 
false and misleading statements and omissions of material fact to 
the CFTC, fraud and deceptive practices, and false reporting. See 
supra note 226.
---------------------------------------------------------------------------

    For such transactions, in addition to the factors discussed above, 
intent to deliver is readily determinable,\282\ delivery failures 
generally result from frustration of the parties' intentions,\283\ and 
cash-settlement is insufficient because delivery of the commodity is 
necessary for compliance purposes.\284\ For the foregoing reasons, 
environmental commodities can be nonfinancial commodities that can be 
delivered through electronic settlement or contractual attestation. 
Therefore, an agreement, contract or transaction in an environmental 
commodity may qualify for the forward exclusion from the swap 
definition if the transaction is intended to be physically settled.
---------------------------------------------------------------------------

    \282\ See Letter from Jennifer Martin, Executive Director, 
Center for Research Solutions (``CRS''), dated July 22, 2011 (``CRS 
Letter'').
    \283\ See 3Degrees Letter.
    \284\ See GreenX Letter.
---------------------------------------------------------------------------

Comments
    Several commenters responded to the Commission's request for 
comment regarding the applicability of the forward exclusion from the 
swap definition for agreements, contracts and transactions in 
environmental commodities.\285\
---------------------------------------------------------------------------

    \285\ One commenter provided a general description of renewable 
energy credits (``RECs''), emission allowances, offsets, (which the 
commenter collectively termed ``environmental commodities'' for 
purposes of its letter), and related transactions. See AWEA Letter. 
According to the commenter, RECs are created by state regulatory 
bodies in conjunction with the production of electricity from a 
qualifying renewable energy facility. The forward sale of a REC 
transfers ownership of the REC from the producing entity to another 
entity that can use the REC for compliance with an obligation to 
sell a certain percentage of renewable energy. Many times, this 
forward sale takes place prior to the construction of a project to 
enable developers to secure related project financing. See AWEA 
Letter. See also Letter from Mary Anne Mason, HoganLovells LLP on 
behalf of Southern California Edison Company, Pacific Gas and 
Electric Company and San Diego Gas and Electric Company 
(``California Utilities''), dated July 22, 2011 (``California 
Utilities Letter'') (stating that the California Utilities transact 
in allowances, under the EPA's and anticipated California cap-and-
trade programs, as well as in RECs, in order to comply with or 
participate in various regulatory and voluntary programs).
    The CFTC understands that, in the United States, emission 
allowances and offsets are issued by the U.S. Environmental 
Protection Agency (``EPA''), state government entities and private 
entities. Emission allowances and offsets are transferred between 
counterparties, often through forward contracts, with the purchasing 
party obtaining the ability to use the allowances or offsets for 
compliance with clean air or greenhouse gas regulations. The forward 
sale of allowances and offsets allows market participants to hedge 
the compliance obligations associated with expected emissions, or to 
meet a voluntary emissions reduction commitment or make an 
environmental claim. See, e.g., AWEA Letter; Letter from Henry 
Derwent, President and CEO, International Emissions Trading 
Association, dated July 22, 2011 (defining a carbon offset as a 
``credit[] granted by a state or regional governmental body or an 
independent standards organization in an amount equal to the 
generation of electricity from a qualifying renewable energy 
facility.'').
---------------------------------------------------------------------------

    Most commenters responding to the Commissions' request for comment 
concerning the appropriate treatment of agreements, contracts or 
transactions in environmental commodities asserted that emission 
allowances, carbon offsets/credits, or RECs should be able to qualify 
for the forward exclusion from the swap definition. In support of this 
view, several commenters explained that the settlement process for 
environmental commodity transactions generally involves ``the transfer 
of title via a tracking system, registry or contractual attestation, in 
exchange for a cash payment.'' \286\ One commenter stated that this 
form of settlement demonstrates that the lack of physical existence of 
a commodity is not relevant to whether a transaction in the commodity 
physically settles for purposes of the forward exclusion.\287\ Another 
commenter contended that title transfer constitutes physical delivery 
because the settlement results in the environmental commodity being 
consumed to meet an environmental obligation or goal, which occurs 
through ``retirement'' of the environmental commodity.\288\ Other 
commenters compared the settlement of a transaction in an environmental 
commodity through an electronic registry system to a warehouse receipt 
that represents title to a physical commodity.\289\
---------------------------------------------------------------------------

    \286\ See 3Degrees Letter. See also WGCEF Letter (advising that 
``physical delivery takes place the moment that title and ownership 
in the environmental commodity itself is transferred from the seller 
to the buyer[,] whether through the execution of a legally binding 
contract or attestation, or submission of records to a centralized 
data base, such as a registry''); Letter from the Hons. Jeffrey A. 
Merkley, Sherrod Brown and Jeanne Shaheen, U.S. Senators, dated 
January 13, 2012 (``Senators Letter'') (relaying that ``[t]he 
purchase or sale of a REC is settled through the transfer of title 
to the REC, either electronically over a tracking system or via a 
paper attestation''); Letter from Harold Buchanan, Chief Executive 
Officer, CE2 Carbon Capital, LLC (``CE2''), dated July 22, 2011 
(``CE2 Letter''); Letter from Jason M. Rosenstock, ML Strategies LLC 
on behalf of The Business Council for Sustainable Energy (``BCSE''), 
dated January 24, 2012 (``BCSE Letter''); NEMA Letter (stating that 
RECs must be physically settled through a REC registry, which 
``ensures that there is a physical megawatt hour from a green 
generator behind the REC'').
    \287\ See 3Degrees Letter. See also GreenX Letter (stating that 
environmental commodities share the same characteristics as tangible 
physical commodities ``in all key respects,'' including that they 
are in limited supply).
    \288\ See CRS Letter. CRS explains that retirement occurs 
through a registry or electronic tracking system by transfer into a 
retirement account (or, alternatively, an exchange of paperwork) and 
that, once retired, an environmental commodity cannot be resold. The 
CRS also argues that such environmental commodity transactions are 
commercial merchandising transactions, and thus may be forward 
contracts, because the primary purpose of the transactions is to 
transfer ownership so that the purchaser may comply with an 
applicable environmental program. See also 3Degrees Letter and AWEA 
Letter.
    \289\ See Letter from Josh Lieberman, General Manager, Renewable 
Energy Markets Association (``REMA''), dated July 22, 2011 (``REMA 
Letter'') (distinguishing RECs, which allow the buyer to own 
environmental attributes, from a pure financial swap, where only 
price risk is transferred); See also GreenX Letter (likening the 
settlement of an environmental commodity transaction (where delivery 
typically would take place by electronic delivery from the registry 
account of the seller to the registry account of the buyer) to that 
of transactions in many tangible physical commodities, such as 
agricultural commodities and metals, where settlement is evidenced 
by an electronic transfer of a warehouse receipt in the records of 
the warehouse and the underlying commodity does not move--it remains 
in the warehouse or vault--but its ownership changes)).

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[[Page 48235]]

    A few commenters also analogized environmental commodities to 
securities, which (with the exception of certificated securities) are 
intangible. Some commenters, for example, asserted that the language of 
the forward exclusion from the swap definition means that non-physical 
items can be physically settled because the exclusion, which references 
securities, ``implies that securities--which lack a strict physical 
existence--may be physically settled.'' \290\
---------------------------------------------------------------------------

    \290\ See CRS Letter. See also CERP Letter (claiming that 
Congress did not intend for the phrase ``physically settled'' in the 
forward exclusion to be limited to tangible commodities because, 
like environmental commodities, securities only exist ``on 
paper.''). See also AWEA Letter.
---------------------------------------------------------------------------

    Some commenters assured the Commissions that applying the forward 
exclusion to transactions in environmental commodities would not permit 
transactions that should be subject to the swap regulatory regime to 
fall outside it. One commenter submitted that intent to deliver with 
respect to environmental commodities will be readily determinable.\291\ 
Another commenter contended that: environmental commodity contracts 
almost universally require delivery and that failure to do so is an 
event of default; to the best of its knowledge, it is rare for such a 
contract to include the right to unilaterally terminate an agreement 
under a pre-arranged contractual provision permitting financial 
settlement; \292\ and defaults generally are the result of something 
frustrating parties' intentions.\293\ Still other commenters 
distinguished environmental commodities from other intangible 
commodities, such as the nonfinancial commodities (such as interest 
rates and temperatures) that the CFTC referred to in its Adaptation 
Notice of Proposed Rulemaking,\294\ because RECs and emissions 
allowances or offsets can be physically transferred from one account to 
another, whereas ``it is not possible to move and physically transfer 
an interest rate or a temperature reading.'' \295\
---------------------------------------------------------------------------

    \291\ See CRS Letter (``unlike a stock or a bond, which can be 
resold for its cash value, purchasers of environmental commodities 
intend to take delivery of RECs or carbon offsets for either 
compliance purposes or in order to make an environmental claim 
regarding their renewable energy use or carbon footprint.''). See 
also GreenX Letter.
    \292\ Such a provision would preclude reliance on the forward 
exclusion.
    \293\ See 3Degrees Letter.
    \294\ See Adaptation of Regulations to Incorporate Swaps, 76 FR 
33066, June 7, 2011.
    \295\ See California Utilities Letter.
---------------------------------------------------------------------------

    As discussed above, the CFTC has addressed the foregoing concerns 
of commenters by providing an interpretation that agreements, contracts 
and transactions in environmental commodities may qualify for the 
forward exclusion from the swap definition.
    One commenter stated its view that the forward exclusion from the 
swap definition should not be available for carbon transactions because 
they should be standardized and conducted on open, transparent and 
regulated exchanges.\296\ This commenter acknowledged the possibility 
that carbon transactions can be physically settled (as the statute 
requires of excluded forward contracts) but argued that, in light of 
the fact that there is no cost associated with making or taking 
delivery of carbon, there is no cost to store it, and there is no delay 
in delivering it, a forward exclusion for carbon transactions may allow 
financial speculators to escape regulation otherwise required by the 
Dodd-Frank Act. The CFTC believes that if a transaction satisfies the 
terms of the statutory exclusion, the CFTC lacks the authority to 
deprive the transaction of the exclusion, absent evasion.\297\
---------------------------------------------------------------------------

    \296\ See Letter from Michelle Chan, Director, Economic Policy 
Programs, Friends of the Earth, dated July 22, 2011.
    \297\ While the commenter contended that ``the intangible nature 
of carbon makes it much easier for speculators or those simply 
seeking to hedge carbon price risk to take delivery of the carbon 
itself rather than enter into a derivatives transaction,'' as the 
CFTC states in section VII.A.2.c), infra, deciding to enter into a 
forward transaction rather than a swap does not constitute evasion. 
Thus, if the transaction in question is a forward contract, that is 
the end of the analysis, absent the presence of other factors that 
may indicate evasion. See AWEA Letter.
---------------------------------------------------------------------------

    One commenter stated that ``[i]n the solar industry, RECs are often 
traded by an individual consumer as an assignment of a right owned by 
that consumer.'' \298\ This commenter also advised that many individual 
consumers transact forward contracts through solar REC (``SREC'') 
aggregators at a fixed price. The CFTC notes \299\ that a transaction 
entered into by a consumer cannot be a forward transaction, and 
accordingly should not be the subject of an interpretation of the 
forward exclusion.\300\
---------------------------------------------------------------------------

    \298\ See Letter from Katherine Gensler, Director, Regulatory 
Affairs, SEIA, dated August 5, 2011 (``SEIA Letter'').
    \299\ See Proposing Release at 29832 n.104.
    \300\ However, in section II.B.3., infra, the Commissions 
provide an interpretation regarding the applicability of the swap 
definition to consumer transactions.
---------------------------------------------------------------------------

    One commenter takes the position that, because EPA emission 
allowances are issued in transactions with the EPA, only resales of 
such allowances (secondary market transactions) could be swaps because 
the EPA's initial issuance of allowances would be excluded from the 
swap definition under CEA section 1a(47)(B)(ix).\301\ The CFTC declines 
to address the commenter's legal conclusion regarding the application 
of CEA section 1a(47)(B)(ix), but agrees that an emission allowance 
created by the EPA is a nonfinancial commodity and that agreements, 
contracts and transactions in such allowances may fall within the 
forward exclusion from the swap definition.
---------------------------------------------------------------------------

    \301\ See Letter from Lauren Newberry, Jeffrey C. Fort, Jeremy 
D. Weinstein, and Christopher B. Berendt, Environmental Markets 
Association, dated July 21, 2011.
---------------------------------------------------------------------------

(iv) Physical Exchange Transactions
    The Commissions received a comment letter seeking clarification 
that physical exchange transactions are forward contracts excluded from 
the swap definition.\302\ As described by the commenter, physical 
exchange transactions involve ``a gas utility entering into a 
transaction with another gas utility or other market participant to 
take delivery of natural gas at one delivery point in exchange for the 
same quantity of gas to be delivered at an alternative delivery point * 
* * for the primary purpose of transferring ownership of the physical 
commodity in order to rationalize the delivery of physical supplies to 
where they are needed'' at a price ``generally reflecting the 
difference in value at the delivery points.'' \303\ This commenter 
stated that ``exchange transactions create binding obligations on each 
party to make and take delivery of physical commodities [, i]n essence 
constituting paired forward contracts that are intended to go to 
physical delivery.'' \304\ The commenter added that, to the extent an 
exchange transaction payment is based on an index price, such pricing 
is not severable from the physical exchange.\305\
---------------------------------------------------------------------------

    \302\ See AGA Letter.
    \303\ Id. This commenter noted that gas utilities often can 
receive gas at more than one interconnection or delivery point on a 
pipeline.
    \304\ Id.
    \305\ Id.
---------------------------------------------------------------------------

    The CFTC interprets the exchange transactions described by the 
commenter, to the extent they are for deferred delivery, as examples of 
transactions in nonfinancial commodities that are within the forward 
exclusion from the definition of the terms ``swap'' and ``future 
delivery.'' Based on the information supplied by the commenter, they 
are commercial merchandising transactions, the primary purpose of which 
is to transfer

[[Page 48236]]

ownership of natural gas between two parties who intend to physically 
settle such transactions. That exchange transactions may involve, in 
addition to gas deliveries at two separate delivery points, a cash 
payment by one party to the other reflecting the difference in value of 
the gas at different delivery points, or that such payment may be based 
on an index, does not necessarily affect the nature of the transactions 
as forward transactions.\306\ For an exchange transaction to fall 
within the forward exclusion, though, the parties to the transaction 
must intend for the transaction to be physically settled, and the 
exchange transaction must satisfy all applicable interpretations set 
forth herein, including that relating to book-outs.\307\
---------------------------------------------------------------------------

    \306\ However, if such payment stems from an embedded option, 
the interpretation set forth in the embedded option section of this 
release, see infra part II.B.2(b)(v), also would be relevant to 
determining whether an exchange transaction were covered by the 
forward exclusion from the swap definition.
    \307\ While the commenter also states that ``[g]as utilities 
contract with interstate pipelines for capacity rights to have their 
gas supplies delivered to specific delivery points,'' its discussion 
of exchange transactions appears unrelated to such capacity rights. 
Therefore, the CFTC's guidance on exchange transactions does not 
address exchange transactions with capacity elements, which, 
depending on their structures, may be covered by the guidance set 
forth in the embedded option section of this release or by the 
CFTC's recent Commodity Options release. See infra note 317. 
Conversely, that parties to an exchange transaction separately enter 
into a capacity transaction with a pipeline operator to transport 
natural gas delivered via an exchange transaction is not relevant to 
today's guidance regarding exchange transactions.
---------------------------------------------------------------------------

(v) Fuel Delivery Agreements
    The CFTC understands that fuel delivery agreements can generally be 
described as agreements whereby two or more parties agree to divide the 
cost of acquiring fuel for generation facilities based on some formula 
or factors, which can include, for example, their respective financial 
contributions to developing the source of the fuel (e.g., a natural gas 
field). One example of a fuel delivery agreement could involve a joint 
power agency providing to a municipal utility a long-term supply of 
natural gas from a natural gas project developed by the joint power 
agency and other entities to provide fuel for, among others, the joint 
power agency's and the municipal utility's natural gas-fired electric 
generating facilities. The municipal utility would pay the joint power 
agency through direct capital contributions to the entity formed to 
develop the natural gas project for the cost of developing it. In 
addition, the municipal utility would pay the joint power agency a 
monthly fee for the natural gas supplied from the natural gas project. 
The monthly fee would be composed of an operating cost fee component, 
an interstate pipeline transportation cost fee component and an 
operating reserve cost fee component. The municipal utility's natural 
gas-fired electric generating facility would be used to supply a 
portion of its expected retail electric load.
    Such agreements are forward transactions if they otherwise meet the 
interpretation set forth in this release regarding the forward 
exclusions (e.g., no optionality other than as permitted by the 
interpretation). Monthly or other fees that are not in the nature of 
option premiums do not convert the transactions from forwards to 
options. Because the transactions as described above do not appear to 
exhibit optionality as to delivery, and no other aspect of the 
transactions as described above seem to exhibit optionality, the fees 
would not seem to resemble option premiums.\308\
---------------------------------------------------------------------------

    \308\ This interpretation is limited to the facts and 
circumstances described herein; the CFTC is not opining on different 
facts or circumstances, which could change the CFTC's 
interpretation.
---------------------------------------------------------------------------

(vi) Cleared/Exchange-Traded Forwards
    In the Proposing Release, the Commissions requested comment 
regarding whether forwards executed on trading platforms should fall 
within the forward exclusion from the swap definition and, if so, 
subject to what parameters.\309\ One commenter requested that the CFTC 
adopt a non-exclusive safe harbor providing that exchange-traded 
contracts with respect to which more than 50 percent of contracts, on 
average on a rolling three-month basis, go to delivery and where 100 
percent of the counterparties are commercial counterparties, are 
neither futures nor swaps (``50/100 Forward Safe Harbor'').\310\ This 
commenter further requested that the CFTC provide an appropriate 
transition period once those thresholds are breached. This commenter 
contended that two hallmarks of the exchange-traded forward markets, 
which it characterized as ``a relatively new development,'' are that 
the participants generally are commercials and a high percentage of 
contracts go to delivery, notwithstanding netting of delivery 
obligations.\311\ This commenter added that, while parties to such 
contracts intend to go to delivery when they enter into them, their 
delivery needs may change as time passes.
---------------------------------------------------------------------------

    \309\ See Proposing Release at 29831-29832, Request for Comment 
30.
    \310\ See Letter from Peter Krenkel, President and CEO, NGX, 
dated Nov. 4, 2010, resubmitted by email to CFTC staff on Sept. 14, 
2011 (``NGX Letter''). One other commenter addressed a related 
issue, asserting that the Commissions should clarify that cleared 
forwards between commercial participants should be permitted under 
the forward contract exclusion. See Ex Parte Communication among 
Evolution Markets Inc. (``Evolution''), Ogilvy Government Relations 
(``Ogilvy'') and CFTC staff on May 18, 2011 at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=197&SearchText=.
    \311\ Id.
---------------------------------------------------------------------------

    The CFTC declines to address this request for the 50/100 Forward 
Safe Harbor, which raises policy issues that are beyond the scope of 
this rulemaking. Should the CFTC consider the implications of the 
requested 50/100 Forward Safe Harbor, including possible additional 
conditions for relief, it would be appropriate for the CFTC to obtain 
further comment from the public on this discrete proposal. For the same 
reasons, the CFTC declines to address at this time the comment 
requesting that the CFTC take the view that cleared forwards between 
commercial participants fall within the scope of the forward contract 
exclusion.
(b) Commodity Options and Commodity Options Embedded in Forward 
Contracts
(i) Commodity Options \312\
---------------------------------------------------------------------------

    \312\ As used in this release, the term ``commodity option'' 
refers to an option that is subject to the CEA.
---------------------------------------------------------------------------

    The CFTC noted in the Proposing Release \313\ that the statutory 
swap definition explicitly provides that commodity options are swaps, 
that it had proposed revisions to its existing options rules in parts 
32 and 33 of its regulations \314\ with respect to the treatment of 
commodity options under the Dodd-Frank Act, and that it had requested 
comment on those proposed revisions in that rulemaking proceeding.\315\ 
Accordingly, the CFTC did not propose an additional interpretation in 
the Proposing Release with respect to commodity options.
---------------------------------------------------------------------------

    \313\ See Proposing Release at 29829-30.
    \314\ 17 CFR Parts 32 and 33.
    \315\ See Commodity Options and Agricultural Swaps, 76 FR 6095 
(Feb. 3, 2011) (proposed).
---------------------------------------------------------------------------

    The CFTC reaffirms that commodity options are swaps under the 
statutory swap definition, and is not providing an additional 
interpretation regarding commodity options in this release. The CFTC 
recently addressed commodity options in the context of a separate final 
rulemaking and interim final rulemaking, under its plenary options 
authority in CEA section 4c(b).\316\ There, the CFTC adopted a modified 
trade option exemption, and has invited

[[Page 48237]]

public comment on the interim final rules.\317\
---------------------------------------------------------------------------

    \316\ 7 U.S.C. 6c(b).
    \317\ See Commodity Options, 77 FR 25320 (Apr. 27, 2012).
---------------------------------------------------------------------------

Comments
    Several commenters in response to the Proposing Release argued that 
commodity options should not be regulated as swaps.\318\ In general, 
these commenters believed that commodity options should qualify for the 
forward exclusion from the swap definition, emphasizing similarities 
between commodity options and forward contracts on nonfinancial 
commodities.\319\
---------------------------------------------------------------------------

    \318\ See Letter from Brian Knapp, Policy Advisor, American 
Petroleum Institute (``API''), dated January 31, 2012 (``API 
Letter''); BGA Letter; COPE Letter; ETA Letter; Just Energy Letter; 
NGSA/NCGA Letter; and WGCEF Letter.
    \319\ For example, one commenter asserted that, similar to a 
forward contract on a nonfinancial commodity, a commodity option 
conveys no ability for a party to unilaterally require a financial 
settlement. Reasoning that both commodity options and forward 
contracts on nonfinancial commodities are intended to settle by 
physical delivery, this commenter contended that they should have 
the same regulatory treatment. See COPE Letter. Similarly, another 
commenter argued that the forward exclusion ``plainly covers'' 
commodity options because they are: (i) Contracts for the sale of 
physical, nonfinancial commodities, (ii) for deferred delivery, and 
(iii) intended to be physically settled, given that purchasers have 
an absolute right to physical delivery and sellers have an absolute 
obligation to physically deliver the amounts called for by the 
purchasers if the option is exercised. See NGSA/NCGA Letter. A third 
commenter recommended that the CFTC interpret the forward exclusion 
``broadly'' to include options that, if exercised, become forwards 
in nonfinancial commodities in light of the particular circumstances 
of the electricity industry, where electric companies use commodity 
options to efficiently meet the demands of electric customers by 
hedging or mitigating commercial risks due to seasonal and 
geographically unique weather and load patterns and fluctuations. 
See ETA letter. In the alternative, a fourth commenter requested 
that the CFTC exercise its plenary options authority under CEA 
section 4c(b), 7 U.S.C. 6c(b), to establish a separate regulatory 
regime for commodity options analogous to the trade option exemption 
under former CFTC Rule 32.4. See WGCEF Letter. See 17 CFR 32.4 
(2011).
---------------------------------------------------------------------------

    The CFTC is not providing an interpretation that commodity options 
qualify as forward contracts in nonfinancial commodities. Such an 
approach would be contrary to the plain language of the statutory swap 
definition, which explicitly provides that commodity options are 
swaps.\320\ This approach also would be a departure from the CFTC's and 
its staff's longstanding interpretation of the forward exclusion with 
respect to the term ``future delivery,'' \321\ which the CFTC has 
determined above to apply to the forward exclusion from the swap 
definition as well.\322\ Further, the CFTC notes that it has recently 
issued final and interim final rules adopting a modified version of the 
CFTC's existing trade option exemption.\323\
---------------------------------------------------------------------------

    \320\ See CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i) 
(defining a swap as, among other things, ``a put, call * * * or 
option of any kind * * * for the purchase or sale * * * of * * * 
commodities'') and CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B) (not 
excluding commodity options from the swap definition).
    \321\ See 1985 CFTC OGC Interpretation, supra note 245. In this 
regard, an option cannot be a forward under the CFTC's precedent, 
because under the terms of the contract the optionee has the right, 
but not the obligation, to make or take delivery, while under a 
forward contract, both parties must have binding delivery 
obligations: one to make delivery and the other to take delivery.
    \322\ See supra part II.B.2(a)(i)(A).
    \323\ See supra note 317.
---------------------------------------------------------------------------

(ii) Commodity Options Embedded in Forward Contracts
    The CFTC is restating the interpretation regarding forwards with 
embedded options from the Proposing Release, but with certain 
modifications based on comments received. The CFTC is providing 
additional interpretations regarding forwards with embedded volumetric 
optionality, optionality in the form of evergreen and renewal 
provisions, and optionality with respect to delivery points and 
delivery dates.
    As was noted in the Proposing Release, 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.'' \324\ The CFTC's Office of General Counsel 
addressed forward contracts that contained embedded options in the 1985 
CFTC OGC Interpretation,\325\ which recently was adhered to by the CFTC 
in its adjudicatory Order in the Wright case.\326\ While both were 
issued prior to the effective date of the Dodd-Frank Act, the CFTC 
believes that, as was stated in the Proposing Release, it is 
appropriate to apply this interpretation to the treatment of forward 
contracts in nonfinancial commodities that contain embedded options 
under the Dodd-Frank Act.\327\
---------------------------------------------------------------------------

    \324\ See Proposing Release at 29830.
    \325\ See 1985 CFTC OGC Interpretation, supra note 245.
    \326\ Wright, supra note 214.
    \327\ See Proposing Release at 29830.
---------------------------------------------------------------------------

    In Wright, the CFTC stated that it 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.\328\ As was stated in the Proposing Release, 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.\329\ Utilizing these principles, the CFTC is 
providing a final interpretation that a forward contract that contains 
an embedded commodity option or options \330\ will be considered an 
excluded nonfinancial commodity forward contract (and not a swap) if 
the embedded option(s):
---------------------------------------------------------------------------

    \328\ Wright, supra note 214, 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.
    \329\ See Proposing Release at 29830.
    \330\ 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.
---------------------------------------------------------------------------

    1. May be used to adjust the forward contract price,\331\ but do 
not undermine the overall nature of the contract as a forward contract;
---------------------------------------------------------------------------

    \331\ For example, a forward with an embedded option with a 
formulaic strike price based on an index value that may not be known 
until after exercise would be a forward if it meets the rest of the 
3 components of this interpretation. Triggering an option to buy or 
sell one commodity based on the price of a different commodity 
reaching a specified level, such as in a cross-commodity 
transaction, does not constitute an adjustment to the forward 
contract price within the meaning of this 3-part interpretation.
---------------------------------------------------------------------------

    2. Do not target the delivery term, so that the predominant feature 
of the contract is actual delivery; and
    3. Cannot be severed and marketed separately from the overall 
forward contract in which they are embedded.\332\
---------------------------------------------------------------------------

    \332\ See Wright, supra note 214, at **6-7.

In evaluating whether an agreement, contract, or transaction qualifies 
for the forward contract exclusions from the swap definition for 
nonfinancial commodities, the CFTC will 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.\333\ Such an approach 
will help

[[Page 48238]]

assure that commodity options that should be regulated as swaps do not 
circumvent the protections established in the Dodd-Frank Act through 
the forward contract exclusion for nonfinancial commodities instead.
---------------------------------------------------------------------------

    \333\ 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 definition of the term ``future 
delivery'' in the CEA. See id. at *5 (``As we have held since 
Stovall, the nature of a contract involves a multi-factor analysis * 
* *.'').
---------------------------------------------------------------------------

    The CFTC also is providing an interpretation, in response to 
commenters,\334\ with respect to forwards with embedded volumetric 
optionality.\335\ Several commenters asserted that agreements, 
contracts, and transactions that contain embedded ``volumetric 
options,'' and that otherwise satisfy the terms of the forward 
exclusions, should qualify as excluded forwards, notwithstanding their 
embedded optionality.\336\ The CFTC believes that agreements, 
contracts, and transactions with embedded volumetric optionality may 
satisfy the forward exclusions from the swap and future delivery 
definitions under certain circumstances. Accordingly, the CFTC is 
providing an interpretation that an agreement, contract, or transaction 
falls within the forward exclusion from the swap and future delivery 
definitions, notwithstanding that it contains embedded volumetric 
optionality, when:
---------------------------------------------------------------------------

    \334\ The CFTC requested comment on, among other things: whether 
there are other factors that should be considered in determining how 
to characterize forward contracts with embedded options with respect 
to nonfinancial commodities; and whether there are provisions in 
forward contracts with respect to nonfinancial commodities, other 
than delivery and price, containing embedded optionality. See 
Proposing Release at 29832.
    \335\ One commenter characterized ``volumetric optionality'' as 
the optionality in a contract settling by physical delivery and used 
to meet varying customer demand for a commodity.'' See WGCEF Letter. 
See also BGA Letter (stating that ``it is commonplace for energy 
suppliers to enter into commercial transactions with customers 
(local distribution companies, electric utility companies, 
industrial, commercial and residential customers, power plants, 
etc.), which provide volumetric, price and delivery-related 
flexibility and variability''). BGA claims that commercial 
transactions containing embedded volumetric optionality ``include, 
but are not limited to, full requirements contracts, interruptible 
load agreements, capacity contracts, tolling agreements, energy 
management agreements, natural gas transportation contracts and 
natural gas storage contracts.'' Id.
    \336\ See, e.g., WGCEF Letter (submitting that ```volumetric 
optionality' is [a] separate and distinct concept from 
`deliverability optionality'''); BGA Letter; AGA Letter; Letter from 
Jeffrey Perryman, Director, Contracts and Compliance, Atmos Energy 
Holdings, Inc. (``Atmos''), dated July 22, 2011 (``Atmos Letter''); 
NGSA/NCGA Letter; Letter from Paul M. Architzel, Wilmer Hale LLP on 
behalf of ONEOK, Inc. (``ONEOK''), dated July 22, 2011 (``ONEOK 
Letter''); COPE Letter.
---------------------------------------------------------------------------

    1. The embedded optionality does not undermine the overall nature 
of the agreement, contract, or transaction as a forward contract;
    2. The predominant feature of the agreement, contract, or 
transaction is actual delivery;
    3. The embedded optionality cannot be severed and marketed 
separately from the overall agreement, contract, or transaction in 
which it is embedded; \337\
---------------------------------------------------------------------------

    \337\ When a forward contract includes an embedded option that 
is severable from the forward contract, the forward can remain 
subject to the forward contract exclusion, if the parties document 
the severance of the embedded option component and the resulting 
transactions, i.e. a forward and an option. Such an option would be 
subject to the CFTC's regulations applicable to commodity options.
---------------------------------------------------------------------------

    4. The seller of a nonfinancial commodity underlying the agreement, 
contract, or transaction with embedded volumetric optionality intends, 
at the time it enters into the agreement, contract, or transaction to 
deliver the underlying nonfinancial commodity if the optionality is 
exercised;
    5. The buyer of a nonfinancial commodity underlying the agreement, 
contract or transaction with embedded volumetric optionality intends, 
at the time it enters into the agreement, contract, or transaction, to 
take delivery of the underlying nonfinancial commodity if it exercises 
the embedded volumetric optionality;
    6. Both parties are commercial parties; \338\ and
---------------------------------------------------------------------------

    \338\ See discussion in section II.B.2.(a)(i)(B), supra.
---------------------------------------------------------------------------

    7. The exercise or non-exercise of the embedded volumetric 
optionality is based primarily on physical factors,\339\ or regulatory 
requirements,\340\ that are outside the control of the parties and are 
influencing demand for, or supply of, the nonfinancial commodity.\341\
---------------------------------------------------------------------------

    \339\ See, e.g., BGA Letter (advising that ``[v]ariability 
associated with an energy customer's physical demand is influenced 
by factors outside the control of * * * energy suppliers (and 
sometimes * * * consumers) * * * including, but not limited to, load 
growth, weather and certain operational considerations (e.g., 
available transportation capacity to deliver physical natural gas 
purchased on the spot market)'').
    \340\ Volumetric optionality in this category would include, for 
example, a supply contract entered into to satisfy a regulatory 
requirement that a supplier procure, or be able to provide upon 
demand, a specified volume of commodity (e.g., electricity). To the 
extent the optionality covers an amount of the commodity in excess 
of the regulatory requirement, such optionality would not 
necessarily be covered by this aspect of the guidance, though it may 
nevertheless be covered by the guidance if such excess volumetric 
optionality is based on physical factors within the meaning of the 
guidance. For example, the California Utilities explained that the 
California Public Utilities Commission (``CPUC'') requires them to 
file a supply plan with the CPUC demonstrating that they have 
procured sufficient capacity resources (including reserves) needed 
to serve their aggregate system load on a monthly and yearly basis. 
See California Utilities Letter. Each utility's system requirement 
is 100 percent of its peak-hourly forecast load plus a 15-17 percent 
reserve margin. The California Utilities enter into resource 
adequacy agreements to procure electric power generating capacity to 
meet these requirements. The ability to call on the additional 15 to 
17% reserve reflected in such an agreement is covered by the 
regulatory requirements part of this element. To the extent the 
California Utilities may have a business need to procure additional 
capacity resources beyond the foregoing regulatory requirement 
(e.g., because they wish to maintain a slightly larger reserve 
margin than required due to a recent upswing in unscheduled plant 
outages due to aging plants), that may be covered under the 
interpretation if the additional capacity is required due to 
physical factors beyond the control of the parties (i.e., the 
unscheduled outage, in the foregoing example).
    \341\ In other words, the predominant basis for failing to 
exercise the option would be that the demand or supply (as 
applicable) that the optionality was intended to satisfy, if needed, 
never materialized, materialized at a level below that for which the 
parties contracted or changed due to physical factors or regulatory 
requirements outside the parties' control. Such failure to exercise, 
or an exercise for a reduced amount of the underlying commodity, 
could, for example, be due to colder than expected weather during 
the summer decreasing demand for air conditioning, in turn 
decreasing demand for power to run the air conditioning. The 
Commission does not interpret this to mean that absolutely all 
factors involved in the decision to exercise an option must be 
beyond the parties' control, but rather the decision must be 
predominantly driven by factors affecting supply and demand that are 
beyond a parties control. This also means that the forward contract 
with embedded volumetric optionality needs to be a commercially 
appropriate method for securing the purchase or sale of the 
nonfinancial commodity for deferred shipment at the time it is 
entered into. The CFTC cautions market participants that, to the 
extent a party relies on the forward exclusion from the swap or 
future delivery definitions, notwithstanding that there is 
volumetric optionality, if that volumetric optionality is 
inconsistent with the seventh element of the interpretation, the 
agreement, contract or transaction may be an option.
---------------------------------------------------------------------------

    The first two elements of the interpretation for embedded 
volumetric optionality, which mirror the CFTC's historical embedded 
option interpretation discussed above, have been modified to reflect 
that embedded volumetric optionality relates to delivery rather than 
price. As noted above, the predominant feature of a forward contract is 
a binding, albeit deferred, delivery obligation. It is essential that 
any embedded option in a forward contract as to volume must not 
undermine a forward contract's overall purpose.\342\ The CFTC 
recognizes that the nature of commercial operations are such that 
supply and demand requirements cannot always be accurately predicted 
and that forward contracts that allow for some optionality as to the 
amount of a nonfinancial commodity actually delivered offer a great 
deal of value to commercial

[[Page 48239]]

participants. Where an agreement, contract, or transaction requires 
delivery of a non-nominal volume of a nonfinancial commodity, even if 
an embedded volumetric option is exercised, the CFTC believes that the 
predominant feature of the contract, notwithstanding the embedded 
volumetric optionality, is actual delivery. This is the case in many 
forward contracts that have an embedded option that allows a party to 
buy or sell an additional amount of a commodity beyond the fixed amount 
called for in the underlying forward contract. For instance, a forward 
contract could call for the delivery of 10,000 bushels of wheat and 
include an option for an additional 5,000 bushels of wheat.\343\
---------------------------------------------------------------------------

    \342\ See discussion in part II.B.2.(a)(i)(B), supra. See also 
supra note 321.
    \343\ In evaluating whether the predominant feature of a 
transaction is actual delivery, the CFTC will look at the contract 
as a whole. Thus, with respect to this contract, the CFTC would 
consider the intent element of the forward exclusions to be 
satisfied because the contract requires the seller to deliver a non-
nominal volume of a commodity (i.e., 10,000 bushels of wheat), 
viewing the contract as a whole. As a result, if the other elements 
of the guidance above are satisfied, this contract would be a 
forward contract, even if the party did not exercise the option for 
the additional 5,000 bushels.
---------------------------------------------------------------------------

    The third element is substantially the same as the third element of 
the interpretation above with respect to commodity options embedded in 
forward contracts generally.
    The fourth and fifth elements are designed to ensure that both 
parties intend to make or take delivery (as applicable), subject to the 
relevant physical factors or regulatory requirements, which may lead 
the parties to deliver more or less than originally intended. This 
distinguishes a forward contract from a commodity option, where only 
the option seller must at all times be prepared to deliver during the 
term of the option. The sixth element is intended to ensure that the 
interpretation is not abused by market participants not engaged in a 
commercial business involving the nonfinancial commodity underlying the 
embedded volumetric optionality.\344\
---------------------------------------------------------------------------

    \344\ The fact that the CFTC is expressly including the fourth 
through sixth elements in the embedded optionality guidance for 
volumetric options but not elsewhere does not mean that intent to 
deliver and the ability to make or take delivery expressed in these 
elements are not part of the facts and circumstances the CFTC will 
consider in the context of determining whether other agreements, 
contracts, and transactions qualify for the forward exclusions. 
Intent to deliver and the ability to make or take delivery have long 
been a part of the CFTC's facts-and-circumstances approach to making 
that determination, and they remain so. The CFTC is emphasizing 
these elements in this guidance because the CFTC has not previously 
expressed the view that an agreement, contract, or transaction with 
embedded volumetric optionality which affects the delivery term may 
qualify as a forward if these facts and circumstances are present.
---------------------------------------------------------------------------

    The seventh element is based on comments stating that parties to 
agreements, contracts, and transactions with embedded volumetric 
optionality intend to make or take delivery (as applicable) of a 
commodity, and that it is merely the volume of a commodity that would 
be required to be delivered if the option is exercised, that varies. It 
is designed to ensure that the volumetric optionality is primarily 
driven by physical factors or regulatory requirements that influence 
supply and demand and that are outside the parties' control, and that 
the optionality is a commercially reasonable way to address uncertainty 
associated with those factors.\345\ Element seven must be interpreted 
with the other elements set forth here. For instance, even if the 
optionality is consistent with element seven, such optionality cannot 
undermine the overall nature of the contract as a forward contract as 
discussed above.
---------------------------------------------------------------------------

    \345\ See, e.g., AGA Letter (advising that ``[i]n general, 
retail demand for natural gas is weather driven * * * as a result 
[of which], a gas utility's peaking supplies must have significant 
flexibility * * * [and g]as utilities * * * use a variety of 
contracts with gas suppliers to physically deal with peak periods of 
demand''); BGA Letter (citing gas supply curtailment due to a 
pipeline outage and power generation curtailment by an Independent 
System Operator for operational reasons as factors outside the 
control of energy suppliers and which could impact the amount of a 
commodity delivered). The CFTC understands BGA's comment to address 
involuntary curtailments, but also recognizes that power buyers may 
agree in advance that the relevant Regional Transmission 
Organization or Independent System Operator may, in order to 
maintain system reliability, curtail power deliveries to the buyers. 
While voluntary curtailments are within the control of the power 
buyer, the potential system reliability issue is not. Therefore, 
such voluntary curtailments would be within the guidance because, if 
triggered, they would be based on a physical factor (e.g., supply 
constraints).
---------------------------------------------------------------------------

    As discussed in the interpretation regarding forwards with embedded 
optionality discussed above, in evaluating whether an agreement, 
contract or transaction with embedded volumetric optionality qualifies 
for the forward exclusions, the CFTC will look to the relevant facts 
and circumstances of the transaction as a whole to evaluate whether the 
transaction qualifies for the forward exclusions from the definitions 
of the terms ``swap'' and ``future delivery.''
    The CFTC is providing further interpretations to explain how it 
would treat some of the specific contracts described in the comment 
letters. According to one commenter, a ``full requirements contract'' 
can be described as a ``contract where the seller agrees to provide all 
requirements for a specific customer's location or delivery point.'' 
\346\ According to another commenter, ``[a] full requirements contract 
* * * is a well-established concept in contract law'' and ``[i]n a 
requirements contract, the purchaser * * * deals exclusively with one 
supplier.'' \347\ This commenter added that, while the amount of 
commodity delivered can vary, it is based on an objective need and that 
the Uniform Commercial Code imposes on the buyer ``an obligation to act 
in good faith with respect to the varying amount that is called for 
delivery.'' \348\ Based upon this description, the CFTC believes that a 
going commercial concern with an exclusive supply contract has no 
option but to get its supply requirements met through that exclusive 
supplier consistent with the terms of the contract. Any instance where 
nominal or zero delivery occurred would have to be because the 
commercial requirements changed or did not materialize. Furthermore, 
any variability in delivery amounts under the contract appears to be 
driven directly by the buyer's commercial requirements and is not 
dependent upon the exercise of any commodity option by the contracting 
parties.
---------------------------------------------------------------------------

    \346\ See Letter from Keith M. Sappenfield, II, Director, US 
Regulatory Affairs, Encana Marketing (USA) Inc. (``Encana''), dated 
July 22, 2011 (``Encana Letter'').
    \347\ See ONEOK Letter. The CFTC notes that this commenter 
discussed full requirements contracts in the context of supply 
agreements between one of its affiliates and retail customers. If 
such customers are non-commercial customers, such contracts are not 
forwards, but nevertheless they may not be swaps under the 
Commissions' guidance regarding the non-exhaustive list of consumer 
transactions, or otherwise if they have characteristics or factors 
described under the consumer transaction interpretation, see infra 
part II.B.3.
    \348\ See, e.g., NY UCC Sec.  2-306(1) (stating that ``[a] term 
which measures the quantity by the output of the seller or the 
requirements of the buyer means such actual output or requirements 
as may occur in good faith.* * *''). This commenter cited Corbin on 
Contracts for the proposition that the mere fact that the quantity 
term of the contract is ``the buyer's needs or requirements'' does 
not render the requirements contract ``a mere options contract'' 
because ``the buyer's promise is not illusory * * * [but] is 
conditional upon the existence of an objective need for the 
commodity.'' See ONEOK Letter (citing Corbin on Contracts Sec.  6.5 
at 240-53 (1995)).
---------------------------------------------------------------------------

    Accordingly, full requirements contracts, as described above, 
appear not to contain embedded volumetric options. Therefore, a full 
requirements contract may qualify for the forward exclusion under the 
same facts and circumstances analysis applicable to all other 
agreements, contracts, and transactions that might be forwards. The 
same analysis would apply to an output

[[Page 48240]]

contract satisfying the terms of this interpretation.\349\
---------------------------------------------------------------------------

    \349\ See Letter from Phillip g. Lookadoo, Esq., Reed Smith LLP 
and Jeremy D. Weinstein, Esq. on behalf of IECA dated May 23, 2012 
(suggesting that output contracts, in addition to full requirements 
contracts, should be within the forward exclusion). An output 
contract has been defined as ``a contract pursuant to which the 
obligor's duty to supply the promised commodity is quantified (and 
therefore limited) by reference to its production thereof.'' See 
Boyd v. Kmart Corp., 110 F.3d 73 (10th Cir. 1997).
---------------------------------------------------------------------------

    With respect to capacity contracts, transmission (or 
transportation) services agreements, and tolling agreements, the CFTC 
understands that: (i) Capacity contracts are generally products 
designed to ensure that sufficient physical generation capacity is 
available to meet the needs of an electrical system;\350\ (ii) 
transmission (or transportation) services agreements are generally 
agreements for the use of electricity transmission lines (or gas 
pipelines) that allow a power generator to transmit electricity (or gas 
supplier to transport gas) to a specific location;\351\ and (iii) 
tolling agreements, as described by commenters, provide a purchaser the 
right to the capacity, energy, ancillary services and any other product 
derived from a specified generating unit, all based upon a delivered 
fuel price and agreed heat rate.\352\
---------------------------------------------------------------------------

    \350\ See California Utilities Letter.
    \351\ See NEMA Letter.
    \352\ See California Utilities Letter.
---------------------------------------------------------------------------

    Such agreements, contracts and transactions, may have features that 
will satisfy the ``forwards with embedded volumetric optionality'' 
interpretation discussed above, or, like full requirements contracts, 
may not contain embedded volumetric options and may satisfy other 
portions of the forward interpretations herein. For example, according 
to one commenter, the delivery obligations in some tolling agreements 
are not optional which is indicative that the predominant feature of 
such tolling agreements is actual delivery.\353\ It is also possible, 
based on descriptions provided to the CFTC, that tolling agreements 
could fit within the interpretation concerning certain physical 
agreements, contracts, or transactions,\354\ or other interpretations 
herein.
---------------------------------------------------------------------------

    \353\ Id.
    \354\ See infra part II.B.2.(b)(iii).
---------------------------------------------------------------------------

    Some commenters focused on forwards with embedded volumetric 
optionality in the natural gas industry. For example, one commenter 
stated that ``peaking supply'' natural gas contracts do not render 
delivery optional. Although the purchaser has the option to specify 
when and if the quantity of gas will be delivered on any given day, 
this commenter asserted that there is no cash settlement alternative. 
If the purchaser does not exercise the right to purchase, then the 
right is terminated. The seller under the transaction must deliver the 
entire quantity of gas that the purchaser specifies, or pay liquidated 
damages. Moreover, the option is not severable and cannot be marketed 
separately from the supply agreement itself.\355\ Similarly, another 
commenter said that there is no ability to sever an embedded option 
from a natural gas forward contract. Moreover, it stated that the 
ability for a gas purchaser to specify a quantity of gas for a certain 
day is not to encourage speculative activity; rather, it is because the 
exact quantity of gas to be needed on that future day is unknown, and 
many gas purchasers have weather-dependent needs that cannot accurately 
be predicted in advance.\356\
---------------------------------------------------------------------------

    \355\ See AGA Letter.
    \356\ See Atmos Letter.
---------------------------------------------------------------------------

    Depending on the relevant facts and circumstances, these types of 
agreements, contracts, and transactions--capacity contracts, 
transmission (or transportation) services agreements, tolling 
agreements, and peaking supply contracts--may satisfy the elements of 
the ``forwards with embedded volumetric options'' interpretation set 
forth above, or may satisfy other portions of this interpretation. If 
they do, they would fall within the forward exclusions from the swap 
and future delivery definitions.
    In addition, the CFTC is providing an interpretation in response to 
a comment that contracts with evergreen or extension terms should be 
considered forwards.\357\ The CFTC is clarifying that an extension term 
in a commercial contract, such as a renewal term in a five year power 
purchase agreement (which, due to the renewal, would require additional 
deliveries), is not an option on the delivery term within the meaning 
of the CFTC's interpretation, and consequently would not render such a 
contract ineligible for the forward exclusions from the definitions of 
the terms ``swap'' and ``future delivery.'' Similarly, an evergreen 
provision, which automatically renews a contract (and, as such, would 
require additional deliveries)\358\ absent the parties affirmatively 
terminating it, would not render such a contract ineligible for the 
forward exclusions from the swap or future delivery definitions.\359\ 
When the Proposing Release stated that a forward contract containing an 
embedded option that does not ``target the delivery term'' is an 
excluded forward contract,\360\ it meant that the embedded option does 
not affect the delivery amount.\361\
---------------------------------------------------------------------------

    \357\ See IECA Letter.
    \358\ The CFTC refers in this and the prior sentence to 
``additional deliveries'' because the IECA's example involves an 
agreement calling for delivery of a physical nonfinancial commodity.
    \359\ Using extension or evergreen provisions to avoid delivery, 
however, as was the case with the ``rolling spot'' contracts at 
issue in CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), could 
constitute evasion or violate other provisions of the CEA (e.g., CEA 
section 4(a), 7 U.S.C. 6(a)). This interpretation does not limit the 
CFTC's other interpretations in this release regarding when delivery 
does not occur (e.g., the Brent Interpretation).
    \360\ See NGSA/NCGA Letter (requesting clarification of the 
phrase ``target the delivery term.'').
    \361\ See Proposing Release at 29830, n.81.
---------------------------------------------------------------------------

    Also, in response to a commenter,\362\ the CFTC clarifies that 
embedded optionality as to delivery points and delivery dates will not 
cause a transaction that otherwise qualifies as a forward contract to 
be considered a swap. The CFTC emphasizes, however, that delivery must 
occur at some delivery point and on some date, or the lack of delivery 
must be due to the transaction being booked out or otherwise be 
consistent with the CFTC's interpretation regarding the forward 
exclusions from the swap and future delivery definitions.
---------------------------------------------------------------------------

    \362\ See COPE Letter.
---------------------------------------------------------------------------

Comments
    Commenters generally supported the CFTC's proposed interpretation 
regarding forwards with embedded options, but many believed that it 
should be modified or expanded. As noted above, several commenters 
believed that forward contracts with embedded options that contain 
optionality as to the quantity/volume of the nonfinancial commodity to 
be delivered should qualify as forwards, and that the CFTC's proposed 
interpretation (which only mentions price optionality) should be 
modified accordingly.\363\ In this regard, several commenters focused 
on forwards with embedded volumetric options in the natural gas 
industry.\364\ One commenter noted that, although the 1985 CFTC OGC 
Interpretation distinguishes forward contracts from trade options, it 
is based on a limited number of agricultural contract examples, so 
additional guidance is needed, particularly in light of the wide range 
of cash market and commercial merchandising contracting practices in

[[Page 48241]]

which delivery terms and amounts vary.\365\
---------------------------------------------------------------------------

    \363\ See AGA Letter; API Letter; Atmos Letter; ONEOK Letter; 
NGSA/NCGA Letter; WGCEF Letter.
    \364\ See AGA Letter; Atmos Letter.
    \365\ See ONEOK Letter. This commenter noted that it offers its 
customers a number of types of contracts for delivery of natural gas 
under which the amount called for delivery may vary. In each of 
these types of contracts, this commenter stated that both parties 
intend the contracts to result in delivery of the commodity, as 
needed. The purpose of these contracts is to ensure that customers, 
most of which are gas or electric utilities, have an adequate supply 
of natural gas regardless of day-to-day changes in demand that may 
be caused by variation in weather, operational considerations, or 
other factors. They are not designed for one-way price protection as 
would be the case with an option. See ONEOK Letter.
---------------------------------------------------------------------------

    In addition, another commenter requested more generally that any 
embedded option (for example, price, quantity, delivery point, delivery 
date, contract term) that does not permit a unilateral election of 
financial settlement based upon the value change in an underlying cash 
market should not render the contract a swap.\366\
---------------------------------------------------------------------------

    \366\ See COPE Letter, Appendix.
---------------------------------------------------------------------------

    As discussed above, the CFTC has provided an additional 
interpretation with respect to forwards with embedded volumetric 
options to address commenters' concerns. The CFTC also has provided an 
interpretation above, regarding price optionality, optionality with 
respect to delivery points and delivery dates specifically in response 
to this commenter, and optionality as to certain contract terms (such 
as evergreen and renewal provisions) to address particular concerns 
raised by commenters. The CFTC declines to adopt a more expansive 
approach with respect to ``any'' embedded option.
    One commenter requested that an option to purchase or sell a 
physical commodity, whether embedded in a forward contract or stand 
alone, should either (i) fall within the statutory forward exclusion 
from the swap definition, or (ii) alternatively, if deemed by the CFTC 
to be a swap, should be exempt from the swap definition pursuant to a 
modified trade option exemption pursuant to CEA section 4c(b).\367\ The 
CFTC has modified its proposed interpretation regarding forwards with 
embedded options as discussed above; contracts with embedded options 
that are swaps under this final interpretation may nevertheless qualify 
for the modified trade option exemption recently adopted by the CFTC 
and discussed above.\368\
---------------------------------------------------------------------------

    \367\ See WGCEF Letter; 7 U.S.C. 6c(b).
    \368\ 77 FR 25320 (Aug. 27, 2012). Encana believed that the 
guidance on forwards with embedded options should include embedded 
physical delivery options because it asserted that many of the 
contracts currently used by participants in the wholesale natural 
gas market contain an option for the physical delivery of natural 
gas. See Encana Letter. To the extent that Encana's comment goes 
beyond volumetric optionality, commodity options are discussed supra 
in section II.B.2(b).
---------------------------------------------------------------------------

    Another commenter urged the CFTC to broadly exempt commercial 
forward contracting from swap regulation by generally excluding from 
the swap definition any forward contract with embedded optionality 
between end users ``whose primary purpose is consistent with that of an 
`end user', and in which any embedded option is directly related to 
`end use.' '' \369\ The CFTC believes that this interpretation is vague 
and overbroad, and declines to adopt it.
---------------------------------------------------------------------------

    \369\ See Letter from Roger Cryan, Vice President for Milk 
Marketing and Economics, National Milk Producers Federation 
(``NMPF''), dated July 22, 2011 (``NMPF Letter'').
---------------------------------------------------------------------------

    Another commenter believed that the CFTC's ``facts and 
circumstances'' approach to forwards with embedded options does not 
provide the legal certainty required by nonfinancial entities engaging 
in commercial contracts in the normal course of business.\370\ This 
commenter further argued that many option-like contract terms could be 
determined to ``target the delivery term'' under a facts and 
circumstances analysis.\371\
---------------------------------------------------------------------------

    \370\ See ETA Letter. Similarly, COPE comments that a 
nonfinancial commodity forward contract that, ``by its terms,'' is 
intended to settle physically should be permitted to contain 
optionality without being transformed into a swap unless such 
optionality negates the physical settlement element of the contract. 
That is, if one party can exercise an option to settle the contract 
financially based upon the value change in an underlying cash 
market, then the intent for physical settlement is not contained in 
``the four corners of the contract'' and may render the contract a 
swap. See COPE Letter. As discussed elsewhere in this release, the 
CFTC historically has eschewed approaches to the forward exclusion 
that rely on the ``four corners of the contract,'' which can provide 
a roadmap to evasion of statutory requirements.
    \371\ Accordingly, this commenter believed that the CFTC should 
provide in its rules that an embedded option or embedded optionality 
will not result in a nonfinancial forward being a swap unless: (i) 
Delivery is optional; (ii) financial settlement is allowed; and 
(iii) transfer and trading of the option separately from the forward 
is permitted. See ETA Letter.
---------------------------------------------------------------------------

    The CFTC has long applied a facts-and-circumstances approach to the 
forward exclusion, including with respect to forwards with embedded 
options, and thus it is an approach with which market participants are 
familiar. That approach balances the need for legal certainty against 
the risk of providing opportunities for evasion.\372\ The CFTC's 
additional interpretation noted above, including clarification about 
the meaning of the phrase ``target the delivery term,'' and forwards 
with embedded volumetric optionality, provides enhanced legal certainty 
in response to the commenter's concerns. \373\
---------------------------------------------------------------------------

    \372\ See also NCFC Letter (supporting the CFTC's guidance 
because it provides legal certainty).
    \373\ See also Commodity Options, 77 FR 25320, 25324 n. 25 (Apr. 
27, 2012) (discussing the CFTC's conclusion that an ``option[] to 
redeem'' under the USDA Commodity Credit Corporation's marketing 
loan program constitutes a cotton producer's contractual right to 
repay its marketing loan and ``redeem'' the collateral (cotton) to 
sell in the open market).
---------------------------------------------------------------------------

Request for Comment
    The CFTC's interpretation regarding forwards with volumetric 
options is an interpretation of the CFTC and may be relied upon by 
market participants. However, the CFTC believes that it would benefit 
from public comment about its interpretation, and therefore requests 
public comment on all aspects of its interpretation regarding forwards 
with embedded volumetric options,\374\ and on the following questions:
---------------------------------------------------------------------------

    \374\ Separately, it is expected that CFTC staff will be issuing 
no-action relief with respect to the conditions of the modified 
trade option exemption (except the enforcement provisions retained 
in Sec.  32.3(d)) until December 31, 2012. This extension will 
afford the CFTC an opportunity to review and evaluate the comments 
received on both the interpretation above regarding embedded 
volumetric optionality, and the modified trade option exemption, in 
order to determine whether any changes thereto are appropriate.
---------------------------------------------------------------------------

    1. Are the elements set forth in the interpretation to distinguish 
forwards with embedded volumetric optionality from commodity options 
appropriate? Why or why not?
    2. Are there additional elements that would be appropriate? Please 
describe and provide support for why such elements would serve to 
distinguish forwards with embedded volumetric optionality from 
commodity options.
    3. Is the seventh element that, to ensure that an agreement, 
contract, or transaction with embedded volumetric optionality is a 
forward and not an option, the volumetric optionality is based 
primarily on physical factors, or regulatory requirements, that are 
outside the control of the parties and are influencing demand for, or 
supply of, the nonfinancial commodity, necessary and appropriate? Why 
or why not? Is the statement of this element sufficiently clear and 
unambiguous? If not, what adjustments would be appropriate?
    4. Are there circumstances where volumetric optionality is based on 
other factors? Please describe. Would such factors, if made a part of 
the interpretation, serve to distinguish forwards with embedded 
volumetric optionality from commodity options? If so, how?
    5. Does the interpretation provide sufficient guidance as to 
whether agreements, contracts, or transactions

[[Page 48242]]

with embedded volumetric optionality permitting a nominal amount, or no 
amount, of a nonfinancial commodity to be delivered are forwards or 
options, viewing the agreements, contracts, or transactions as a whole, 
if they satisfy the seven elements of the interpretation? Why or why 
not? Does this interpretation encourage evasion, or do the seven 
elements sufficiently distinguish forwards from agreements, contracts, 
and transactions that may evade commodity options regulation?
    6. Is the interpretation sufficiently clear with respect to 
capacity contracts, transmission (or transportation) services 
agreements, peaking supply contracts, or tolling agreements? Why or why 
not? Do capacity contracts, transmission (or transportation) services 
agreements, peaking supply contracts, or tolling agreements generally 
have features that satisfy the forwards with volumetric options 
interpretation included in this release? If so, which ones? If not, why 
not? Could these types of agreements, contracts, and transactions 
qualify for the forward exclusions under other parts of the 
interpretation set forth above? Are there material differences in the 
structure, operation, or economic effect of these types of agreements, 
contracts, and transactions as compared to full requirements contracts 
that are relevant to whether such agreements, contracts, and 
transactions are options under the CEA? Please explain. If so, what are 
the material differences?
    7. Do the agreements, contracts, and transactions listed in 
question No. 6 above have embedded optionality in the first instance? 
Based on descriptions by commenters, it appears that they may have a 
binding obligation for delivery, but have no set amount specified for 
delivery. Instead, delivery (including the possibility of nominal or 
zero delivery) is determined by the terms and conditions contained 
within the agreement, contract, or transaction (including, for example, 
the satisfaction of a condition precedent to delivery, such as a 
commodity price or temperature reaching a level specified in the 
agreement, contract, or transaction). That is, the variation in 
delivery is not driven by the exercise of embedded optionality by the 
parties. Do the agreements, contracts, and transactions listed in 
question No. 6 exhibit these kinds of characteristics? If so, should 
the CFTC consider them in some manner other than its forward 
interpretation? Why or why not?
(iii) Certain Physical Commercial Agreements, Contracts or Transactions
    The CFTC is providing an interpretation in response to comments 
regarding certain physical commercial agreements for the supply and 
consumption of energy that provide flexibility, such as tolls on power 
plants, transportation agreements on natural gas pipelines, and natural 
gas storage agreements.\375\ Commenters recognized that these types of 
agreements, contracts or transactions may have option-like features, 
but analogized them to leases and concluded that they were forwards 
rather than swaps. One commenter, for example, characterized taking 
power produced pursuant to a physical tolling agreement--which can 
involve one party thereto providing fuel for a generation plant and 
having the exclusive right to take the power produced by that plant 
from the fuel provided--thus, in effect, ``renting'' the plant to the 
extent the plant is used to produce power from the fuel provided--as 
more akin to a lease than to an option.\376\
---------------------------------------------------------------------------

    \375\ See BGA Letter and California Utilities Letter. This 
interpretation also may apply to firm transmission agreements 
pursuant to which transmission service may not be interrupted for 
any reason except during an emergency when continued delivery of 
power is not possible. See http://www.interwest.org/wiki/index.php?title=Firm_transmission_service.
    \376\ See California Utilities Letter.
---------------------------------------------------------------------------

    The CFTC will interpret an agreement, contract or transaction not 
to be an option if the following three elements are satisfied: (1) The 
subject of the agreement, contract or transaction is usage of a 
specified facility or part thereof rather than the purchase or sale of 
the commodity that is to be created, transported, processed or stored 
using the specified facility; (2) the agreement, contract or 
transaction grants the buyer the exclusive use of the specified 
facility or part thereof during its term, and provides for an 
unconditional obligation on the part of the seller to grant the buyer 
the exclusive use of the specified facility or part thereof; \377\ and 
(3) the payment for the use of the specified facility or part thereof 
represents a payment for its use rather than the option to use it. In 
such agreements, contracts and transactions, while there is optionality 
as to whether the person uses the specified facility, the person's 
right to do so is legally established, does not depend upon any further 
exercise of an option and merely represents a decision to use that for 
which the lessor already has paid. In this context, the CFTC would not 
consider actions such as scheduling electricity transmission, gas 
transportation or injection of gas into storage to be exercising an 
option if all three elements of the interpretation above are satisfied. 
As with the interpretation regarding forwards with embedded options 
generally, discussed above, in evaluating whether flexible physical 
commercial agreements that meet the 3-part test qualify for the forward 
exclusions, the CFTC will look to the specific facts and circumstances 
of the agreement, contract or transaction as a whole to evaluate 
whether the agreement, contract or transaction qualifies for the 
forward exclusions from the definitions of ``swap'' and ``future 
delivery.''
---------------------------------------------------------------------------

    \377\ In this regard, the usage rights offered for sale should 
be limited to the capacity of the specified facility. While 
overselling such capacity would not per se be inconsistent with 
satisfying the terms of this interpretation, the CFTC cautions 
market participants that overselling not based on reasonable 
commercial expectations of the use of the specified facility could 
lead the contract to be deemed evasion and lead to an agreement, 
contract or transaction being considered a swap, as it would 
undermine the ``right'' being offered. For example, given physical 
constraints of the power grid and gas pipelines, overselling 
transmission or transportation capacity would be per se inconsistent 
with satisfying the terms of this interpretation.
---------------------------------------------------------------------------

    However, in the alternative, if the right to use the specified 
facility is only obtained via the payment of a demand charge or 
reservation fee, and the exercise of the right (or use of the specified 
facility or part thereof) entails the further payment of actual storage 
fees, usage fees, rents, or other analogous service charges not 
included in the demand charge or reservation fee, such agreement, 
contract or transaction is a commodity option subject to the swap 
definition.
Comments
    Two commenters addressed ``lease-like'' physical agreements, 
contracts or transactions.\378\ One of these commenters asserted that 
there are many physical commercial agreements for the supply and 
consumption of energy that effectively provide leases on flexible 
energy assets, such as tolls on power plants, transportation agreements 
on natural gas pipelines and natural gas storage agreements.\379\ 
According to this commenter, these assets have the capability to be 
turned on and off to meet fluctuating demand due to weather and other 
factors; physical contracts around these assets transfer that delivery 
flexibility to the contract holder. The commenter believed that these 
types of commercial arrangements should not be considered commodity 
options, but rather should be excluded forwards. The other commenter 
described tolling agreements as having the characteristics of a lease, 
in that the

[[Page 48243]]

purchasing entity obtains the exclusive right to the use of the power 
plant during the term of the agreement.\380\ This commenter asserted 
that such agreements should not be considered commodity options, but 
rather forwards because the obligations are not contingent. The CFTC is 
providing the above interpretation that these types of agreements, 
contracts and transactions are not commodity options if the above 
conditions are satisfied, but may qualify for the forward exclusions 
under the facts and circumstances, in response to these commenters' 
concerns.
---------------------------------------------------------------------------

    \378\ See BGA Letter and California Utilities Letter.
    \379\ See BGA Letter.
    \380\ See California Utilities Letter.
---------------------------------------------------------------------------

(iv) Effect of Interpretation on Certain Agreements, Contracts and 
Transactions
    In the Proposing Release,\381\ the CFTC requested comment regarding 
how its proposed interpretation concerning the forward contract 
exclusion would affect full requirements contracts, reserve sharing 
agreements, tolling agreements, energy management agreements and 
ancillary services. The CFTC asked whether such agreements, contracts 
or transactions have optionality as to delivery and, if so, whether 
they, or any other agreement, contract or transaction in a nonfinancial 
commodity, should be excluded from the swap definition.\382\
---------------------------------------------------------------------------

    \381\ See Request for Comment 35, which stated: 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?
    See Proposing Release at 29832.
    \382\ Id.
---------------------------------------------------------------------------

    Commenters generally believed that such types of agreements, 
contracts and transactions, although they may contain delivery 
optionality, should be considered forwards rather than swaps or 
commodity options.\383\ By contrast, one commenter believed that traded 
power markets involve many types of contracts that are actually 
exchanges of cash flows based on referenced values and that have no 
relevant characteristics of physical delivery.\384\
---------------------------------------------------------------------------

    \383\ See Atmos Letter; BGA Letter; California Utilities Letter; 
COPE Letter; ETA Letter; Encana Letter; FERC Staff Letter; IECA 
Letter; NEMA Letter; ONEOK Letter; and Letter from Kenneth R. 
Carretta, General Regulatory Counsel--Markets, PSEG Services Corp., 
on behalf of the Public Service Electric and Gas Company, PSEG Power 
LLC, and PSEG Energy Resources & Trade LLC (``PSEG Companies''), 
dated July 22, 2011 (``PSEG Letter'').
    \384\ See Better Markets Letter. This commenter stated that 
ancillary services are in substance swaps based on congestion costs 
between two transmission points, measured by the difference between 
actual prices assigned at those points by the grid operator. 
Capacity contracts are often documented using trading agreements for 
transactions in physicals, but this commenter believed that they 
constitute swaps that are used to hedge the price risk associated 
with periodic auctions of the contracts to provide reliable capacity 
to the grid operator. This commenter asserted that such contracts do 
not meet the CFTC's appropriate tests to exclude them, which should 
be made explicit in the guidance. This commenter stated that basic 
power contracts often do not meet the intent to deliver test because 
power buyers and sellers each schedule delivery to/from the grid, 
and such transactions can be settled based on readily available 
price differentials rather than scheduling capacity and load as a 
pair. At a minimum, this commenter believed that guidance should be 
provided to require that, in order to demonstrate intent to deliver, 
secondary delivery-related costs (e.g., congestion charges and 
penalties to which those scheduling capacity and load on the grid 
are subject) must be allocated by contract. Id.
---------------------------------------------------------------------------

    With the exception of energy management agreements, which are 
discussed below, the interpretations that the CFTC has already provided 
above may apply to such types of agreements, contracts and 
transactions. Specifically, to the extent that such types of 
agreements, contracts and transactions are forwards with embedded 
volumetric options, the CFTC has provided an additional interpretation 
in section II.B.2.b(iii) above. To the extent such types of agreements, 
contracts or transactions are physical commercial agreements, contracts 
or transactions discussed in section II.B.2.b(iii), supra, the CFTC has 
provided an interpretation in that section. To the extent such types of 
agreements, contracts and transactions are considered commodity 
options, the CFTC has addressed commodity options under the separate 
rulemaking establishing a modified trade option exemption.\385\ And to 
the extent that such types of agreements, contracts, and transactions, 
such as ancillary services, occur in Regional Transmission 
Organizations or Independent System Operators, or entered into between 
entities described in section 201(f) of the Federal Power Act,\386\ 
they may be addressed through the public interest waiver process in CEA 
section 4(c)(6).\387\
---------------------------------------------------------------------------

    \385\ See supra note 317.
    \386\ 16 U.S.C. 824(f).
    \387\ 7 U.S.C. 6(c)(6).
---------------------------------------------------------------------------

    With regard to Energy Management Agreements (``EMAs''), in general, 
commenters expressed the view that EMAs are forwards, and not swaps, 
although they did not provide analysis to support that conclusion.\388\ 
They also did not provide a working definition of EMAs. The CFTC 
understands that EMAs can cover a number of services and transactions, 
which can include spot, forward and swap transactions. EMAs can include 
services such as: (i) Acting as a financial intermediary by 
substituting one party's credit and liquidity for those of a less 
credit worthy owner of illiquid energy producing assets (i.e. the other 
party to the EMA) to facilitate the owner's purchase of fuel and sale 
of power; \389\ (ii) providing market information to assist the owner 
in developing and refining a risk-management plan for the plant; \390\ 
and (iii) procuring fuel, arranging delivery and storage, selling 
excess power not needed to serve load for another party.\391\ The 
entity carrying out these activities may receive a portion of the 
revenue generated from such activities as compensation for its efforts. 
Because commenters did not provide a working definition of EMAs, the 
CFTC cannot state categorically that EMAs are or are not swaps. 
However, if the fuel acquisition, sales of excess generation and any 
other transactions executed under the auspices of an EMA are not swaps, 
nothing about the fact that the transactions are executed as a result 
of or pursuant to an EMA transforms the transactions into swaps. For 
example, if one party hires another party to enter into spot or forward 
transactions on its behalf, the fact that their relationship is 
governed by an EMA does not render those transactions swaps.\392\ 
Conversely, were swaps to be executed by one party on behalf of another 
party as a result of, or pursuant to, an EMA, the parties thereto would 
need to consider their respective roles thereunder (e.g. principal 
versus agent) and whether commodity trading advisor, introducing 
broker, futures commission merchant, or other registration or other 
elements of the Dodd-Frank Act regime were implicated. At a minimum, 
the fact that a swap was executed would implicate

[[Page 48244]]

reporting and recordkeeping requirements.\393\
---------------------------------------------------------------------------

    \388\ See, e.g., Encana Letter and BGA Letter.
    \389\ See, e.g., The Royal Bank of Scotland Group plc, Order 
Approving Notice To Engage in Activities Complementary to a 
Financial Activity, 2008 Federal Reserve Bulletin volume 94.
    \390\ Id.
    \391\ See, e.g., Energy Management Agreement between Long Island 
Lighting Company and Long Island Power Authority, available at 
http://www.lipower.org/pdfs/company/papers/contract/energy.pdf.
    \392\ Similarly, using an EMA would not render swaps entered as 
a result of or pursuant to an EMA spot or forward transactions.
    \393\ This interpretation is limited to the facts and 
circumstances described herein; the CFTC is not opining on different 
facts or circumstances, which could change the CFTC's 
interpretation.
---------------------------------------------------------------------------

(v) Liquidated Damages Provisions
    The Commissions also received several comments discussing 
contractual liquidated damages provisions. The CFTC is clarifying that 
the presence, in an agreement, contract, or transaction involving 
physical settlement of a nonfinancial commodity, of a liquidated 
damages provision (which may be referred to by another name, such as a 
``cover costs'' or ``cover damages'' provision) does not necessarily 
render such an agreement, contract, or transaction ineligible for the 
forward exclusion.\394\ Such a provision in an agreement, contract, or 
transaction is consistent with the use of the forward exclusion, 
provided that the parties intend the transaction to be physically 
settled.\395\ However, liquidated damages provisions can be used to 
mask a lack of intent to deliver.\396\ In light of the possibility for 
evasion of the Dodd-Frank Act, the CFTC will continue to utilize its 
historical facts-and-circumstances approach in determining whether the 
parties to a particular agreement, contract, or transaction with a 
liquidated damage provision have the requisite intent to deliver.
---------------------------------------------------------------------------

    \394\ With respect to performance guarantees, the fact that a 
failure to deliver a nonfinancial commodity triggers a payment under 
a performance guaranty does not excuse the performance, nor render 
delivery optional. Accordingly, such a payment trigger would not 
itself preclude an agreement, contract, or transaction from being 
covered by the forward exclusion from the swap or future delivery 
definitions. But see supra part II.B.1.g, which provides that the 
CFTC is interpreting the term ``swap'' (that is not a security-based 
swap or mixed swap) to include a guarantee of such swap, to the 
extent that a counterparty to a swap position would have recourse to 
the guarantor in connection with the position.
    \395\ See 1985 CFTC OGC Interpretation, supra note 245 (stating 
generally that while ``[s]ome contracts provide for a liquidated 
damages of penalty clause if the producer fails to deliver, the 
presence of such clauses in a contract does not change the analysis 
of the nature of the contract [if] * * * it is intended that 
delivery of the physical crop occur, absent destruction of all or a 
portion of the crop by forces which neither party can control''). 
See generally Corbin on Contracts Sec.  58.1 (characterizing 
liquidated damages provisions as designed to ``[d]etermin[e] the 
amount of damages that are recoverable for a breach of contract'').
    \396\ In that regard, see 1985 CFTC OGC Interpretation, supra 
note 245 (stating that ``a contract provision which permitted a 
producer to avoid delivery for a reason other than for an 
intervening condition not in the control of either party could 
change any conclusion about the nature of the contract'').
---------------------------------------------------------------------------

Comments
    One commenter notes that a commercial merchandising arrangement 
involving a nonfinancial commodity may provide that the remedy for a 
failure to make or take delivery is the payment of a market-rate 
replacement price, a payment on a performance guaranty, or ``cover 
damages'' to compensate the non-breaching party for the failure of the 
other party to fulfill its contractual obligations.\397\ Such a 
contractual damages or remedy provision, this commenter contended, is 
not analogous to a financial settlement option in a trading 
instrument.\398\ This commenter further asserted that one party or the 
other may be unable to perform, or excused or prevented for commercial 
reasons from performing, its contractual obligations to make or take 
delivery of a nonfinancial commodity, and therefore may be liable to 
the other party for a monetary payment, calculated in accordance with 
the contract.\399\
---------------------------------------------------------------------------

    \397\ See ETA Letter.
    \398\ Id. This commenter cited FERC Order No. 890, which 
recognizes that ``[w]hile any party to any contract can choose to 
fail to perform, that does not convey a contractual right to fail to 
perform'' and that the Edison Electric Institute Master Power 
Purchase and Sale Agreement (``EEI MPPSA'') clearly obligates the 
supplier to provide power, except in cases of force majeure. As the 
ETA explains, ``[t]he EEI MPPSA is a master agreement frequently 
used to document transactions for deferred delivery and receipt of 
nonfinancial electric energy, and the terms of the ISDA North 
American Power Annex contain substantially identical master 
agreement provisions * * *.'' Id.
    \399\ According to this commenter, parties typically include 
liquidated damages provisions in their agreements, contracts and 
transactions to address situations in which ``one party or the other 
may be unable, excused or prevented for commercial reasons from 
performing its contractual obligations to deliver or receive [the 
relevant commodity],'' not to serve as ``a financial settlement 
`option' analogous to a financial settlement option in a trading 
instrument.'' Id.
---------------------------------------------------------------------------

    Another commenter noted that physically settled gas contracts, 
including peaking contracts (both for daily and monthly supply), bullet 
day contracts and weather contracts, use the NAESB Base Contract, which 
does not provide for financial settlement other than a liquidated 
damages provision, which would compensate a utility for its cost of 
obtaining alternative supply at the prevailing market price if the 
seller fails to deliver.\400\ This commenter stated its view that the 
seller has no real opportunity to arbitrage its obligation to deliver 
based on changes in price, and the purchaser has no incentive to fail 
to take delivery of its specified quantities of gas, because they are 
needed for the physical operations of its system.\401\
---------------------------------------------------------------------------

    \400\ See AGA Letter.
    \401\ Id. See also Atmos Letter (stating that there is no 
financial incentive for a seller to fail to deliver natural gas 
under contracts used in the natural gas industry, as the standard 
remedy for such a failure to deliver is to pay liquidated damages 
sufficient to compensate the purchaser for having to obtain its 
required natural gas).
---------------------------------------------------------------------------

    The CFTC generally agrees with these comments regarding liquidated 
damages provisions, and has provided the final interpretation described 
above to address them.
(c) Security Forwards \402\
---------------------------------------------------------------------------

    \402\ 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.
---------------------------------------------------------------------------

    As the Commissions stated in the Proposing Release, the Commissions 
believe it is appropriate to address how the exclusions from the swap 
and security-based swap definitions apply to security forwards and 
other purchases and sales of securities.\403\ The Commissions are 
restating the interpretation set out in the Proposing Release without 
modification.
---------------------------------------------------------------------------

    \403\ See Proposing Release at 29830.
---------------------------------------------------------------------------

    The Dodd-Frank Act excludes purchases and sales of securities from 
the swap and security-based swap definitions in a number of different 
clauses.\404\ Under these exclusions, purchases and sales of securities 
on a fixed or contingent basis \405\ and sales of securities for 
deferred shipment or delivery that are intended to be physically 
delivered \406\ are explicitly excluded from the swap and security-
based swap definitions.\407\ The exclusion from the swap and security-
based swap definitions of a sale of a security for deferred shipment or 
delivery involves an agreement to purchase one or more securities, or 
groups or indexes of securities, at a future date at a certain price.
---------------------------------------------------------------------------

    \404\ See sections 1a(47)(B)(ii), (v), and (vi) of the CEA, 7 
U.S.C. 1a(47)(B)(ii), (v), and (vi).
    \405\ See section 1a(47)(B)(v) of the CEA, 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]''); and section 1a(47)(B)(vi) 
of the CEA, 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'').
    \406\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. 
1a(47)(B)(ii).
    \407\ The Commissions note that calling an agreement, contract, 
or transaction a swap or security-based swap does not determine its 
status. See supra part II.D.1.
---------------------------------------------------------------------------

    As with other purchases and sales of securities, security forwards 
are

[[Page 48245]]

excluded from the swap and security-based swap definitions. 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.\408\ 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.\409\ 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.\410\
---------------------------------------------------------------------------

    \408\ A purchase or sale of a security occurs at the time the 
parties become contractually bound, not at the time of settlement 
(regardless of whether cash or physically settled). See Securities 
Offering Reform, 70 FR 44722 (Aug. 3, 2005).
    \409\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. 
1a(47)(B)(ii).
    \410\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C. 
1a(47)(B)(v) and (vi).
---------------------------------------------------------------------------

    In the Proposing Release, the Commissions provided the following 
specific interpretation in the context of forward sales of mortgage-
backed securities (``MBS'') guaranteed or sold by the Federal National 
Mortgage Association (``Fannie Mae''), the Federal Home Loan Mortgage 
Corporation (``Freddie Mac''), and the Government National Mortgage 
Association (``Ginnie Mae'').\411\ The Commissions are restating their 
interpretation regarding such forward sales.
---------------------------------------------------------------------------

    \411\ The Commissions provided the interpretation in the 
Proposing Release in response to commenters on the ANPR. See 
Proposing Release at 29830. These commenters requested clarification 
that forward sales of MBS guaranteed or sold by Fannie Mae, Freddie 
Mac and Ginnie Mae would not be included in the swap and security-
based swap definitions in order to provide the certainty needed to 
avoid unnecessary disruption of this market. Id.
---------------------------------------------------------------------------

    MBS guaranteed or sold by Fannie Mae, Freddie Mac and Ginnie Mae 
are eligible to be sold in the ``To-Be-Announced'' (``TBA'') market, 
which is essentially a forward or delayed delivery market.\412\ 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.'' \413\ 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.\414\ In a TBA transaction, the seller and the buyer agree to five 
terms before entering into the transaction: (i) The type of security, 
which will usually be a certain type of MBS guaranteed or sold by 
Fannie Mae, Freddie Mac or Ginnie Mae and the type of mortgage 
underlying the MBS; (ii) the coupon or interest rate; (iii) the face 
value (the total dollar amount of MBS the purchaser wishes to 
purchase); (iv) the price; and (v) the settlement date.\415\ The 
purchaser will contract to acquire a specified dollar amount of MBS, 
which may be satisfied when the seller delivers one or more MBS pools 
at settlement.\416\
---------------------------------------------------------------------------

    \412\ Task Force on Mortgage-Backed Securities Disclosure, 
``Staff Report: Enhancing Disclosure in the Mortgage-Backed 
Securities Markets,'' part II.E.2 (Jan. 2003), which is available at 
http://www.sec.gov/news/studies/mortgagebacked.htm (``MBS Staff 
Report'').
    \413\ Id.
    \414\ Id.
    \415\ Id.
    \416\ Id. The good delivery guidelines, titled ``Uniform 
Practices for the Clearance and Settlement of Mortgage-Backed 
Securities and Other Related Securities,'' which govern the 
mechanics of trading and settling MBS, contain specific guidelines 
for trading and settling MBS guaranteed or sold by Fannie Mae, 
Freddie Mac and Ginnie Mae in the TBA market. The good delivery 
guidelines outline the basic terms and conditions for trading, 
confirming, delivering and settling MBS. The good delivery 
guidelines set forth the basic characteristics that MBS guaranteed 
or sold by Fannie Mae, Freddie Mac and Ginnie Mae must have to be 
able to be delivered to settle an open TBA transaction. Id. The 
Securities Industry and Financial Markets Association (``SIFMA'') is 
the successor to the Bond Market Association and publishes the good 
delivery guidelines, which are available at http://www.sifma.org/services/standard-forms-and-documentation/securitized-products/.
---------------------------------------------------------------------------

    The Commissions are confirming 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.\417\ Moreover, as the purchase or sale of a security, the 
Commissions also are confirming that 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 would fall outside the swap and 
security-based swap definitions.\418\
---------------------------------------------------------------------------

    \417\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. 
1a(47)(B)(ii).
    \418\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C. 
1a(47)(B)(v) and (vi).
---------------------------------------------------------------------------

Comments
    The Commissions received two comments on the interpretation 
regarding security forwards. One commenter recommended that the 
Commissions codify in the text of the final rules the interpretation 
regarding forward sales of MBS in the TBA market.\419\ The Commissions 
are not codifying the interpretation because codification will create a 
bright-line test. The Commissions note that the analysis as to whether 
any product falls within the exclusion for sales of securities on a 
deferred settlement or delivery basis requires flexibility, including 
the consideration of applicable facts and circumstances. Because the 
interpretation regarding forward sales of MBS in the TBA market is 
based on particular facts and circumstances, the Commissions do not 
believe that a bright-line test is appropriate.
---------------------------------------------------------------------------

    \419\ See Letter from Lisa M. Ledbetter, Vice President and 
General Counsel, Legislative & Regulatory Affairs, Freddie Mac, Jul. 
21, 2011.
---------------------------------------------------------------------------

    Another commenter suggested that the Commissions narrow the 
exclusion for contracts for the purchase and sale of securities for 
subsequent delivery as applied to security-based swaps because parties 
can use the formal characterization of a delivery contract for 
securities to disguise a transaction that is substantively a security-
based swap.\420\ This commenter was concerned because this commenter 
believes that the securities subject to such a delivery obligation are 
often easily convertible into cash, which facilitates cash settlement 
without actual delivery.\421\ As such, this commenter suggested that 
the Commissions should provide a test for determining whether parties 
have a bona fide intent to deliver.\422\ This commenter recommended 
that such test should prohibit cash settlement options in contracts for 
subsequent delivery and should not consider a party that frequently 
unwinds physical positions with cash settlements using side agreements 
as having the requisite intent to deliver.\423\ The Commissions are not 
providing a test at this time for determining whether parties have a 
bona fide intent to deliver because the analysis as to whether sales of 
securities for deferred shipment or delivery are intended to be 
physically delivered is a facts and circumstances determination and a 
bright-line test will not allow for the flexibility needed in such 
analysis. Further, the Commissions note that the purchase and sale of a 
security occurs at the time the forward contract is entered into.\424\
---------------------------------------------------------------------------

    \420\ See Better Markets Letter.
    \421\ Id.
    \422\ Id.
    \423\ Id.
    \424\ See supra note 408.

---------------------------------------------------------------------------

[[Page 48246]]

3. Consumer and Commercial Agreements, Contracts, and Transactions
    The Commissions noted in the Proposing Release that ``[c]onsumers 
enter into various types of agreements, contracts, and transactions as 
part of their household and personal lives that may have attributes 
that could be viewed as falling within the swap or security-based swap 
definition.\425\ Similarly, businesses and other entities, whether or 
not for profit, also enter into agreements, contracts, and transactions 
as part of their operations relating to, among other things, 
acquisitions or sales of property (tangible and intangible), provisions 
of services, employment of individuals, and other matters that could be 
viewed as falling within the definitions.'' \426\
---------------------------------------------------------------------------

    \425\ See Proposing Release at 29832.
    \426\ Id.
---------------------------------------------------------------------------

    Commenters on the ANPR pointed out a number of areas in which a 
broad reading of the swap and security-based swap definitions could 
cover certain consumer and commercial arrangements that historically 
have not been considered swaps or security-based swaps.\427\ Examples 
of such instruments cited by those commenters included evidences of 
indebtedness with a variable rate of interest; commercial contracts 
containing acceleration, escalation, or indexation clauses; agreements 
to acquire personal property or real property, or to obtain mortgages; 
employment, lease, and service agreements, including those that contain 
contingent payment arrangements; and consumer mortgage and utility rate 
caps.\428\
---------------------------------------------------------------------------

    \427\ Id.
    \428\ Id.
---------------------------------------------------------------------------

    The Commissions also stated in the Proposing Release that they ``do 
not believe that Congress intended to include these types of customary 
consumer and commercial agreements, contracts, or transactions in the 
swap or security-based swap definition, to limit the types of persons 
that can enter into or engage in them, or to otherwise to subject these 
agreements, contracts, or transactions to the regulatory scheme for 
swaps and security-based swaps.'' \429\
---------------------------------------------------------------------------

    \429\ Id. If these types of arrangements were subject to Title 
VII, the persons that could enter into or engage in them could be 
restricted because Title VII imposes restrictions on entering into 
swaps and security-based swaps with persons who are not eligible 
contract participants (``ECPs''). See sections 723(1), 763(e), and 
768(b) of the Dodd-Frank Act. The Dodd-Frank Act amended the 
Securities Act and the Exchange Act to require that security-based 
swap transactions involving a person that is not an ECP must be 
registered under the Securities Act and effected on a national 
securities exchange, and also amended the CEA to require that swap 
transactions involving a person that is not an ECP must be entered 
into on, or subject to the rules of, a board of trade designated as 
a contract market. Id. The Commissions note that many consumers and 
commercial and non-profit entities may not be ECPs. See section 
1a(18) of the CEA, 7 U.S.C. 1a(18). Further, if these types of 
arrangements were subject to Title VII, they would be subject to the 
full regulatory scheme for swaps and security-based swaps created by 
Title VII. These requirements could increase costs for consumers and 
commercial and non-profit entities and potentially disrupt their 
ability to enter into these arrangements.
---------------------------------------------------------------------------

    Accordingly, the Commissions proposed an interpretation in the 
Proposing Release to assist consumers and commercial and non-profit 
entities in understanding whether certain agreements, contracts, or 
transactions that they enter into would be regulated as swaps or 
security-based swaps.\430\ The Commissions are adopting the 
interpretation set out in the Proposing Release with certain 
modifications in response to commenters.\431\
---------------------------------------------------------------------------

    \430\ See Proposing Release at 29832-33.
    \431\ See infra note 447 and accompanying text.
---------------------------------------------------------------------------

    With respect to consumers, the Commissions have determined that the 
types of agreements, contracts, or transactions that will not be 
considered swaps or security-based swaps when entered into by consumers 
(natural persons) as principals (or by their agents)\432\ primarily for 
personal, family, or household purposes, include:\433\
---------------------------------------------------------------------------

    \432\ For example, a mortgage broker may arrange a rate lock on 
behalf of a consumer borrower.
    \433\ The Commissions are not addressing here the applicability 
of any other provisions of the CEA, the Federal securities laws or 
the Commissions' regulations to such agreements, contracts or 
transactions.
---------------------------------------------------------------------------

     Agreements, contracts, or transactions to acquire or lease 
real or personal property, to obtain a mortgage, to provide personal 
services, or to sell or assign rights owned by such consumer (such as 
intellectual property rights);
     Agreements, contracts, or transactions to purchase 
products or services for personal, family or household purposes at a 
fixed price or a capped or collared price, at a future date or over a 
certain time period (such as agreements to purchase for personal use or 
consumption nonfinancial energy commodities, including agreements to 
purchase home heating fuel or agreements involving residential fuel 
storage, in either case, where the consumer takes delivery of and uses 
the fuel, and the counterparty is a merchant that delivers in the 
service area where the consumer resides);\434\
---------------------------------------------------------------------------

    \434\ These agreements, contracts, or transactions require the 
parties respectively to make and take delivery of the underlying 
commodity to each other directly; delivery may be deferred for 
convenience or necessity. But see section 2(c)(2)(D) of the CEA, 7 
U.S.C. 2(c)(2)(D), generally prohibiting certain leveraged, margined 
or financed agreements, contracts and transactions with non-ECPs 
when actual delivery does not occur within 28 days). The Commissions 
view consumer agreements, contracts, and transactions involving 
periodic or future purchases of consumer products and services as 
transactions that are not swaps. This interpretation does not extend 
to consumer agreements, contracts or transactions containing 
embedded optionality or embedded derivatives other than those 
discussed in the text associated with this footnote. This analysis 
of consumer contracts is separate from the forward contract analysis 
for commercial merchandising transactions discussed in supra part 
II.B.2. The CFTC continues to view the forward contract exclusion 
for nonfinancial commodities as limited to commercial merchandising 
transactions.
---------------------------------------------------------------------------

     Agreements, contracts, or transactions that provide for an 
interest rate cap or lock on a consumer loan or mortgage, where the 
benefit of the rate cap or lock is realized only if the loan or 
mortgage is made to the consumer;
     Consumer loans or mortgages with variable rates of 
interest or embedded interest rate options, including such loans with 
provisions for the rates to change upon certain events related to the 
consumer, such as a higher rate of interest following a default; \435\
---------------------------------------------------------------------------

    \435\ An example of a consumer loan with a variable rate of 
interest is credit card debt that includes a ``teaser'' rate. The 
teaser rate is a low, adjustable introductory interest rate that is 
temporary.
---------------------------------------------------------------------------

     Service agreements, contracts, or transactions that are 
consumer product warranties, extended service plans, or buyer 
protection plans, such as those purchased with major appliances and 
electronics; \436\
---------------------------------------------------------------------------

    \436\ One commenter indicated that such service agreements, 
contracts, or transactions may be regulated as insurance in some but 
not all states. However, the Commissions believe that it is 
appropriate to address these agreements, contracts, or transactions 
in the context of their guidance regarding consumer and commercial 
arrangements. See NAIC Letter.
---------------------------------------------------------------------------

     Consumer options to acquire, lease, or sell real or 
personal property, such as options to lease apartments or purchase rugs 
and paintings, and purchases made through consumer layaway plans; \437\
---------------------------------------------------------------------------

    \437\ The Commissions believe that options entered into by 
consumers that result in physical delivery of the commodity, if 
exercised, are not the type of agreements, contracts or transactions 
that Congress intended to regulate as swaps or security-based swaps. 
Conversely, options entered into by consumers that cash settle based 
on the difference between the market price and the contract price of 
a commodity are not within the scope of this interpretation.
---------------------------------------------------------------------------

     Consumer agreements, contracts, or transactions where, by 
law or regulation, the consumer may cancel the transaction without 
legal cause; \438\ and
---------------------------------------------------------------------------

    \438\ Examples of these types of transactions include consumer 
transactions that may be cancelled pursuant to the Federal Reserve 
Board's Regulation Z, 12 CFR Part 226 (i.e. certain consumer credit 
transactions that involve a lien on the consumer's principal 
dwelling), consumer mail/telephone orders that may be cancelled when 
orders have not been filled under 16 CFR Part 435, and other 
consumer transactions that have cancellations rights conferred by 
statute or regulation.

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[[Page 48247]]

     Consumer guarantees of credit card debt, automobile loans, 
---------------------------------------------------------------------------
and mortgages of a friend or relative.

The Commissions have included in the interpretation above several 
additional examples of consumer arrangements that the Commissions do 
not consider to be swaps or security-based swaps. These additional 
examples have been included in response to commenters \439\ and the 
Commissions' determination that such additional examples would assist 
consumers in identifying other agreements, contracts, or transactions 
that they enter into that would not be regulated as swaps or security-
based swaps.\440\
---------------------------------------------------------------------------

    \439\ See supra note 96 and accompanying text. See also infra 
notes 436, 454 and 455 and accompanying text.
    \440\ The additional example regarding consumer options to 
acquire, lease, or sell real or personal property was added in 
response to a commenter on the ANPR. See Letter from White & Case 
LLP, dated September 20, 2010. The Commissions also are providing as 
additional examples consumer agreements, contracts, or transactions 
where, by law or regulation, the consumer may cancel the transaction 
without legal cause, and consumer guarantees of credit card debt, 
automobile loans, and mortgages of a friend or relative.
---------------------------------------------------------------------------

    The types of commercial agreements, contracts, or transactions that 
involve customary business arrangements (whether or not involving a 
for-profit entity) and will not be considered swaps or security-based 
swaps under this interpretation include:
     Employment contracts and retirement benefit arrangements;
     Sales, servicing, or distribution arrangements;
     Agreements, contracts, or transactions for the purpose of 
effecting a business combination transaction; \441\
---------------------------------------------------------------------------

    \441\ These business combination transactions include, for 
example, a reclassification, merger, consolidation, or transfer of 
assets as defined under the Federal securities laws or any tender 
offer subject to section 13(e) and/or section 14(d) or (e) of the 
Exchange Act, 15 U.S.C. 78m(e) and/or 78n(d) or (e). These business 
combination agreements, contracts, or transactions can be contingent 
on the continued validity of representations and warranties and can 
contain earn-out provisions and contingent value rights.
---------------------------------------------------------------------------

     The purchase, sale, lease, or transfer of real property, 
intellectual property, equipment, or inventory;
     Warehouse lending arrangements in connection with building 
an inventory of assets in anticipation of a securitization of such 
assets (such as in a securitization of mortgages, student loans, or 
receivables); \442\
---------------------------------------------------------------------------

    \442\ The Commissions believe that such lending arrangements 
included in this category are traditional borrower/lender 
arrangements documented using, for example, a loan agreement or 
indenture, as opposed to a synthetic lending arrangement documented 
in the form of, for example, a total return swap. The Commissions 
also note that securitization transaction agreements also may 
contain contingent obligations if the representations and warranties 
about the underlying assets are not satisfied.
---------------------------------------------------------------------------

     Mortgage or mortgage purchase commitments, or sales of 
installment loan agreements or contracts or receivables;
     Fixed or variable interest rate commercial loans or 
mortgages entered into by banks \443\ and non-banks, including the 
following:
---------------------------------------------------------------------------

    \443\ While the Commissions have included fixed or variable 
interest rate commercial loans entered into by banks, the 
Commissions understand that the CEA does not apply to, and the CFTC 
may not exercise regulatory authority over, identified banking 
products, and that the definitions of the terms ``security-based 
swap'' and ``security-based swap agreement'' do not include 
identified banking products. See infra note 488, regarding 
identified banking products. However, such loans and mortgages 
provided by certain banks may not qualify as identified banking 
products because those banks may not satisfy the definition of 
``bank'' for purposes of the ``identified banking products'' 
definition. See 7 U.S.C. 27(a).
---------------------------------------------------------------------------

     Fixed or variable interest rate commercial loans or 
mortgages entered into by the Farm Credit System institutions and 
Federal Home Loan Banks;
     Fixed or variable interest rate commercial loans or 
mortgages with embedded interest rate locks, caps, or floors, provided 
that such embedded interest rate locks, caps, or floors are included 
for the sole purpose of providing a lock, cap, or floor on the interest 
rate on such loan or mortgage and do not include additional provisions 
that would provide exposure to enhanced or inverse performance, or 
other risks unrelated to the interest rate risk being addressed;
     Fixed or variable interest rate commercial loans or 
mortgages with embedded interest rate options, including such loans or 
mortgages that contain provisions causing the interest rate to change 
upon certain events related to the borrower, such as a higher rate of 
interest following a default, provided that such embedded interest rate 
options do not include additional provisions that would provide 
exposure to enhanced or inverse performance, or other risks unrelated 
to the primary reason the embedded interest rate option is included; 
and
     Commercial agreements, contracts, and transactions 
(including, but not limited to, leases, service contracts, and 
employment agreements) containing escalation clauses linked to an 
underlying commodity such as an interest rate or consumer price index.

In response to commenters,\444\ the Commissions have included in the 
interpretation above several additional examples of commercial 
arrangements that the Commissions do not consider to be swaps or 
security-based swaps.
---------------------------------------------------------------------------

    \444\ See infra notes 456 and 461 and accompanying text.
---------------------------------------------------------------------------

    The Commissions intend for this interpretation to enable consumers 
to engage in transactions relating to their households and personal or 
family activities without concern that such arrangements would be 
considered swaps or security-based swaps. Similarly, with respect to 
commercial business arrangements, this interpretation should allow 
commercial and non-profit entities to continue to operate their 
businesses and operations without significant disruption and provide 
that the swap and security-based swap definitions are not read to 
include commercial and non-profit operations that historically have not 
been considered to involve swaps or security-based swaps.
    The types of agreements, contracts, and transactions discussed 
above are not intended to be exhaustive of the customary consumer or 
commercial arrangements that should not be considered to be swaps or 
security-based swaps. There may be other, similar types of agreements, 
contracts, and transactions that also should not be considered to be 
swaps or security-based swaps. In determining whether similar types of 
agreements, contracts, and transactions entered into by consumers or 
commercial entities are swaps or security-based swaps, the Commissions 
intend to consider the characteristics and factors that are common to 
the consumer and commercial transactions listed above:
     They do not contain payment obligations, whether or not 
contingent, that are severable from the agreement, contract, or 
transaction;
     They are not traded on an organized market or over-the-
counter; and
     In the case of consumer arrangements, they:

--Involve an asset of which the consumer is the owner or beneficiary, 
or that the consumer is purchasing, or they involve a service provided, 
or to be provided, by or to the consumer, or
     In the case of commercial arrangements, they are entered 
into:

--By commercial or non-profit entities as principals (or by their 
agents) to serve an independent commercial, business, or non-profit 
purpose, and
--Other than for speculative, hedging, or investment purposes.
    Two of the key components reflected in these characteristics that 
distinguish these agreements, contracts, and transactions from swaps 
and security-based swaps are that: (i) The payment provisions of the 
agreement, contract, or transaction are not severable; and (ii)

[[Page 48248]]

the agreement, contract, or transaction is not traded on an organized 
market or over-the-counter, and therefore such agreement, contract, or 
transaction does not involve risk-shifting arrangements with financial 
entities, as would be the case for swaps and security-based swaps.\445\ 
In response to commenters,\446\ the Commissions clarify that merely 
because an agreement, contract, or transaction is assignable does not 
mean that it is ``traded'' or that the agreement, contract, or 
transaction is a swap or security-based swap. An assignment of a 
contractual obligation must be analyzed to assure that the result is 
not to sever the payment obligations.
---------------------------------------------------------------------------

    \445\ There also are alternative regulatory regimes that have 
been enacted as part of the Dodd-Frank Act specifically to provide 
enhanced protections to consumers relating to various consumer 
transactions. See, e.g., the Consumer Financial Protection Act of 
2010, Public Law 111-203, tit. X, 124 Stat. 1376 (Jul. 21, 2010) 
(establishing the Bureau of Consumer Financial Protection to 
regulate a broad category of consumer products and amending certain 
laws under the jurisdiction of the Federal Trade Commission); the 
Mortgage Reform and Anti-Predatory Lending Act, Public Law 111-203, 
tit. XIV, 124 Stat. 1376 (Jul. 21, 2010) (amending existing laws, 
and adding new provisions, related to certain mortgages). Some of 
these agreements, contracts, or transactions are subject to 
regulation by the Federal Trade Commission and other Federal 
financial regulators and state regulators.
    \446\ See infra note 470.
---------------------------------------------------------------------------

    This interpretation is not intended to be the exclusive means for 
consumers and commercial or non-profit entities to determine whether 
their agreements, contracts, or transactions fall within the swap or 
security-based swap definition. If there is a type of agreement, 
contract, or transaction that is not enumerated above, or does not have 
all the characteristics and factors that are listed above (including 
new types of agreements, contracts, or transactions that may be 
developed in the future), the agreement, contract, or transaction will 
be evaluated based on its particular facts and circumstances. Parties 
to such an agreement, contract or transaction may also seek an 
interpretation from the Commissions as to whether the agreement, 
contract or transaction is a swap or security-based swap.
Comments
    Eleven commenters provided comments on the proposed interpretation 
set forth in the Proposing Release regarding consumer and commercial 
arrangements.\447\ While most commenters supported the proposed 
interpretation, these commenters suggested certain changes.
---------------------------------------------------------------------------

    \447\ See BGA Letter; Letter from The Coalition for Derivatives 
End-Users, Jul. 22, 2011, (``CDEU Letter''); ETA Letter; Letter from 
Robbie Boone, Vice President, Government Affairs, Farm Credit 
Council, Jul. 22, 2011 (``FCC Letter''); FERC Staff Letter; Letter 
from Warren N. Davis, Of Counsel, Sutherland Asbill & Brennan LLP, 
on behalf of the Federal Home Loan Banks, Jul. 22, 2011 (``FHLB 
Letter''); IECA Letter; ISDA Letter; Just Energy Letter; PMAA/NEFI 
Letter; and SEIA Letter.
---------------------------------------------------------------------------

    Four commenters recommended that the Commissions codify the 
proposed interpretation regarding consumer and commercial 
arrangements.\448\ The Commissions are not codifying the 
interpretation. The interpretation is intended to provide guidance to 
assist consumers and commercial and non-profit entities in evaluating 
whether certain arrangements that they enter into will be regulated as 
swaps or security-based swaps. The interpretation is intended to allow 
the flexibility necessary, including the consideration of the 
applicable facts and circumstances by the Commissions, in evaluating 
consumer and commercial arrangements to ascertain whether they may be 
swaps or security-based swaps. The representative characteristics and 
factors taken together are indicators that a consumer or commercial 
arrangement is not a swap or security-based swap and the Commissions 
have provided specific examples demonstrating how these characteristics 
and factors apply to some common types of consumer and commercial 
arrangements. However, as the interpretation is not intended to be a 
bright-line test for determining whether a particular consumer or 
commercial arrangement is a swap or security-based swap, if the 
particular arrangement does not meet all of the identified 
characteristics and factors, the arrangement will be evaluated based on 
its particular facts and circumstances.
---------------------------------------------------------------------------

    \448\ See ETA Letter; FERC Letter; IECA Letter; and Just Energy 
Letter.
---------------------------------------------------------------------------

    One commenter was concerned that the interpretation itself 
implicitly suggests that many types of consumer and commercial 
arrangements could be swaps, although none of these arrangements 
historically has been considered a swap.\449\ The Commissions do not 
intend to suggest that many types of consumer and commercial 
arrangements that historically have not been considered swaps are 
within the swap or security-based swap definitions. The Commissions 
provided the interpretation in response to comments received on the 
ANPR. Commenters on the ANPR identified areas in which a broad reading 
of the swap and security-based swap definitions could cover certain 
consumer and commercial arrangements that historically have not been 
considered swaps or security-based swaps.\450\ The Commissions believe 
it is appropriate to provide the interpretation to allow consumers and 
commercial and non-profit entities to engage in such transactions 
without concern that such arrangements would be considered swaps or 
security-based swaps.
---------------------------------------------------------------------------

    \449\ See IECA Letter.
    \450\ See Proposing Release at 29832.
---------------------------------------------------------------------------

    One commenter requested that the Commissions remove the term 
``customary'' from the description of consumer and commercial 
arrangements in the interpretation.\451\ The Commissions note that the 
use of the term ``customary'' was not intended to limit the 
interpretation, but rather was used to describe certain types of 
arrangements that consumers and businesses may normally or generally 
enter into. The Commissions also note that the term ``customary'' is 
itself not a separate representative characteristic or factor for 
purposes of the interpretation.
---------------------------------------------------------------------------

    \451\ See ISDA Letter.
---------------------------------------------------------------------------

    This commenter also requested that specific examples of consumer 
and commercial arrangements that are not swaps or security-based swaps 
include ``any other similar agreements, contracts, or transactions.'' 
\452\ The specific examples are not intended to be an exhaustive list 
and the Commissions do not believe that it is necessary to include a 
general catchall provision. The interpretation also includes a list of 
representative characteristics and factors to be used to analyze other 
consumer and commercial arrangements.
---------------------------------------------------------------------------

    \452\ Id.
---------------------------------------------------------------------------

    Several commenters suggested additional examples of consumer and 
commercial arrangements that the Commissions should not consider to be 
swaps or security-based swaps.\453\ One commenter suggested that the 
Commissions should expand the example of ``consumer agreements, 
contracts, or transactions to purchase products or services at a fixed 
price or a capped or collared price, at a future date or over a certain 
time period (such as agreements to purchase home heating fuel)'' to 
include all nonfinancial energy commodities in the parenthetical 
example.\454\ The Commissions have modified the identified consumer 
example to include all nonfinancial energy commodities. The 
parenthetical example was not intended to be limited to agreements to 
purchase home heating fuel.
---------------------------------------------------------------------------

    \453\ See CDEU Letter; FCC Letter; FERC Letter; FHLB Letter; 
ISDA Letter; Just Energy Letter; PMAA/NEFI Letter; and SEIA Letter.
    \454\ See Just Energy Letter.
---------------------------------------------------------------------------

    One commenter suggested that the Commissions should include as an

[[Page 48249]]

additional example residential fuel storage contracts.\455\ The 
Commissions agree that these arrangements should not be considered 
swaps or security-based swaps, provided that they are residential fuel 
storage contracts where the consumer takes delivery of and consumes the 
fuel, and the counterparty is a merchant (or agent of a merchant) that 
delivers in the service area where the consumer's residence is located. 
Although the consumer may not immediately consume the fuel contracted 
for, because it will ultimately consume the fuel for personal, family, 
or household purposes, such a transaction is a type of customary 
consumer transaction excluded from the swap and security-based swap 
definitions.
---------------------------------------------------------------------------

    \455\ See PMAA/NEFI Letter.
---------------------------------------------------------------------------

    Three commenters requested clarification that commercial loans and 
mortgages would fall within the interpretation regardless of whether 
entered into by a bank or non-bank.\456\ Two of these commenters were 
concerned that the specific example was limited to commercial loans and 
mortgages entered into by non-banks and did not address commercial 
loans and mortgages entered into by financial institutions that are 
banks but whose loans and mortgages do not qualify as identified 
banking products.\457\ The Commissions are revising the example to 
clarify that it includes fixed or variable interest rate commercial 
loans or mortgages entered into by both banks and non-banks, including 
such loans and mortgages entered into by the Farm Credit System 
institutions and Federal Home Loan Banks. The Commissions understand 
that the CEA does not apply to, and the CFTC may not exercise 
regulatory authority over, and the definitions of the terms ``security-
based swap'' and ``security-based swap agreement'' do not include, any 
fixed or variable interest rate commercial loan or mortgage entered 
into by a bank that is an identified banking product.\458\ However, 
loans and mortgages provided by certain banks may not qualify as 
identified banking products because those banks do not satisfy the 
definition of ``bank'' for purposes of the ``identified banking 
products'' definition.\459\ According to commenters,\460\ while this 
definition of ``bank'' includes insured depository institutions, 
certain foreign banks, credit unions, institutions regulated by the 
Federal Reserve and trust companies, it does not include certain other 
financial institutions that provide commercial loans or mortgages, such 
as government-sponsored enterprises (including the Federal Home Loan 
Banks) and certain cooperatives (including the Farm Credit System 
institutions).
---------------------------------------------------------------------------

    \456\ See CDEU Letter; FCC Letter; and FHLB Letter.
    \457\ See FCC Letter and FHLB Letter.
    \458\ See infra note 488, regarding identified banking products.
    \459\ See 7 U.S.C. 27(a). See also FCC Letter and FHLB Letter.
    \460\ See supra note 457.
---------------------------------------------------------------------------

    Three commenters suggested that the Commissions should include as 
additional examples commercial rate lock agreements and commercial 
loans with interest rate caps, floors, or options.\461\ The Commissions 
agree that these arrangements should not be considered swaps or 
security-based swaps, provided that the interest rate locks, caps, or 
floors, or interest rate options are embedded in the commercial loans 
or mortgages and not entered into separately from the commercial loans 
and mortgages, and are including these arrangements as examples in the 
interpretation. However, the Commissions are limiting the 
interpretation to embedded interest rate locks, caps, or floors, and 
interest rate options because interest rate locks, caps, or floors, or 
interest rate options that are entered into separately from the 
commercial loans and mortgages fall within the swap definition.\462\ In 
order to further distinguish these arrangements from swaps and 
security-based swaps, the interpretation provides the following: (i) 
The embedded interest rate lock, cap, or floor must be included for the 
sole purpose of providing a lock, cap, or floor on the interest rate on 
such loan or mortgage and may not include additional provisions that 
would provide exposure to enhanced or inverse performance, or other 
risks unrelated to the interest rate risk being addressed, and (ii) the 
embedded interest rate option may not include additional provisions 
that would provide exposure to leverage, inverse performance, or other 
risks unrelated to the primary reason the embedded interest rate option 
is included in the commercial loan or mortgage.
---------------------------------------------------------------------------

    \461\ See CDEU Letter; FCC Letter; and FHLB Letter. These 
commenters indicated that such arrangements are similar to the 
arrangements included in the list of examples of consumer 
arrangements that the Commissions would not consider to be swaps or 
security-based swaps.
    \462\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C. 
1a(47)(A)(i). Similarly, with respect to consumer agreements, 
contracts and transactions providing for an interest rate cap or an 
interest rate lock on a consumer loan or mortgage, the Commissions 
are limiting this example to interest rate caps and interest rate 
locks entered into in connection with the consumer loan or mortgage 
and prior to closing on the loan or mortgage. For this purpose, both 
because obtaining a consumer loan or mortgage can involve a great 
deal of documentation, which can be entered into at different times 
during the process, and because consumers may have some flexibility 
as to their deadline for deciding when to include or exclude an 
interest rate cap or lock in their consumer loans or mortgages, the 
Commissions will consider an interest rate cap or lock to be entered 
into in connection with a consumer loan or mortgage if it is 
included in the final terms of the loan at closing.
---------------------------------------------------------------------------

    Four commenters suggested additional examples of commercial 
arrangements that relate to nonfinancial energy commodities.\463\ These 
arrangements are more appropriately addressed in the context of the 
forward contract exclusion for nonfinancial commodities \464\ or the 
trade option exemption.\465\
---------------------------------------------------------------------------

    \463\ See BGA Letter (commercial physical transactions in the 
natural gas and electric power markets should also fall under the 
category of exemptions from the swap definition); FERC Letter 
(commercial transactions executed or traded on RTOs/ISOs should be 
included in the interpretation); Just Energy Letter (commercial 
arrangements to purchase products or services at a fixed price or a 
capped or collared price, at a future date or over a certain time 
period); and PMAA/NEFI Letter (petroleum fuel and gas storage 
contracts between bona fide commercial market participants or 
entities other than financial entities).
    \464\ See supra part II.B.2. The Commissions note that they 
provided the interpretation regarding consumer arrangements because 
the CFTC in the past has not interpreted the forward contract 
exclusion for nonfinancial commodities to apply to consumer 
arrangements. See supra note 434.
    \465\ See supra note 317 and accompanying text.
---------------------------------------------------------------------------

    One commenter supported the representative characteristics and 
factors the Commissions set forth to distinguish consumer and 
commercial arrangements from swaps and security-based swaps.\466\ Two 
commenters were concerned with certain of these characteristics and 
factors because these commenters believed that such characteristics and 
factors are common in a wide variety of consumer and commercial 
arrangements.\467\ Both commenters suggested that the Commissions 
remove ``for other than speculative, hedging or investment purposes'' 
from the interpretation because many of the types of transactions 
listed as examples may be undertaken for speculative, hedging or 
investment purposes and because all commercial merchandising 
transactions are ``risk-shifting'' of commercial obligations and risks, 
and ``hedge'' the enterprise's commercial risks.\468\ The Commissions 
are not revising the interpretation to remove or otherwise modify this 
representative characteristic and factor. The Commissions believe that 
commercial arrangements undertaken for speculative, hedging or 
investment purposes may be a swap or a security-based swap depending on 
the particular facts and circumstances of the arrangement.
---------------------------------------------------------------------------

    \466\ See FCC Letter.
    \467\ See ETA Letter and ISDA Letter.
    \468\ Id.

---------------------------------------------------------------------------

[[Page 48250]]

    One of these commenters also suggested the Commissions remove ``do 
not contain payment obligations that are severable'' from the 
interpretation because assignment of rights and delegation of 
obligations are common in a wide variety of consumer and commercial 
transactions.\469\ The Commissions are not revising the interpretation 
to remove or otherwise modify this representative characteristic and 
factor. The Commissions believe that the severability of payment 
obligations could be indicative of a consumer or commercial arrangement 
that may be a swap or a security-based swap depending on the particular 
facts and circumstances of the arrangement because the severability of 
payment obligations could be indicative of an instrument that is merely 
an exchange of payments, such as is the case with swaps and security-
based swaps.
---------------------------------------------------------------------------

    \469\ See ISDA Letter.
---------------------------------------------------------------------------

    One of these commenters also suggested that the Commissions remove 
``not traded on an organized market or over the counter'' from the 
interpretation because many of the types of contracts listed as 
examples are assignable and frequently assigned or traded.\470\ The 
other commenter did not suggest removing this factor, but requested 
that the factor be modified to provide that the arrangement is not 
traded on a ``registered entity'' in order not to include transactions 
on organized wholesale electricity markets.\471\ The Commissions are 
not revising the interpretation to remove or otherwise modify this 
representative characteristic and factor. The Commissions believe that 
the trading of an instrument on an organized market or over the counter 
could be indicative of a consumer or commercial arrangement that may be 
a swap or a security-based swap depending on the particular facts and 
circumstances of the arrangement. However, as noted above, the 
Commissions are clarifying that merely because an arrangement is 
assignable does not mean that it is ``traded'' or that the arrangement 
is a swap or security-based swap. An assignment of a contractual 
obligation must be analyzed to assure that the result is not to sever 
the payment obligations.
---------------------------------------------------------------------------

    \470\ Id.
    \471\ See ETA Letter.
---------------------------------------------------------------------------

    Further, as noted above, the representative characteristics and 
factors are not intended to be a bright-line test for determining 
whether a particular consumer or commercial arrangement is a swap or 
security-based swap. These representative characteristics and factors 
taken together are indicators that a consumer or commercial arrangement 
is not a swap or security-based swap. These representative 
characteristics and factors also do not imply or presume that a 
consumer or commercial arrangement that does not meet all of these 
characteristics and factors is a swap or security-based swap. As noted 
above, if a particular arrangement does not meet all of these 
characteristics and factors, the parties will need to evaluate the 
arrangement based on the particular facts and circumstances. Moreover, 
as noted above, if there is a type of consumer or commercial 
arrangement that does not meet all of these characteristics and 
factors, a party to the arrangement can seek an interpretation from the 
Commissions as to whether the arrangement is outside the scope of the 
swap and security-based swap definitions.
Residential Exchange Program
    One commenter requested that the CFTC further define the term 
``swap'' to exclude consumer benefits under the Pacific Northwest 
Electric Power Planning and Conservation Act of 1980 (``Northwest Power 
Act'') \472\ and transactions under the ``Residential Exchange 
Program'' (``REP'').\473\ According to this commenter, the REP was 
established by Congress ``[t]o extend the benefits of low cost Federal 
System hydro power to residential and small farm electric power 
consumers throughout the Pacific Northwest Region.'' \474\ Based on the 
commenter's description, REP transactions do not appear to be among the 
types of transactions historically considered swaps or security-based 
swaps. Although the REP transactions described by the commenter share 
some features with spread options (e.g., they settle in cash based on 
the difference between two price sources),\475\ in both swaps and 
security-based swaps, each party assumes market risk.\476\ By contrast, 
neither party assumes or hedges risk in an REP transaction.\477\ 
Instead, the Commissions view an REP transaction essentially as a 
subsidy provided to residential and small farm utility customers.\478\ 
Accordingly, the Commissions do not consider the REP transactions 
described by the commenter to be swaps or security-based swaps.
---------------------------------------------------------------------------

    \472\ 16 U.S.C. Chapter 12H.
    \473\ Letter from Virginia K. Schaeffer, Attorney, Office of 
General Counsel, Bonneville Power Administration, Jul. 22, 2011 
(``BPA Letter''). This commenter refers to the implementation of 
Section 5(c) of the Northwest Power Act, 16 U.S.C. 839c(c), as the 
``Residential Exchange Program.'' See Id.
    \474\ See BPA Letter. This commenter explained that, under the 
REP: ``A Pacific Northwest electric utility has a right to * * * 
sell power to Bonneville at the utility's average system cost (ASC) 
of providing that power * * * Bonneville[] is required to purchase 
that power at the utility's ASC, and then sell an equivalent amount 
of power back to the utility at Bonneville's rates[,] which are 
based in substantial part on low cost Federal hydro power. As 
required by the Residential Exchange Statute, the amount of such 
power ``exchanged'' is based on the related utility's residential 
and small farm customer's power needs (also known as ``loads'') in 
the Pacific Northwest Region. Under this ``exchange,'' no actual 
power is transferred to or from Bonneville. Instead, consistent with 
Congressional intent, the exchange transaction is implemented as an 
accounting device that avoids the costs and burdens associated with 
a physical exchange of power and that results in the payment of 
funds by Bonneville to the REP exchanging utilities. Reduced to the 
essentials, the Residential Exchange Statute as implemented in * * * 
REP contracts results in Bonneville making cash payments for the 
positive difference between the utility's ASC and Bonneville's lower 
rate multiplied by the qualifying residential and small farm loads. 
And, as required under the Residential Exchange Statute, the entire 
monetary benefit Bonneville provides to the REP exchanging utilities 
is in turn passed through to the residential and small farm power 
consumers of that utility.'' Id.
    \475\ A spread option is ``an option in which the payout is 
based on the difference in performance between two assets.'' 
Superderivatives, ``Spread option in EQ'' definition, available at 
http://www.sdgm.com/Support/Glossary.aspx?letter=S. See also S.J. 
Denga and S.S. Oren, Electricity derivatives and risk management, 
Science Direct at 945 (2006), available at http://
www.ieor.berkeley.edu/~oren/pubs/Deng%20and%20Oren-86.pdf (defining 
a spark spread options as ``cross-commodity options paying out the 
difference between the price of electricity sold by generators and 
the price of the fuels used to generate it''); Chicago Mercantile 
Exchange, Soybean-Corn Price Ratio Options Fact Card (describing its 
soybean-corn price ratio option contract as ``an option on the ratio 
between the price of the referencing Soybean futures contract and 
the price of the referencing Corn futures contract * * *''), 
available at http://www.cmegroup.com/trading/agricultural/files/AC-440-Soybean-CornRatioOptionsFC.pdf.
    \476\ Even a hedging party assumes the risk that the market can 
move against its hedging position, causing the hedge to reduce the 
profit it otherwise would have made on an unhedged position.
    \477\ The fact that the Commissions are relying in part on this 
aspect of REP transactions to interpret such transactions to be 
neither swaps nor security-based swaps does not mean that market 
participants should conclude, in other contexts, that a lack of 
market risk removes an agreement, contract, or transaction from the 
swap and security-based swap definitions. The Commissions' 
conclusion as to REP transactions is based on the unique facts and 
circumstances presented by the commenter.
    \478\ See, e.g., Paul M. Murphy, Northwest Public Power 
Association, Background and Summary of the Residential Exchange 
Program Settlement Agreement, March 16, 2011, available at http://www.nwppa.org/cwt/external/wcpages/wcmedia/documents/background_and_summary_of_rep_settlement_agreement.pdf (characterizing the 
REP as ``require[ing] BPA to subsidize the residential and small 
farm consumers of the higher cost utilities in the Pacific 
Northwest'').
---------------------------------------------------------------------------

Loan Participations
    The Commissions provided an interpretation in the Proposing Release 
regarding the treatment of loan participations.\479\ The Commissions 
are

[[Page 48251]]

restating the interpretation set out in the Proposing Release with 
certain modifications in response to commenters.\480\
---------------------------------------------------------------------------

    \479\ See Proposing Release at 29834.
    \480\ See infra note 504 and accompanying text.
---------------------------------------------------------------------------

    Loan participations arise when a lender transfers or offers a 
participation in the economic risks and benefits of all or a portion of 
a loan or commitment it has entered into with a borrower to another 
party as an alternative or precursor to assigning to such person the 
loan or commitment or an interest in the loan or commitment.\481\ The 
Commissions understand that two types of loan participations exist in 
the market today,\482\ LSTA-style participations\483\ and LMA-style 
participations.\484\ LSTA-style participations transfer a beneficial 
ownership interest in the underlying loan or commitment to the 
participant.\485\ LMA-style participations do not transfer a beneficial 
ownership interest in the underlying loan or commitment to the 
participant, but rather create a debtor-creditor relationship between 
the grantor and the participant under which a future beneficial 
ownership interest is conveyed.\486\
---------------------------------------------------------------------------

    \481\ See Loan Market Association, ``Guide to Syndicated 
Loans,'' section 6.2.4 (``A [loan] participation * * * is made 
between the existing lender and the participant. This creates new 
contractual rights between the existing lender and the participant 
which mirror existing contractual rights between the existing lender 
and the borrower. However this is not an assignment of those 
existing rights and the existing lender remains in a direct 
contractual relationship with the borrower.''), available at http://www.lma.eu.com/uploads/files/Introductory_Guides/Guide_to_Par_Syndicated_Loans.pdf.
    \482\ See Letter from R. Bram Smith, Executive Director, The 
Loan Syndications and Trading Association, Jan. 25, 2011 (``January 
LSTA Letter''); Letter from Elliot Ganz, General Counsel, The Loan 
Syndications and Trading Association, Mar. 1, 2011 (``March LSTA 
Letter''); and Letter from Clare Dawson, Managing Director, The Loan 
Market Association, Feb. 23, 2011. The Commissions understand that 
neither type of loan participation is a ``synthetic'' transaction. 
See March LSTA Letter. Both types of loan participations are merely 
transfers of cash loan positions and the ratio of underlying loan to 
participation is always one to one. Id.
    \483\ The LSTA is The Loan Syndications and Trading Association.
    \484\ The LMA is The Loan Market Association.
    \485\ See Letter from Clare Dawson, Managing Director, The LMA, 
Jul. 22, 2011 (``July LMA Letter'').
    \486\ See Id. The participant may exercise an ``elevation'' 
right and request that the grantor use commercially reasonable 
efforts to cause the participant to become the legal owner, by 
assignment, of the underlying loan or commitment. Id.
---------------------------------------------------------------------------

    Depending on the facts and circumstances, a loan participation may 
be a security under the Federal securities laws and, as such, the loan 
participation would be excluded from the swap definition as the 
purchase and sale of a security on a fixed or contingent basis.\487\ In 
addition, depending on the facts and circumstances, a loan 
participation may be an identified banking product and, as such, would 
be excluded from CFTC jurisdiction and from the security-based swap and 
security-based swap agreement definitions.\488\
---------------------------------------------------------------------------

    \487\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C. 
1a(47)(b)(v) and (vi), as amended by section 721(a)(21) of the Dodd-
Frank Act (excluding purchases and sales of a security on a fixed or 
contingent basis, respectively from the swap definition).
    \488\ See section 403(a) of the Legal Certainty for Bank 
Products Act of 2000, 7 U.S.C. 27a(a), as amended by section 
725(g)(2) of the Dodd-Frank Act (providing that, under certain 
circumstances, the CEA shall not apply to, and the CFTC shall not 
exercise regulatory authority over, identified banking products, and 
the definitions of the terms ``security-based swap'' and ``security-
based swap agreement'' shall not include identified banking 
products).
---------------------------------------------------------------------------

    The Commissions believe it is important to provide further guidance 
as to the other circumstances in which certain loan participations 
would not fall within the swap and security-based swap definitions. 
Consistent with the proposal, the Commissions do not interpret the swap 
and security-based swap definitions to include loan participations that 
reflect an ownership interest in the underlying loan or commitment. The 
Commissions believe that for a loan participation to not be considered 
a swap or security-based swap, the loan participation must represent a 
current or future direct or indirect ownership interest in the loan or 
commitment that is the subject of the loan participation.
    In evaluating whether the loan participation represents such an 
ownership interest, the Commissions believe the following 
characteristics should be present:
     The grantor of the loan participation is a lender under, 
or a participant or sub-participant in, the loan or commitment that is 
the subject of the loan participation.
     The aggregate participation in the loan or commitment that 
is the subject of the loan participation does not exceed the principal 
amount of such loan or commitment. Further, the loan participation does 
not grant, in the aggregate, to the participant in such loan 
participation a greater interest than the grantor holds in the loan or 
commitment that is the subject of the loan participation.
     The entire purchase price for the loan participation is 
paid in full when acquired and not financed. The Commissions believe a 
purchase price would not be paid in full if the grantor of the loan 
participation extends financing to the participant or if such 
participant levers its purchase, including by posting collateral to 
secure a future payment obligation.
     The loan participation provides the participant all of the 
economic benefit and risk of the whole or part of the loan or 
commitment that is the subject of the loan participation.
    These characteristics, which were identified by commenters,\489\ 
are intended to distinguish loan participations from swaps and 
security-based swaps based on loans. The first characteristic above 
addresses the ownership of the underlying loan or commitment. Swaps and 
security-based swaps may be created using a synthetic or derivative 
structure that does not require ownership of the underlying loan.\490\ 
The second characteristic above addresses the ratio of the 
participation to the underlying loan or commitment. Swaps and security-
based swaps based on loans may involve synthetic exposure to a loan 
that is a multiple of the principal amount.\491\ The third 
characteristic above addresses leverage in the financing of a loan 
participation. Leverage could be indicative of an instrument that is 
merely an exchange of payments and not a transfer of the ownership of 
the underlying loan or commitment, such as may be the case with a swap 
or security-based swap.\492\ The fourth characteristic above addresses 
the level of participation in the economic benefits and risks of the 
underlying loan or commitment. This characteristic is indicative of 
ownership when analyzed with the other characteristics and, as noted 
above, swaps and security-based swaps may be created using a synthetic 
or derivative structure that does not require ownership of the 
underlying loan.
---------------------------------------------------------------------------

    \489\ See infra note 504 and accompanying text. See also infra 
notes 490, 491, and 492 and accompanying text.
    \490\ See July LMA Letter.
    \491\ Id.
    \492\ Id.
---------------------------------------------------------------------------

    The Commissions agree with commenters that the loan participation 
does not have to be a ``true participation,'' as the Commissions had 
stated in their interpretation in the Proposing Release,\493\ in order 
for the loan participation to fall outside the swap and security-based 
swap definitions.\494\ The Commissions note that the ``true 
participation'' analysis is used to determine whether a transaction has 
resulted in the underlying assets being legally isolated from a 
transferor's creditors for U.S. bankruptcy law

[[Page 48252]]

purposes.\495\ This analysis is unrelated to and does not inform 
whether a loan participation is a swap or security-based swap. This 
analysis also may be subject to varying interpretations.\496\ Further, 
the Commissions understand that this analysis could result in certain 
loan participations that reflect an ownership interest in the 
underlying loan or commitment being included in the swap and security-
based swap definitions, which the Commissions do not intend.\497\
---------------------------------------------------------------------------

    \493\ Proposing Release at 29834.
    \494\ See infra note 503 and accompanying text.
    \495\ Id.
    \496\ Id.
    \497\ Id.
---------------------------------------------------------------------------

    Rather, as noted above, the Commissions believe that the analysis 
as to whether a loan participation is outside the swap and security-
based swap definitions should be based on whether the loan 
participation reflects an ownership interest in the underlying loan or 
commitment. The Commissions understand that the characteristics noted 
above are indicative, based on comments received,\498\ of whether a 
loan participation represents such an ownership interest. Further, in 
response to commenters,\499\ the Commissions are clarifying that the 
interpretation applies to loan participations that are entered into 
both with respect to outstanding loans and with respect to a lender's 
commitments to lend and fund letters of credit (e.g., under a revolving 
credit facility).
---------------------------------------------------------------------------

    \498\ See supra note 482. See infra note 501.
    \499\ See infra note 506 and accompanying text.
---------------------------------------------------------------------------

    The Commissions believe that the interpretation will prevent 
disruption in the syndicated loan market for loan participations. Loan 
participations facilitate a lender's diversification of its portfolio 
holdings, provide a key component of the efficient settlement process, 
and enhance liquidity in the global syndicated loan market.\500\ The 
interpretation will enable this market to continue operating as it did 
prior to the enactment of Title VII.
---------------------------------------------------------------------------

    \500\ See January LSTA Letter.
---------------------------------------------------------------------------

Comments
    Commenters supported the interpretation that certain loan 
participations should not be included in the swap and security-based 
swaps definitions.\501\ Commenters agreed with the proposal that a loan 
participation should represent a current and future direct or indirect 
ownership interest in the loan or commitment that is the subject of the 
loan participation.\502\ However, commenters disagreed with the 
proposal that a loan participation should be required to be a ``true 
participation'' in order for the loan participation to fall outside the 
swap and security-based swap definitions because LMA-style 
participations do not represent a beneficial ownership in the 
underlying loan or commitment such that they would be considered a true 
participation.\503\ Commenters requested that the Commissions remove 
this factor and instead recognize additional factors.\504\ The 
Commissions agree that a loan participation does not have to be a true 
participation in order for the loan participation to fall outside the 
swap and security-based swap definitions and are revising the 
interpretation as noted above.
---------------------------------------------------------------------------

    \501\ See FCC Letter; Letter from Richard M. Whiting, Executive 
Director and General Counsel, Financial Services Roundtable, Jul. 
22, 2011 (``FSR Letter''); July LMA Letter; Letter from R. Bram 
Smith, Executive Director, The LSTA, Jul. 22, 2011 (``July LSTA 
Letter''); MFA Letter; and Letter from Kenneth E. Bentsen, Jr., 
Executive Vice President, Public Policy and Advocacy, SIFMA, Jul. 
22, 2011 (``SIFMA Letter'').
    \502\ See FSR Letter; July LMA Letter; July LSTA Letter; MFA 
Letter; and SIFMA Letter. Commenters indicated that both LSTA-style 
participations and LMA-style participations represent a current or 
future direct or indirect ownership interest in the related loan or 
commitment. Id.
    \503\ See July LMA Letter; July LSTA Letter; MFA Letter; and 
SIFMA Letter. These commenters indicated that neither LMA-style 
participations nor certain LSTA-style participations are true 
participations. See July LMA Letter; July LSTA Letter; and SIFMA 
Letter. Further, according to the July LSTA Letter, ``[l]oan market 
participants in the United States will likely interpret the `true 
participation' requirement as a requirement that loan participations 
must qualify for `true sale' treatment in order to avoid 
classification as a `swap.' A `true sale' or `true participation' 
analysis is a test aimed at determining whether a transaction has 
resulted in the underlying assets being legally isolated from the 
transferor's creditors for U.S. bankruptcy law purposes. Its 
underlying purpose is to distinguish between a sale and a financing, 
not between a sale and a swap.'' If this is the case, certain LSTA-
style participations, which typically are offered in the United 
States, could be determined under a ``true sale'' analysis to be a 
financing and not a true participation. See July LSTA Letter.
    \504\ See July LMA Letter; July LSTA Letter; MFA Letter; and 
SIFMA Letter. Commenters recommended that the Commissions revise the 
interpretation by providing that the Commissions do not interpret 
the swap and security-based swap definitions to include loan 
participations in which (1) the participant is acquiring a current 
or future direct or indirect ownership interest in the related loan 
or commitment, and (2) the agreement pursuant to which the 
participant is acquiring such an interest (i) is a participation 
agreement that is, or any similar agreement of a type that has been, 
is presently, or in the future becomes, customarily entered into in 
the primary or secondary loan markets, (ii) requires the grantor to 
represent that it is a lender under, or a participant or sub-
participant in, the loan or commitment, (iii) provides that the 
participant is entitled to receive from the grantor all of the 
economic benefit of the whole or part of a loan or commitment to the 
extent of payments received by the grantor in respect of such loan 
or commitment, and (iv) requires that 100% of the purchase price 
calculated with respect to the loan or commitment is paid on the 
settlement date. See id. The characteristics identified by these 
commenters are reflected in the Commission's revised interpretation.
---------------------------------------------------------------------------

    One commenter also indicated that loan participations are entered 
into both with respect to outstanding loans and with respect to a 
lender's commitments to lend and fund letters of credit (e.g., under a 
revolving credit facility).\505\ This commenter requested that the 
Commissions revise the proposed interpretation to reflect both 
outstanding loans and a lender's commitments.\506\ The Commissions 
agree and are revising the interpretation to reflect both outstanding 
loans and loan commitments as noted above.
---------------------------------------------------------------------------

    \505\ See July LMA Letter.
    \506\ Id.
---------------------------------------------------------------------------

C. Final Rules and Interpretations Regarding Certain Transactions 
Within the Scope of the Definitions of the Terms ``Swap'' and 
``Security-Based Swap''

1. In General
    In light of provisions in the Dodd-Frank Act that specifically 
address certain foreign exchange products, the Commissions in the 
Proposing Release proposed rules to clarify the status of products such 
as foreign exchange forwards, foreign exchange swaps, foreign exchange 
options, non-deliverable forwards involving foreign exchange 
(``NDFs''), and cross-currency swaps. The Commissions also proposed a 
rule to clarify the status of forward rate agreements and provided 
interpretations regarding: (i) Combinations and permutations of, or 
options on, swaps or security-based swaps; and (ii) contracts for 
differences (``CFDs'').
    The Commissions are adopting the rules as proposed without 
modification and are restating the interpretations provided in the 
Proposing Release without modification. In addition, the Commissions 
are providing additional interpretations regarding foreign exchange 
spot transactions and retail foreign currency options.
    As adopted, rule 1.3(xxx)(2) under the CEA and rule 3a69-2 under 
the Exchange Act explicitly define the term ``swap'' to include certain 
foreign exchange-related products and forward rate agreements unless 
such products are excluded by the statutory exclusions in subparagraph 
(B) of the swap definition.\507\ In adopting these rules, the 
Commissions do not mean to suggest that the list of agreements, 
contracts, and transactions set forth in rule 1.3(xxx)(2) under the CEA 
and rule

[[Page 48253]]

3a69-2(b) under the Exchange Act is an exclusive list.
---------------------------------------------------------------------------

    \507\ See section 1a(47)(B) of the CEA, 7 U.S.C. 1a(47)(B).
---------------------------------------------------------------------------

2. Foreign Exchange Products
(a) Foreign Exchange Products Subject to the Secretary's Swap 
Determination: Foreign Exchange Forwards and Foreign Exchange Swaps
    The CEA, as amended by the Dodd-Frank Act, provides that ``foreign 
exchange forwards'' and ``foreign exchange swaps'' shall be considered 
swaps under the swap definition unless the Secretary of the Treasury 
(``Secretary'') issues a written determination that either foreign 
exchange swaps, foreign exchange forwards, or both: (i) Should not be 
regulated as swaps; and (ii) are not structured to evade the Dodd-Frank 
Act in violation of any rule promulgated by the CFTC pursuant to 
section 721(c) of the Dodd-Frank Act.\508\ A foreign exchange forward 
is defined in the CEA as ``a transaction that solely involves the 
exchange of two different currencies on a specific future date at a 
fixed rate agreed upon on the inception of the contract covering the 
exchange.'' \509\ A foreign exchange swap, in turn, is defined as ``a 
transaction that solely involves an exchange of 2 different currencies 
on a specific date at a fixed rate that is agreed upon on the inception 
of the contract covering the exchange; and a reverse exchange of the 2 
currencies described in subparagraph (A) at a later date and at a fixed 
rate that is agreed upon on the inception of the contract covering the 
exchange.'' \510\
---------------------------------------------------------------------------

    \508\ See section 1a(47)(E)(i) of the CEA, 7 U.S.C. 
1a(47)(E)(i). The Secretary published in the Federal Register a 
request for comment as to whether an exemption from the swap 
definition for foreign exchange swaps, foreign exchange forwards, or 
both, is warranted, and on the application of the statutory factors 
that the Secretary must consider in making a determination regarding 
whether to exempt these products. See Determinations of Foreign 
Exchange Swaps and Forwards, 75 FR 66829 (Oct. 28, 2010). 
Subsequently, the Secretary published in the Federal Register a 
proposed determination to exempt both foreign exchange swaps and 
foreign exchange forwards from the definition of the term ``swap'' 
in the CEA. See Determination of Foreign Exchange Swaps and Foreign 
Exchange Forwards Under the Commodity Exchange Act, Notice of 
Proposed Determination, 76 FR 25774 (May 5, 2011) (``Notice of 
Proposed Determination''). The comment period on the Secretary's 
proposed determination closed on June 6, 2011. A final determination 
has not yet been issued.
    \509\ See section 1a(24) of the CEA, 7 U.S.C. 1a(24).
    \510\ See section 1a(25) of the CEA, 7 U.S.C. 1a(25).
---------------------------------------------------------------------------

    Under the Dodd-Frank Act, if foreign exchange forwards or foreign 
exchange swaps are no longer considered swaps due to a determination by 
the Secretary, nevertheless, certain provisions of the CEA added by the 
Dodd-Frank Act would continue to apply to such transactions.\511\ 
Specifically, those transactions still would be subject to certain 
requirements for reporting swaps, and swap dealers and major swap 
participants engaging in such transactions still would be subject to 
certain business conduct standards.\512\
---------------------------------------------------------------------------

    \511\ The Secretary's determination also does not affect the 
CFTC's jurisdiction over retail foreign currency agreements, 
contracts, or transactions pursuant to section 2(c)(2) of the CEA, 7 
U.S.C. 2(c)(2). See section 1a(47)(F)(ii) of the CEA, 7 U.S.C. 
1a(47)(F)(ii).
    \512\ See, e.g., sections 1a(47)(E)(iii) and (iv) of the CEA, 7 
U.S.C. 1a(47)(E)(iii) and (iv) (reporting and business conduct 
standards, respectively). In addition, a determination by the 
Secretary does not exempt any foreign exchange forward or foreign 
exchange swap traded on a designated contract market or a swap 
execution facility, or cleared by a derivatives clearing 
organization, from any applicable antifraud or anti-manipulation 
provision under the CEA. See sections 1a(47)(F)(i) and 1b(c) of the 
CEA, 7 U.S.C. 1a(47)(F)(i) and 1b(c).
---------------------------------------------------------------------------

    The Commissions are adopting the rules as proposed to explicitly 
define by rule the term ``swap'' to include foreign exchange forwards 
and foreign exchange swaps (as those terms are defined in the 
CEA),\513\ in order to include in one rule the definitions of those 
terms and the related regulatory authority with respect to foreign 
exchange forwards and foreign exchange swaps.\514\ The final rules 
incorporate the provision of the Dodd-Frank Act that foreign exchange 
forwards and foreign exchange swaps will no longer be considered swaps 
if the Secretary issues the written determination described above to 
exempt such products from the swap definition.\515\ The final rules 
also reflect the continuing applicability of certain reporting 
requirements and business conduct standards in the event that the 
Secretary makes such a determination.\516\
---------------------------------------------------------------------------

    \513\ See rules 1.3(xxx)(3)(iii) and (iv) under the CEA and rule 
3a69-2(c)(3) and (4) under the Exchange Act.
    \514\ See rules 1.3(xxx)(2)(i)(C) and (D) under the CEA and 
rules 3a69-2(b)(1)(iii) and (iv) under the Exchange Act. The rules 
further provide that foreign exchange forwards and forward exchange 
swaps are not swaps if they fall within one of the exclusions set 
forth in subparagraph (B) of the statutory swap definition. See rule 
1.3(xxx)(2)(ii) under the CEA and rule 3a69-2(b)(2) under the 
Exchange Act.
    \515\ See rule 1.3(xxx)(3) under the CEA and rule 3a69-2(c) 
under the Exchange Act.
    \516\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-
2(c)(2) under the Exchange Act. The exclusion of foreign exchange 
forwards and foreign exchange swaps would become effective upon the 
Secretary's submission of the determination to exempt to the 
appropriate Congressional Committees. See sections 1a(47)(E)(ii) and 
1b of the CEA, 7 U.S.C. 1a(46)(E)(ii) and 1b.
---------------------------------------------------------------------------

Comments
    Two commenters recommended that the Commissions defer action on 
defining foreign exchange swaps and foreign exchange forwards in their 
regulations until the Secretary has made his final determination about 
whether to exempt them.\517\ One commenter believed that finalizing the 
Commissions' proposal prior to the Secretary's final determination 
would be ``premature.'' \518\ The other commenter believed that the 
industry will be ``better positioned'' to assess the need to clarify 
the scope of the swap definition with respect to foreign exchange 
derivatives after the Secretary has made his determination.\519\ The 
Commissions understand that, if the final rules are effective before 
the Secretary issues a written determination, market participants 
entering into foreign exchange forwards and foreign exchange swaps 
might incur costs in order to comply with the requirements of the CEA 
(as amended by the Dodd-Frank Act) that could be rendered unnecessary 
if the Secretary subsequently were to issue a written determination to 
exempt.\520\ The Commissions, however, believe the final rules are 
necessary because in the event the Secretary issues a written 
determination to exempt, certain reporting requirements and business 
conduct standards will continue to apply to the exempted instruments, 
and the final rules set forth those requirements that will continue to 
apply.
---------------------------------------------------------------------------

    \517\ See CME Letter and SIFMA Letter.
    \518\ See CME Letter. This commenter also believes that if the 
Secretary exempts foreign exchange swaps and foreign exchange 
forwards from the swap definition, it would create an ``awkward'' 
situation both for the CFTC and market participants, given that 
options on such products would be swaps but the products into which 
they exercise would not be swaps, and would result in a lack of 
clarity and consistency for market participants. Id.
    \519\ See SIFMA Letter.
    \520\ These costs market participants may incur relate to the 
upfront and ongoing costs associated with the regulation of Title 
VII instruments generally. See infra parts X and XI, for a 
discussion of these costs. The Commissions also note that the final 
rules will reduce (and may eliminate), the costs of determining 
whether foreign exchange swaps and foreign exchange forwards are 
subject to Title VII, as well as the costs associated with 
determining which provisions of the new Title VII regulatory regime 
will apply to these instruments. Id.
---------------------------------------------------------------------------

    Further, the Commissions do not believe that adopting the rules is 
premature, as the Secretary may issue a determination at any time, and 
the Secretary's authority to do so is independent of the Commissions' 
authority to issue these rules to further define the term ``swap.'' 
\521\ The

[[Page 48254]]

Commissions' final rules are consistent with this statutory framework 
by specifically providing that, in the event a determination to exempt 
is issued, foreign exchange swaps and foreign exchange forwards will 
not be considered swaps, and will be subject only to those CEA 
requirements that are specified in the statute.\522\ As such, the final 
rules accommodate the possibility of (rather than the certainty of) an 
exemptive determination made by the Secretary.
---------------------------------------------------------------------------

    \521\ Compare section 712(d)(1) of the CEA (Commissions' joint 
rulemaking authority to further define the term ``swap''), with 
section 1a(47)(E) and 1b of the CEA (Secretary's authority to 
determine to exempt foreign exchange swaps and foreign exchange 
forwards from the definition of ``swap.'').
    \522\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-
2(c)(2) under the Exchange Act. The statutory requirements that 
remain applicable, notwithstanding a written determination by the 
Secretary to exempt, are that foreign exchange swaps and foreign 
exchange forwards shall be reported to either a swap data 
repository, or, if there is no swap data repository that would 
accept such swaps or forwards, to the CFTC pursuant to section 4r of 
the CEA, 7 U.S.C. 6r, within such time period as the CFTC may by 
rule or regulation prescribe, and any party to a foreign exchange 
swap or forward that is a swap dealer or major swap participant 
shall conform to the business conduct standards contained in section 
4s(h) of the CEA, 7 U.S.C. 6s(h). Section 1a(47)(E)(iii) and (iv) of 
the CEA, 7 U.S.C. 1a(47)(E)(iii) and (iv).
---------------------------------------------------------------------------

    Moreover, commenters provided no support for the assertion that the 
situation would be awkward for market participants because options on 
foreign exchange forwards and foreign exchange swaps will be swaps, 
regardless of whether the Secretary determines to exempt the underlying 
transactions from the swap definition. The Commissions note that 
Congress drew the distinction in the statute between foreign currency 
options and foreign exchange forwards and foreign exchange swaps. The 
Commissions conclude that adopting these final rules would not 
contribute to a lack of clarity or consistency for market participants, 
regardless of any determination the Secretary makes.
(b) Foreign Exchange Products Not Subject to the Secretary's Swap 
Determination
    The Commissions are adopting rules as proposed stating that a 
determination by the Secretary that foreign exchange forwards or 
foreign exchange swaps, or both, should not be regulated as swaps would 
not affect certain other products involving foreign currency, such as 
foreign currency options, NDFs, currency swaps and cross-currency 
swaps.\523\ The rules explicitly define the term ``swap'' to include 
such products, irrespective of whether the Secretary makes a 
determination to exempt foreign exchange forwards or foreign exchange 
swaps from the swap definition.\524\
---------------------------------------------------------------------------

    \523\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-
2(c)(5) under the Exchange Act.
    \524\ See rule 1.3(xxx)(2)(i) under the CEA and rule 3a69-
2(b)(1) under the Exchange Act. The final rules provide, however, 
that none of these products are swaps if they fall within one of the 
exclusions set forth in subparagraph (B) of the statutory swap 
definition. See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-
2(b)(2) under the Exchange Act. Also, the rules do not define the 
term ``swap'' to include currency swaps because they are already 
included in the statutory definition, but the rules clarify that 
currency swaps are not subject to the Secretary's determination. See 
section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C. 
1a(47)(A)(iii)(VII); rule 1.3(xxx)(3)(v)(A) under the CEA; and rule 
3a69-2(c)(5)(i) under the Exchange Act.
---------------------------------------------------------------------------

(i) Foreign Currency Options \525\
---------------------------------------------------------------------------

    \525\ This discussion is not intended to address, and has no 
bearing on, the CFTC's jurisdiction over foreign currency options in 
other contexts. See, e.g., CEA sections 2(c)(2)(A)(iii) and 
2(c)(2)(B)-(C), 7 U.S.C. 2(c)(2)(A)(iii) and 2(c)(2)(B)-(C) (off-
exchange options in foreign currency offered or entered into with 
retail customers).
---------------------------------------------------------------------------

    As discussed above, the statutory swap definition includes options, 
and it expressly enumerates foreign currency options. It encompasses 
any agreement, contract, or transaction that is a put, call, cap, 
floor, collar, or similar option of any kind that is for the purchase 
or sale, or based on the value, of 1 or more interest or other rates, 
currencies, commodities, securities, instruments of indebtedness, 
indices, quantitative measures, or other financial or economic 
interests or property of any kind.\526\ Foreign exchange options traded 
on a national securities exchange (``NSE''), however, are securities 
under the Federal securities laws and not swaps or security-based 
swaps.\527\
---------------------------------------------------------------------------

    \526\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C. 
1a(47)(A)(i).
    \527\ See section 1a(47)(B)(iv) of the CEA, 7 U.S.C. 
1a(47)(B)(iv).
---------------------------------------------------------------------------

    Any determination by the Secretary, discussed above, that foreign 
exchange forwards or foreign exchange swaps should not be regulated as 
swaps would not impact foreign currency options because a foreign 
currency option is neither a foreign exchange swap nor a foreign 
exchange forward, as those terms are defined in the CEA. The 
Commissions did not receive any comments either on the proposed rule 
further defining the term ``swap'' to include foreign currency options 
or the proposed rule clarifying that foreign currency options are not 
subject to the Secretary's determination to exempt foreign exchange 
swaps and foreign exchange forwards.\528\ Consequently, the Commissions 
are adopting rules to explicitly define the term ``swap'' to include 
foreign currency options (other than foreign currency options traded on 
an NSE).\529\ The rules also state that foreign currency options are 
not foreign exchange forwards or foreign exchange swaps under the 
CEA.\530\
---------------------------------------------------------------------------

    \528\ A comment regarding the CFTC's jurisdiction over retail 
foreign currency options is discussed below.
    \529\ See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-
2(b)(1) under the Exchange Act. The final rules treat the terms 
foreign currency options, currency options, foreign exchange 
options, and foreign exchange rate options as synonymous. Moreover, 
for purposes of the final rules, foreign currency options include 
options to enter into or terminate, or that otherwise operate on, a 
foreign exchange swap or foreign exchange forward, or on the terms 
thereof. As discussed above, foreign exchange options traded on an 
NSE are securities and therefore are excluded from the swap 
definition. See supra note 527 and accompanying text.
    \530\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-
2(c)(5) under the Exchange Act.
---------------------------------------------------------------------------

(ii) Non-Deliverable Forward Contracts Involving Foreign Exchange
    As explained by the Commissions in the Proposing Release,\531\ an 
NDF generally is similar to a forward foreign exchange contract,\532\ 
except that at maturity the NDF does not require physical delivery of 
currencies; rather, the contract typically is settled in a reserve 
currency, such as U.S. dollars. One of the currencies involved in the 
transaction, usually an emerging market currency, may be subject to 
capital controls or similar restrictions, and is therefore said to be 
``nondeliverable.'' \533\ If the spot market exchange rate on the 
settlement date is greater (in foreign currency per dollar terms) than 
the previously agreed forward exchange rate, the party to the contract 
that is long the nondeliverable (e.g. emerging market) currency must 
pay its counterparty the difference between the contracted forward 
price and the spot market rate, multiplied by the notional amount.\534\
---------------------------------------------------------------------------

    \531\ See Proposing Release at 29836.
    \532\ A deliverable forward foreign exchange contract is an 
obligation to buy or sell a specific currency on a future settlement 
date at a fixed price set on the trade date. See Laura Lipscomb, 
Federal Reserve Bank of New York, ``An Overview of Non-Deliverable 
Foreign Exchange Forward Markets,'' 1 (May 2005) (citation omitted) 
(``Fed NDF Overview'').
    \533\ See id. at 1-2 (citation omitted).
    \534\ See id. at 2. Being long the emerging market currency 
means that the holder of the NDF contract is the ``buyer'' of the 
emerging market currency and the ``seller'' of dollars. Conversely, 
if the emerging market currency appreciates relative to the 
previously agreed forward rate, the holder of the contract that is 
short the emerging market currency must pay its counterparty the 
difference between the spot market rate and the contracted forward 
price, multiplied by the notional amount. See id. at 2, n.4.
---------------------------------------------------------------------------

    NDFs are not expressly enumerated in the swap definition, but as 
was stated in the Proposing Release,\535\ they satisfy clause (A)(iii) 
of the swap definition because they provide for a future

[[Page 48255]]

(executory) payment based on an exchange rate, which is an ``interest 
or other rate[ ]'' within the meaning of clause (A)(iii).\536\ Each 
party to an NDF transfers to its counterparty the risk of the exchange 
rate moving against the counterparty, thus satisfying the requirement 
that there be a transfer of financial risk associated with a future 
change in rate. This financial risk transfer in the context of an NDF 
is not accompanied by a transfer of an ownership interest in any asset 
or liability. Thus, an NDF is a swap under clause (A)(iii) of the swap 
definition.\537\
---------------------------------------------------------------------------

    \535\ See Proposing Release at 29836.
    \536\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C. 
1a(47)(A)(iii) (providing that a swap is an agreement, contract, or 
transaction ``that provides on an executory basis for the exchange, 
on a fixed or contingent basis, of 1 or more payments based on the 
value or level of 1 or more interest or other rates, currencies, 
commodities, securities, instruments of indebtedness, indices, 
quantitative measures, or other financial or economic interests or 
property of any kind, or any interest therein or based on the value 
thereof, and that transfers, as between the parties to the 
transaction, in whole or in part, the financial risk associated with 
a future change in any such value or level without also conveying a 
current or future direct or indirect ownership interest in an asset 
(including any enterprise or investment pool) or liability that 
incorporates the financial risk so transferred * * * .'').
    \537\ In addition, as was noted in the Proposing Release, at 
least some market participants view NDFs as swaps today, and thus 
NDFs also may fall within clause (A)(iv) of the swap definition as 
``an agreement, contract, or transaction that is, or in the future 
becomes, commonly known to the trade as a swap.'' See Proposing 
Release at 29836. See also section 1a(47)(A)(iv) of the CEA, 7 
U.S.C. 1a(47)(A)(iv). Cf. rule 35.1(b)(1)(i) under the CEA, 17 CFR 
35.1(b)(1)(i) (providing that the definition of ``swap agreement'' 
includes a ``forward foreign exchange agreement,'' without reference 
to convertibility or delivery).
---------------------------------------------------------------------------

    Moreover, the Commissions have determined that NDFs do not meet the 
definitions of ``foreign exchange forward'' or ``foreign exchange 
swap'' set forth in the CEA.\538\ NDFs do not involve an ``exchange'' 
of two different currencies (an element of the definition of both a 
foreign exchange forward and a foreign exchange swap); instead, they 
are settled by payment in one currency (usually U.S. dollars).\539\
---------------------------------------------------------------------------

    \538\ In the Notice of Proposed Determination, the Secretary 
stated that his authority to issue a determination ``is limited to 
foreign exchange swaps and forwards and does not extend to other 
foreign exchange derivatives'' and noted that ``NDFs may not be 
exempted from the CEA's definition of ``swap'' because they do not 
satisfy the statutory definitions of a foreign exchange swap or 
forward.'' See Notice of Proposed Determination.
    \539\ Likewise, the Commissions have determined that a foreign 
exchange transaction, which initially is styled as or intended to be 
a ``foreign exchange forward,'' and which is modified so that the 
parties settle in a reference currency (rather than settle through 
the exchange of the 2 specified currencies), does not conform with 
the definition of ``foreign exchange forward'' in the CEA. See infra 
note 626.
---------------------------------------------------------------------------

    Notwithstanding their ``forward'' label, NDFs also do not fall 
within the forward contract exclusion of the swap definition because 
currency is outside the scope of the forward contract exclusion for 
nonfinancial commodities.\540\ Nor have NDFs traditionally been 
considered commercial merchandising transactions. Rather, as the 
Commissions observed in the Proposing Release,\541\ NDF markets appear 
to be driven in large part by speculation \542\ and hedging,\543\ which 
features are more characteristic of swap markets than forward markets.
---------------------------------------------------------------------------

    \540\ Currency is an excluded commodity under the CEA. See 
section 1a(19)(i) of the CEA, 7 U.S.C. 1a(19)(i). In accordance with 
the interpretation regarding nonfinancial commodities, which as 
discussed above, see supra part II.B.2(a), are exempt and 
agricultural commodities that can be physically delivered, currency 
does not qualify as a nonfinancial commodity for purposes of the 
forward exclusion from the swap definition.
    \541\ See Proposing Release at 29836.
    \542\ See Fed NDF Overview at 5 (``[E]stimates vary but many 
major market participants estimate as much as 60 to 80 percent of 
NDF volume is generated by speculative interest, noting growing 
participation from international hedge funds.'') and 4 (``[D]ealers 
note that much of the volume in Chinese yuan NDFs is generated by 
speculative positioning based on expectations for an alteration in 
China's current, basically fixed exchange rate.'') (italics in 
original).
    \543\ See id. at 4 (noting that ``[much of the] Korean won NDF 
volume[,] * * * estimated to be the largest of any currency, * * * 
is estimated to originate with international investment portfolio 
managers hedging the currency risk associated with their onshore 
investments'').
---------------------------------------------------------------------------

Comments
    Commenters who addressed the nature of NDFs believed that NDFs 
should not be considered swaps, but rather should be categorized as 
foreign exchange forwards. In general, commenters maintained that NDFs 
are functionally and economically equivalent to foreign exchange 
forwards, and therefore should be treated in the same manner for 
regulatory purposes.\544\ In support of this view, commenters made 
several arguments, including that both NDFs and foreign exchange 
forwards require the same net value to be transferred between 
counterparties; the purpose for using them is the same--to cover 
foreign currency exchange risk; both are typically short term 
transactions; and both may be cleared by CLS Bank.\545\
---------------------------------------------------------------------------

    \544\ See CDEU Letter; Letter from The Committee on Investment 
of Employee Benefit Assets, dated Jul. 22, 2011 (``CIEBA Letter''); 
Letter from Bruce C. Bennett, Covington & Burling LLP, dated Jul. 
22, 2011 (``Covington Letter''); and Letter from Karrie McMillan and 
Cecelia Calaby, the Investment Company Institute/American Bar 
Association Securities Association, dated Jul. 22, 2011 (``ICI/ABASA 
Letter'').
    \545\ See Covington Letter and ICI/ABASA Letter. CLS Bank 
operates the largest multi-currency cash settlement system to 
eliminate settlement risk in the foreign exchange market.
---------------------------------------------------------------------------

    In addition, commenters believed that not treating NDFs as foreign 
exchange forwards or foreign exchange swaps would be contrary to both 
domestic and international market practices. As specific examples, 
commenters noted that NDFs typically are traded as part of a bank's or 
broker's foreign exchange desk; the Federal Reserve Bank of New York 
has described an NDF in a 1998 publication as an instrument ``similar 
to an outright forward,'' except that there is no physical delivery or 
transfer of the local currency; the Bank for International Settlements 
(``BIS'') categorizes NDFs in its ``outright forward'' category; 
various European regulations do not distinguish between the two 
transaction types; standard foreign exchange trading documentation 
includes both net- and physically-settled foreign exchange transactions 
in general definitions of foreign exchange transactions; and special 
rules under the U.S. tax code apply equally to physically settled and 
cash settled foreign exchange forwards.\546\
---------------------------------------------------------------------------

    \546\ See Covington Letter and ICI/ABASA Letter.
---------------------------------------------------------------------------

    Commenters also raised potential negative consequences to certain 
U.S. market participants if NDFs are not considered to be foreign 
exchange forwards. For example, one commenter argued that treating NDFs 
as swaps will put U.S. corporations doing business in emerging markets 
at a disadvantage relative to U.S. corporations doing business solely 
in developed markets.\547\ This commenter stated that NDFs are widely 
used by U.S. corporations that do business in emerging markets to hedge 
their exposure to the currencies of those markets, and that regulating 
NDFs as swaps would significantly increase the cost of hedging those 
exposures.\548\
---------------------------------------------------------------------------

    \547\ See Covington Letter.
    \548\ See supra note 520.
---------------------------------------------------------------------------

    With respect to the Commissions' legal conclusion that NDFs are not 
foreign exchange forwards, and thus are not subject to the Secretary's 
determination, one commenter stated that the Commissions' reading of 
the definition of the term ``foreign exchange forward'' as not 
including NDFs is ``too restrictive.'' \549\ In this regard, this 
commenter believed that the term ``exchange'' should be read to include 
``the economic exchange that occurs in net settlement rather than being 
narrowly read as the physical `exchange' of two different currencies.''
---------------------------------------------------------------------------

    \549\ See ICI/ABASA Letter.
---------------------------------------------------------------------------

    One commenter, in contrast, agreed with the Commissions' 
interpretation that NDFs are not encompassed within the definition of 
the term ``foreign

[[Page 48256]]

exchange forward.'' \550\ This commenter requested, though, that the 
CFTC exempt NDFs from the swap definition, using its exemptive 
authority under section 4(c) of the CEA.\551\
---------------------------------------------------------------------------

    \550\ See CIEBA Letter.
    \551\ 7 U.S.C. 6(c).
---------------------------------------------------------------------------

    While commenters raised a number of objections to the Commissions' 
proposal to define NDFs as swaps, these objections primarily raise 
policy arguments. No commenter has provided a persuasive, alternative 
interpretation of the statute's plain language in the definition of the 
term ``foreign exchange forward'' to overcome the Commissions' 
conclusion that, under the CEA, NDFs are swaps, not foreign exchange 
forwards.
    One commenter believed that the Commissions' interpretation of 
``exchange of 2 different currencies'' as used in the foreign exchange 
forward definition is too restrictive, and that the phrase should be 
read broadly to mean an economic exchange of value in addition to 
physical exchange; the Commissions believe that this contention is 
misplaced.\552\ This commenter essentially asks the Commissions to 
interpret the statutory language to mean an exchange of foreign 
currencies themselves, as well as an exchange based on the value of 
such currencies. However, only the word ``exchange'' appears in the 
relevant definitions, reinforcing the conclusion that Congress intended 
the definition of ``foreign exchange forward'' to be distinct from 
other types of transactions covered by the definition of ``swap'' in 
the CEA. Moreover, the language of each definition emphasizes that 
these transactions may ``solely'' involve an exchange. The ordinary 
meaning of the verb ``exchange'' is to ``barter'' \553\ or ``part with, 
give or transfer for an equivalent,'' \554\ i.e., each party is both 
giving to and receiving from the other party. This does not occur under 
an NDF, in which only a single party makes a payment.
---------------------------------------------------------------------------

    \552\ See ICI/ABASA Letter.
    \553\ See Webster's New World Dictionary (3d College Ed. 1988).
    \554\ See Black's Law Dictionary.
---------------------------------------------------------------------------

    Elsewhere in the CEA, Congress used explicit language that 
potentially could provide support for a broader interpretation of the 
type advocated by this commenter, but such language is absent from the 
definition of the term ``foreign exchange forward.'' For example, 
section 2(a)(1)(C)(ii) confers exclusive jurisdiction on the CFTC over 
``contracts of sale for future delivery of a group or index of 
securities (or any interest therein or based upon the value thereof) 
[that meet certain requirements]''. If the phrase ``exchange of 2 
different currencies'' had been intended to include economic exchanges 
of value, as suggested by this commenter, that phrase would have 
included language similar to ``based on the value thereof'' to indicate 
that other mechanisms of transferring value may occur in these 
particular types of transactions. Instead, as noted above, Congress 
limited the scope of each of these particular transactions by using the 
words ``solely involves the exchange of 2 different currencies''. The 
Commissions conclude that the use of the word ``solely'' provides 
further support for the Commissions' interpretation that exchange means 
an actual interchange of the 2 different currencies involved in the 
transaction.\555\
---------------------------------------------------------------------------

    \555\ This commenter's request that the CFTC exempt NDFs from 
the swap definition using its exemptive authority under section 4(c) 
of the CEA, 7 U.S.C. 6(c), and that the SEC exercise its exemptive 
authority under section 36 of the Exchange Act, 78 U.S.C. 78mm, with 
respect to NDFs, is beyond the scope of this rulemaking.
---------------------------------------------------------------------------

(iii) Currency Swaps and Cross-Currency Swaps
    A currency swap \556\ and a cross-currency swap \557\ each 
generally can be described as a swap in which the fixed legs or 
floating legs based on various interest rates are exchanged in 
different currencies. Such swaps can be used to reduce borrowing costs, 
to hedge currency exposure, and to create synthetic assets \558\ and 
are viewed as an important tool, given that they can be used to hedge 
currency and interest rate risk in a single transaction.
---------------------------------------------------------------------------

    \556\ A swap that exchanges a fixed rate against a fixed rate is 
known as a currency swap. See Federal Reserve System, ``Trading and 
Capital-Markets Activities Manual,'' section 4335.1 (Jan. 2009).
    \557\ Cross-currency swaps with a fixed leg based on one rate 
and a floating leg based on another rate, where the two rates are 
denominated in different currencies, are generally referred to as 
cross-currency coupon swaps, while those with a floating leg based 
on one rate and another floating leg based on a different rate are 
known as cross-currency basis swaps. Id. Cross-currency swaps also 
include annuity swaps and amortizing swaps. In cross-currency 
annuity swaps, level cash flows in different currencies are 
exchanged with no exchange of principal; annuity swaps are priced 
such that the level payment cash flows in each currency have the 
same net present value at the inception of the transaction. An 
amortizing cross-currency swap is structured with a declining 
principal schedule, usually designed to match that of an amortizing 
asset or liability. Id.
    See also Derivatives ONE, ``Cross Currency Swap Valuation'' (``A 
cross currency swap is swap of an interest rate in one currency for 
an interest rate payment in another currency * * * This could be 
considered an interest rate swap with a currency component.''), 
available at http://www.derivativesone.com/cross-currency-swap-valuation/; Financial Accounting Standards Board, ``Examples 
Illustrating Application of FASB Statement No. 138,'' Accounting for 
Certain Derivative Instruments and Certain Hedging Activities, 
section 2, Example 1, at 3 (``The company designates the cross-
currency swap as a fair value hedge of the changes in the fair value 
of the loan due to both interest and exchange rates.''), available 
at http://www.fasb.org/derivatives/examples.pdf.
    \558\ BMO Capital Markets, ``Cross Currency Swaps,'' available 
at http://www.bmocm.com/products/marketrisk/intrderiv/cross/default.aspx.
---------------------------------------------------------------------------

    Currency swaps and cross-currency swaps are not foreign exchange 
swaps as defined in the CEA because, although they may involve an 
exchange of foreign currencies, they also require contingent or 
variable payments in different currencies. Because the CEA defines a 
foreign exchange swap as a swap that ``solely'' involves an initial 
exchange of currencies and a reversal thereof at a later date, subject 
to certain parameters, currency swaps and cross-currency swaps would 
not be foreign exchange swaps. Similarly, currency swaps and cross-
currency swaps are not foreign exchange forwards because foreign 
exchange forwards ``solely'' involve an initial exchange of currencies, 
subject to certain parameters, while currency swaps and cross-currency 
swaps contain additional elements, as discussed above.
    Currency swaps are expressly enumerated in the statutory definition 
of the term ``swap.'' \559\ Cross-currency swaps, however, are 
not.\560\ Accordingly, based on the foregoing considerations, the 
Commissions are adopting rules explicitly defining the term ``swap'' to 
include cross-currency swaps.\561\ The rules also state that neither 
currency swaps nor cross-currency swaps are foreign exchange forwards 
or foreign exchange swaps as those terms are defined in the CEA. The 
Commissions did not receive any comments either on the rule further 
defining the term ``swap'' to include cross-currency swaps or the rule 
clarifying that cross-currency swaps and currency swaps are not subject 
to the Secretary's determination to exempt foreign exchange swaps and 
foreign exchange forwards.
---------------------------------------------------------------------------

    \559\ See section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C. 
1a(47)(A)(iii)(VII).
    \560\ Clause (A)(iii) of the swap definition expressly refers to 
a cross-currency rate swap. See section 1a(47)(A)(iii)(V) of the 
CEA, 7 U.S.C. 1a(47)(A)(iii)(V). Although the swap industry appears 
to use the term ``cross-currency swap,'' rather than ``cross-
currency rate swap'' (the term used in section 1a(47)(A)(iii)(V) of 
the CEA), the Commissions interpret these terms as synonymous.
    \561\ See rule 1.3(xxx)(2)(i)(A) under the CEA and rule 3a69-
2(b)(1)(i) under the Exchange Act.
---------------------------------------------------------------------------

(c) Interpretation Regarding Foreign Exchange Spot Transactions
    The CEA generally does not confer regulatory jurisdiction on the 
CFTC with respect to spot transactions.\562\ In

[[Page 48257]]

the context of foreign currency, spot transactions typically settle 
within two business days after the trade date (``T+2'').\563\ The 
accepted market practice of a two-day settlement for spot foreign 
currency transactions has been recognized by the CFTC \564\ and the 
courts.\565\
---------------------------------------------------------------------------

    \562\ But see supra note 227.
    \563\ Bank for International Settlements, Triennial Central Bank 
Survey, Report on Global Foreign Exchange Market Activity in 2010 at 
32 (Dec. 2010) (defining a foreign exchange spot transaction to 
provide for cash settlement within 2 business days); Sam Y. Cross, 
Federal Reserve Bank of New York, ``All About * * *. The Foreign 
Exchange Market in the United States'' at 31-32 (1998).
    \564\ See CFTC Division of Trading and Markets, Report on 
Exchange of Futures for Physicals at 124-127 (1987) (noting that 
foreign currency spot transactions settle in 2 days).
    \565\ See CFTC v. Frankwell Bullion, Ltd., 99 F.3d 299, 300 (9th 
Cir. 1996) (``Spot transactions in foreign currencies call for 
settlement within two days.''); CFTC v. Int'l Fin. Servs. (NewYork), 
Inc., 323 F. Supp. 2d 482, 495 (S.D.N.Y. 2004) (noting that spot 
transactions ordinarily call for settlement within two days); Bank 
Brussels Lambert, S.A. v. Intermetals Corp., 779 F.Supp. 741, 742 
(S.D.N.Y. 1991) (same). But the Commissions understand that the 
settlement cycle for spot transactions exchanging Canadian dollars 
for U.S. dollars (or vice versa) is T+1. See Cross, supra 563, at 
31.
---------------------------------------------------------------------------

    The Commissions recognize that the new foreign exchange forward 
definition in the CEA, which was added by the Dodd-Frank Act and which 
applies to an exchange of two different currencies ``on a specific 
future date,'' could be read to apply to any foreign exchange 
transaction that does not settle on the same day. Such a reading could 
render most foreign exchange spot transactions foreign exchange 
forwards under the CEA; as a result, such transactions would be subject 
to the CEA reporting and business conduct standards requirements 
applicable to foreign exchange forwards even if the Secretary 
determines to exempt foreign exchange forwards from the definition of 
``swap.'' The Commissions do not believe that Congress intended, solely 
with respect to foreign exchange transactions, to extend the reach of 
the CEA to transactions that historically have been considered spot 
transactions. At the same time, however, the Commissions do not want to 
enable market participants simply to label as ``spot'' foreign exchange 
transactions that regularly settle after the relevant foreign exchange 
spot market settlement deadline, or with respect to which the parties 
intentionally delay settlement, both of which would be properly 
categorized as foreign exchange forwards, or CEA section 2(c)(2) 
transactions (discussed separately below), in order to avoid applicable 
foreign exchange regulatory requirements.
    Accordingly, the Commissions are providing an interpretation that a 
bona fide foreign exchange spot transaction, i.e., a foreign exchange 
transaction that is settled on the customary timeline of the relevant 
spot market, is not within the definition of the term ``swap.'' In 
general, a foreign exchange transaction will be considered a bona fide 
spot transaction if it settles via an actual delivery of the relevant 
currencies within two business days. In certain circumstances, however, 
a foreign exchange transaction with a longer settlement period 
concluding with the actual delivery of the relevant currencies may be 
considered a bona fide spot transaction depending on the customary 
timeline of the relevant market.\566\ In particular, as discussed 
below, the Commissions will consider a foreign exchange transaction 
that is entered into solely to effect the purchase or sale of a foreign 
security to be a bona fide spot transaction where certain conditions 
are met.
---------------------------------------------------------------------------

    \566\ In this regard, while the Commissions will look at the 
relevant facts and circumstances, they will not expect that an 
unintentional settlement failure or delay for operational reasons or 
due to a market disruption will undermine the character of a bona 
fide spot foreign exchange transaction as such.
---------------------------------------------------------------------------

    The CFTC will consider the following to be a bona fide spot foreign 
exchange transaction: An agreement, contract or transaction for the 
purchase or sale of an amount of foreign currency equal to the price of 
a foreign security with respect to which (i) the security and related 
foreign currency transactions are executed contemporaneously in order 
to effect delivery by the relevant securities settlement deadline and 
(ii) actual delivery of the foreign security and foreign currency 
occurs by such deadline (such transaction, a ``Securities Conversion 
Transaction'').\567\ For Securities Conversion Transactions, the CFTC 
will consider the relevant foreign exchange spot market settlement 
deadline to be the same as the securities settlement deadline. As noted 
above, while the CFTC will look at the relevant facts and 
circumstances, it does not expect that an unintentional settlement 
failure or delay for operational reasons or due to a market disruption 
will undermine the character of a bona fide spot foreign exchange 
transaction as such.
---------------------------------------------------------------------------

    \567\ The interpretation herein with respect to Security 
Conversion Transactions is limited to such transactions.
---------------------------------------------------------------------------

    The CFTC also will interpret a Securities Conversion Transaction as 
not leveraged, margined or financed within the meaning of section 
2(c)(2)(C) of the CEA.\568\ While it is possible to view the fact that 
the buyer of a currency in such a transaction does not pay for the 
currency until it is delivered as leverage (in that the buyer puts 
nothing down until taking delivery, thus achieving 100% leverage) or a 
financing arrangement, the CFTC does not interpret it as such for 
purposes of CEA section 2(c)(2)(C).\569\ Congress recognized that 
settlement of bona fide spot foreign exchange transactions typically 
takes two days.\570\ The fact that Congress expressly excluded these 
types of bona fide spot foreign exchange transactions does not mean 
that Congress intended to subject Security Conversion Transactions to 
regulation under the retail foreign exchange regime.\571\ For the 
foregoing reasons, the CFTC will interpret a Securities Conversion 
Transaction as not leveraged, margined or financed within the meaning 
of section 2(c)(2)(C) of the CEA.\572\
---------------------------------------------------------------------------

    \568\ 7 U.S.C. 2(c)(2)(C). Similarly, a Securities Conversion 
Transaction is not an option, option on a futures contract or 
futures contract and thus would not be subject to CEA section 
2(c)(2)(B), 7 U.S.C. 2(c)(2)(B). Of course, optionality as to 
settlement would render the transaction an option and is 
inconsistent with a ``spot'' characterization.
    \569\ Cf. 12 CFR 220.8(b)(1) under Regulation T (12 CFR Part 
220) (generally permits a customer to purchase a security (including 
a foreign security) in a cash account, rather than a margin account, 
even if the customer has no collateral in the account, if payment 
for the security is made within the appropriate payment period). 
Similarly, if a foreign exchange buyer in a Securities Conversion 
Transaction posts no margin or collateral on the trade date, the 
CFTC does not consider that transaction to be ``margined'' within 
the meaning of 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).
    \570\ See section 2(c)(2)(C)(i)(II) of the CEA, 7 U.S.C. 
2(c)(2)(C) (``[s]ubclause (I) of this clause shall not apply to * * 
* a contract of sale that * * * results in delivery within 2 
days'').
    \571\ The CFTC notes, for example, that Congress recognized that 
settlement in various spot markets in commodities other than foreign 
exchange can be longer than two days. See CEA section 
2(c)(2)(D)(ii)(III)(aa) (disapplying the DCM-trading requirement for 
certain commodity transactions with non-ECPs when the contract 
``results in actual delivery within 28 days or such other longer 
period as the [CFTC] may determine by rule or regulation based on 
the typical commercial practice in cash or spot markets for the 
commodity involved'').
    \572\ This interpretation is not intended to address, and has no 
bearing on, the CFTC's interpretation of the term ``actual 
delivery'' as set forth in section 2(c)(2)(D)(ii)(III)(aa), 7 CFR 
2(c)(2)(D)(ii)(III)(aa). See Retail Commodity Transactions under the 
Commodity Exchange Act, 76 FR 77670, Dec. 14, 2011.
---------------------------------------------------------------------------

Comments
    One commenter requested clarification regarding the status of 
foreign exchange spot transactions.\573\ This commenter recommended 
that the Commissions clarify that foreign exchange spot transactions, 
which this commenter defined as ``transactions of

[[Page 48258]]

one currency into another that settle within a customary settlement 
cycle,'' are neither foreign exchange forwards nor swaps.\574\ Another 
commenter indicated that the customary settlement cycle for purchases 
of most non-U.S. denominated securities is ``T+3'' (in some securities 
markets, such as South Africa, the settlement cycle can take up to 
seven days), and requires the buyer to pay for the foreign securities 
in the relevant foreign currency.\575\ Typically, according to this 
commenter, a broker-dealer or bank custodian acting on behalf of the 
buyer or seller will enter into a foreign currency transaction to 
settle on a T+3 basis (or the relevant settlement period) as well. 
Timing the foreign exchange transaction to settle at the same time as 
the securities transaction benefits the customer by reducing his or her 
exposure to currency risk on the securities transaction between trade 
date and settlement date. The Commissions have provided the 
interpretation described above regarding the interplay between the 
foreign exchange forward definition, the meaning of ``leveraged, 
margined or financed'' under section 2(c)(2)(C) of the CEA, and bona 
fide foreign exchange spot transactions to address these commenters' 
concerns.
---------------------------------------------------------------------------

    \573\ See SIFMA Letter.
    \574\ Id. In this commenter's view, such clarification is 
necessary to avoid the statutory foreign exchange forward definition 
``unwittingly captur[ing] many typical foreign exchange spot 
transactions * * * settl[ing] within a customary settlement cycle,'' 
which this commenter stated is generally ``T+2'' in the United 
States, but can be ``T+3'' in some other countries.
    \575\ See Letter from Phoebe A. Papageorgiou, Senior Counsel, 
American Bankers Ass'n and James Kemp, Managing Director, Global 
Foreign Exchange Division, dated April 18, 2012 (``ABA/Global FX 
Letter''). This commenter requested clarification that the purchase, 
sale or exchange of a foreign currency by a bank on behalf of a 
retail customer for the sole purpose of effecting a purchase or sale 
of a foreign security or in order to clear or settle such purchase 
or sale, when the settlement period for such FX transaction is 
within the settlement cycle for such foreign security, is excluded 
from the retail foreign exchange under the CEA. The CFTC has 
provided the clarification regarding the meaning of ``leveraged, 
margined or financed'' under section 2(c)(2)(C) of the CEA to 
address this commenter's concern.
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(d) Retail Foreign Currency Options
    The CFTC is providing an interpretation regarding the status of 
retail foreign currency options that are described in section 
2(c)(2)(B) of the CEA.\576\ As noted above, the Commissions proposed to 
include foreign currency options generally within the definition of the 
term ``swap,'' subject to the statutory exclusions in subparagraph (B) 
of the definition. The statutory exclusions from the swap definition 
encompass transactions described in sections 2(c)(2)(C) and (D) of the 
CEA, but not those in section 2(c)(2)(B) of the CEA.\577\ Section 
2(c)(2)(B) of the CEA applies to futures, options on futures and 
options on foreign currency (other than foreign currency options 
executed or traded on a national securities exchange), and permits such 
transactions to be entered into with counterparties who are not ECPs 
\578\ on an off-exchange basis by certain enumerated regulated 
entities.\579\ No issue arises with respect to futures or options on 
futures in foreign currency that are covered by section 2(c)(2)(B) of 
the CEA, because they are expressly excluded from the statutory swap 
definition.\580\ Commodity options, including options on foreign 
currency, however, are not excluded from the swap definition (other 
than foreign currency options executed or traded on a national 
securities exchange).
---------------------------------------------------------------------------

    \576\ 7 U.S.C. 2(c)(2)(B).
    \577\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C. 
1a(47)(B)(i). Sections 2(c)(2)(B), (C), and (D) of the CEA, 7 U.S.C. 
2(c)(2)(B), (C), and (D), govern certain types of off-exchange 
transactions in commodities, including foreign currency, in which 
one of the parties to the transaction is not an ECP.
    \578\ ECPs are defined in section 1a(18) of the CEA, 7 U.S.C. 
1a(18).
    \579\ Section 2(c)(2)(B)(i) of the CEA provides: (i) This Act 
applies to, and the Commission shall have jurisdiction over, an 
agreement, contract, or transaction in foreign currency that--(I) is 
a contract of sale of a commodity for future delivery (or an option 
on such a contract) or an option (other than an option executed or 
traded on a national securities exchange registered pursuant to 
section 6(a) of the Securities Exchange Act of 1934, 15 U.S.C. 
78f(a)); and (II) is offered to, or entered into with, a person that 
is not an eligible contract participant, unless the counterparty, or 
the person offering to be the counterparty, of the person is 
[certain regulated counterparties enumerated in the statute.] 7 
U.S.C. 2(c)(2)(B)(i). Thus, under section 2(c)(2)(B)(i) of the CEA, 
the CEA's exchange-trading requirement generally applies with 
respect to futures, options on futures, and options on foreign 
currency. See section 4(a) of the CEA, 7 U.S.C. 6(a) (generally 
requiring futures contracts to be traded on or subject to the rules 
of a DCM); section 4c(b) of the CEA, 7 U.S.C. 6c(b) (prohibiting 
trading options subject to the CEA contrary to CFTC rules, 
regulations or orders permitting such trading); Part 32 of the 
CFTC's rules, 17 CFR Part 32 (generally prohibiting entering into 
options subject to the CEA (other than options on futures) other 
than on or subject to the rules of a DCM); and CFTC Rule 33.3(a), 17 
CFR 33.3(a) (prohibiting entering into options on futures other than 
on or subject to the rules of a DCM). However, if the counterparty 
to the non-ECP is an enumerated regulated entity identified in 
section 2(c)(2)(B)(i)(II) of the CEA, 7 U.S.C. 2(c)(2)(B)(i)(II), 
the CEA's exchange-trading requirement does not apply. Accordingly, 
an enumerated regulated entity--including a banking institution 
regulated by the OCC--can, pursuant to section 2(c)(2)(B) of the 
CEA, lawfully enter into a future, an option on a future, or an 
option on foreign currency with a non-ECP counterparty on an off-
exchange basis.
    \580\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C. 
1a(47)(B)(i).
---------------------------------------------------------------------------

    The CFTC notes that, in further defining the term ``swap'' to 
include foreign currency options, the Proposing Release stated that the 
proposal was not intended to address, and had no bearing on, the CFTC's 
jurisdiction over foreign currency options in other contexts, 
specifically citing section 2(c)(2)(B) of the CEA.\581\ Nonetheless, 
the CFTC acknowledges the ambiguity in the statute regarding the status 
of off-exchange foreign currency options with non-ECPs that are subject 
to section 2(c)(2)(B) of the CEA. While foreign currency options are 
swaps, they also are subject to section 2(c)(2)(B) of the CEA when 
entered into off-exchange with non-ECPs, and there is no statutory 
exclusion from the swap definition for section 2(c)(2)(B) transactions. 
If foreign currency options were deemed to be swaps, then, pursuant to 
section 2(e) of the CEA, as added by the Dodd-Frank Act,\582\ they 
could not be entered into by non-ECP counterparties, except on a DCM. 
This would render the provisions of section 2(c)(2)(B) of the CEA, 
permitting off-exchange foreign currency options with non-ECPs by 
enumerated regulated entities, a nullity.
---------------------------------------------------------------------------

    \581\ See Proposing Release at 29835 n.125.
    \582\ 7 U.S.C. 2(e).
---------------------------------------------------------------------------

    The CFTC believes that Congress did not intend the swap definition 
to overrule and effectively repeal another provision of the CEA in such 
an oblique fashion.\583\ Nor is there anything in the legislative 
history of the Dodd-Frank Act to suggest a congressional intent to 
prohibit only one type of off-exchange foreign currency transaction 
with non-ECPs (out of the three types of off-exchange foreign currency 
transactions with non-ECPs that are addressed in CEA section 
2(c)(2)(B)). The omission of section 2(c)(2)(B) of the CEA from the 
exclusions set forth in the statutory swap definition appears to be a 
scrivener's error.\584\ Accordingly, the CFTC is applying the exclusion 
from the swap definition to foreign currency options described in CEA 
section 2(c)(2)(B).
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    \583\ The CFTC notes in this regard that repeals by implication 
are strongly disfavored by the courts. See, e.g., Village of 
Barrington, Ill. v. Surface Transp. Bd., 636 F.3d 650, 662 (D.C. 
Cir. 2011) (``Repeals by implication, however, are strongly 
disfavored `absent a clearly expressed congressional intention' '') 
(quoting Branch v. Smith, 538 U.S. 254, 273, 123 S.Ct. 1429 (2003)); 
Agri Processor Co., Inc. v. N.L.R.B., 514 F.3d 1, 4 (D.C. Cir. 2008) 
(``[a]mendments by implication, like repeals by implication, are not 
favored'' and ``will not be found unless an intent to repeal [or 
amend] is `clear and manifest.' '') (quoting United States v. 
Welden, 377 U.S. 95, 102 n. 12, 84 S.Ct. 1082 (1964) and Rodriguez 
v. United States, 480 U.S. 522, 524, 107 S.Ct. 1391 (1987)).
    \584\ See, e.g., Singer and Singer, Sutherland Statutes and 
Statutory Construction Sec.  47:38 (7th ed. 2011) (``Words may be 
supplied in a statute * * * where omission is due to inadvertence, 
mistake, accident, or clerical error'').

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[[Page 48259]]

3. Forward Rate Agreements
    The Commissions are adopting rules as proposed to explicitly define 
the term ``swap'' to include forward rate agreements (``FRAs'').\585\ 
The Commissions did not receive any comments on the proposed rules 
regarding the inclusion of FRAs in the swap definition.
---------------------------------------------------------------------------

    \585\ See rules 1.3(xxx)(2)(i)(E) under the CEA and rule 3a69-
2(b)(1)(v) under the Exchange Act.
---------------------------------------------------------------------------

    In general, an FRA is an over-the-counter contract for a single 
cash payment, due on the settlement date of a trade, based on a spot 
rate (determined pursuant to a method agreed upon by the parties) and a 
pre-specified forward rate. The single cash payment is equal to the 
product of the present value (discounted from a specified future date 
to the settlement date of the trade) of the difference between the 
forward rate and the spot rate on the settlement date multiplied by the 
notional amount. The notional amount itself is not exchanged.\586\
---------------------------------------------------------------------------

    \586\ See generally ``Trading and Capital-Markets Activities 
Manual,'' supra note 556, section 4315.1 (``For example, in a six-
against-nine-month (6x9) FRA, the parties agree to a three-month 
rate that is to be netted in six months' time against the prevailing 
three-month reference rate, typically LIBOR. At settlement (after 
six months), the present value of the net interest rate (the 
difference between the spot and the contracted rate) is multiplied 
by the notional principal amount to determine the amount of the cash 
exchanged between the parties * * * . If the spot rate is higher 
than the contracted rate, the seller agrees to pay the buyer the 
differences between the prespecified forward rate and the spot rate 
prevailing at maturity, multiplied by a notional principal amount. 
If the spot rate is lower than the forward rate, the buyer pays the 
seller.'').
---------------------------------------------------------------------------

    An FRA provides for the future (executory) payment based on the 
transfer of interest rate risk between the parties as opposed to 
transferring an ownership interest in any asset or liability.\587\ 
Thus, the Commissions believe that an FRA satisfies clause (A)(iii) of 
the swap definition.\588\
---------------------------------------------------------------------------

    \587\ It appears that at least some in the trade view FRAs as 
swaps today. See, e.g., The Globecon Group, Ltd., ``Derivatives 
Engineering: A Guide to Structuring, Pricing and Marketing 
Derivatives,'' 45 (McGraw-Hill 1995) (``An FRA is simply a one-
period interest-rate swap.''); DerivActiv, Glossary of Financial 
Derivatives Terms (``A swap is * * * a strip of FRAs.''), available 
at http://www.derivactiv.com/definitions.aspx?search= 
forward+rate+agreements. Cf. Don M. Chance, et al., ``Derivatives in 
Portfolio Management,'' 29 (AIMR 1998) (``[An FRA] involves one 
specific payment and is basically a one-date swap (in the sense that 
a swap is a combination of FRAs[,] with some variations).''). Thus, 
FRAs also may fall within clause (A)(iv) of the swap definition, as 
``an agreement, contract, or transaction that is, or in the future 
becomes, commonly known to the trade as a swap.'' See section 
1a(47)(a)(iv) of the CEA, 7 U.S.C. 1a(47)(a)(iv).
    \588\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C. 
1a(47)(A)(iii). CFTC regulations have defined FRAs as swap 
agreements. See rule 35.1(b)(1)(i) under the CEA, 17 CFR 
35.1(b)(1)(i); Exemption for Certain Swap Agreements, 58 FR 5587 
(Jan. 22, 1993). The CFTC recently repealed that rule and amended 
Part 35 of its rules in light of the enactment of Title VII of the 
Dodd-Frank Act. See Agricultural Swaps, 76 FR 49291 (Aug. 10, 2011).
---------------------------------------------------------------------------

    Notwithstanding their ``forward'' label, FRAs do not fall within 
the forward contract exclusion from the swap definition. FRAs do not 
involve nonfinancial commodities and thus are outside the scope of the 
forward contract exclusion. Nor is an FRA a commercial merchandising 
transaction, as there is no physical product to be delivered in an 
FRA.\589\ Accordingly, the Commissions believe that the forward 
contract exclusion from the swap definition for nonfinancial 
commodities does not apply to FRAs.\590\
---------------------------------------------------------------------------

    \589\ See Regulation of Hybrid and Related Instruments, 52 FR 
47022, 47028 (Dec. 11, 1987) (stating ``[FRAs] do not possess all of 
the characteristics of forward contracts heretofore delineated by 
the [CFTC]'').
    \590\ The Commissions note that Current European Union law 
includes FRAs in the definition of ``financial instruments.'' See 
Markets in Financial Instruments Directive (MiFID), ``Directive 
2004/39/EC of the European Parliament and of the Council,'' Annex 
I(C), 4, 5, 10 (Apr. 21, 2004), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF 20070921:EN:PDF. European Commission legislation on derivatives, 
central clearing, and trade repositories applies to FRAs that are 
traded over-the-counter and, thus, would subject such transactions 
to mandatory clearing, reporting and other regulatory requirements. 
See Regulation of the European Parliament and of the Council on OTC 
derivatives, central counterparties and trade repositories, tit. I, 
art. 2 (1(3b)), 7509/1/12 REV 1 (Mar. 19, 2012).
---------------------------------------------------------------------------

    Based on the foregoing considerations, the Commissions are adopting 
rules to provide greater clarity by explicitly defining the term 
``swap'' to include FRAs. As with the foreign exchange-related products 
discussed above, the final rules provide that FRAs are not swaps if 
they fall within one of the exclusions set forth in subparagraph (B) of 
the swap definition.
4. Combinations and Permutations of, or Options on, Swaps and Security-
Based Swaps
    Clause (A)(vi) of the swap definition provides that ``any 
combination or permutation of, or option on, any agreement, contract, 
or transaction described in any of clauses (i) through (v)'' of the 
definition is a swap.\591\ The Commissions provided an interpretation 
regarding clause (A)(vi) in the Proposing Release.\592\ The Commissions 
received no comments on the interpretation provided in the Proposing 
Release regarding combinations and permutations of, or options on, 
swaps and security-based swaps and are restating their interpretation 
of clause (A)(vi) of the swap definition with one technical correction 
and one clarification.
---------------------------------------------------------------------------

    \591\ See section 1a(47)(vi) of the CEA, 7 U.S.C. 1a(47)(vi). 
Clause (A)(vi) of the swap definition refers specifically to other 
types of swaps in the swap definition. However, because section 
3(a)(68) of the Exchange Act defines a security-based swap as a swap 
[with some connection to a security], clause (A)(vi) of the swap 
definition is relevant to determining whether any combination or 
permutation of, or option on, a security-based swap is a security-
based swap.
    \592\ See Proposing Release at 29838.
---------------------------------------------------------------------------

    Clause (A)(vi) means, for example, that an option on a swap or 
security-based swap (commonly known as a ``swaption'') would itself be 
a swap or security-based swap, respectively. The Commissions also 
interpret clause (A)(vi) to mean that a ``forward swap'' would itself 
be a swap or security-based swap, respectively.\593\ By listing 
examples here, the Commissions do not intend to limit the broad 
language of clause (A)(vi) of the swap definition, which is designed to 
capture those agreements, contracts and transactions that are not 
expressly enumerated in the CEA swap definition but that nevertheless 
are swaps.\594\
---------------------------------------------------------------------------

    \593\ Forward swaps are also commonly known as forward start 
swaps, or deferred or delayed start swaps. A forward swap can 
involve two offsetting swaps that both start immediately, but one of 
which ends on the deferred start date of the forward swap itself. 
For example, if a counterparty wants to hedge its risk for four 
years, starting one year from today, it could enter into a one-year 
swap and a five-year swap, which would partially offset to create a 
four-year swap, starting one year forward. A forward swap also can 
involve a contract to enter into a swap or security-based swap at a 
future date or with a deferred start date. A forward swap is not a 
nonfinancial commodity forward contract or security forward, both of 
which are excluded from the swap definition and discussed elsewhere 
in this release.
    \594\ This category could include categories of agreements, 
contracts or transactions that do not yet exist as well as more 
esoteric swaps that exist but that Congress did not refer to by name 
in the statutory swap definition.
---------------------------------------------------------------------------

5. Contracts for Differences
    As the Proposing Release notes, the Commissions have received 
inquiries over the years regarding the treatment of CFDs under the CEA 
and the Federal securities laws.\595\ A CFD generally is an agreement 
to exchange the difference in value of an underlying asset between the 
time at which a CFD position is established and the time at which it is 
terminated.\596\ If the value increases, the

[[Page 48260]]

seller pays the buyer the difference; if the value decreases, the buyer 
pays the seller the difference. CFDs can be traded on a number of 
products, including treasuries, foreign exchange rates, commodities, 
equities, and stock indexes. Equity CFDs closely mimic the purchase of 
actual shares. The buyer of an equity CFD receives cash dividends and 
participates in stock splits.\597\ In the case of a long position, a 
dividend adjustment is credited to the client's account. In the case of 
a short position, a dividend adjustment is debited from the client's 
account. CFDs generally are traded over-the-counter (though they also 
are traded on the Australian Securities Exchange) in a number of 
countries outside the United States.
---------------------------------------------------------------------------

    \595\ See Proposing Release at 29838.
    \596\ See Ontario Securities Commission, Staff Notice 91-702, 
``Offerings of Contracts for Difference and Foreign Exchange 
Contracts to Investors in Ontario,'' at part IV.1 (defining a CFD as 
``a derivative product that allows an investor to obtain economic 
exposure (for speculative, investment or hedging purposes) to an 
underlying asset * * * such as a share, index, market sector, 
currency or commodity, without acquiring ownership of the underlying 
asset''), available at http://www.osc.gov.on.ca/documents/en/Securities-Category9/sn_20091030_91-702_cdf.pdf (Oct. 30, 2009); 
Financial Services Authority, Consultation Paper 7/20, ``Disclosure 
of Contracts for Difference--Consultation and draft Handbook text,'' 
at part 2.2 (defining a CFD on a share as ``a derivative product 
that gives the holder an economic exposure, which can be long or 
short, to the change in price of a specific share over the life of 
the contract''), available at http://www.fsa.gov.uk/pubs/cp/cp07_20.pdf (Nov. 2007).
    \597\ See, e.g., Int'l Swaps and Derivatives Ass'n, ``2002 ISDA 
Equity Derivatives Definitions,'' art. 10 (Dividends) and 11 
(Adjustments and Modifications Affecting Indices, Shares and 
Transactions).
---------------------------------------------------------------------------

    The Commissions provided an interpretation in the Proposing Release 
regarding the treatment of CFDs. The Commissions are restating the 
interpretation set out in the Proposing Release without modification.
    CFDs, unless otherwise excluded, fall within the scope of the swap 
or security-based swap definition, as applicable.\598\ Whether a CFD is 
a swap or security-based swap will depend on the underlying product of 
that particular CFD transaction. Because CFDs are highly variable and a 
CFD can contain a variety of elements that would affect its 
characterization, the Commissions believe that market participants will 
need to analyze the features of the underlying product of any 
particular CFD in order to determine whether it is a swap or a 
security-based swap. The Commissions are not adopting rules or 
additional interpretations at this time regarding CFDs.
---------------------------------------------------------------------------

    \598\ In some cases, depending on the facts and circumstances, 
the SEC may determine that a particular CFD on an equity security, 
for example, should be characterized as constituting a purchase or 
sale of the underlying equity security and, therefore, be subject to 
the requirements of the Federal securities laws applicable to such 
purchases or sales.
---------------------------------------------------------------------------

Comments
    Two commenters requested that the Commissions clarify that non-
deliverable forward contracts are not CFDs.\599\ These commenters 
requested that the Commissions determine that NDFs involving foreign 
exchange are not swaps. Given that the Commissions are defining NDFs as 
swaps and that CFDs involving foreign currency also would be swaps, 
there is no need to distinguish NDFs involving foreign exchange from 
CFDs involving foreign exchange.
---------------------------------------------------------------------------

    \599\ See Covington Letter and ICI/ABASA Letter.
---------------------------------------------------------------------------

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
    The Commissions are restating the interpretation provided in the 
Proposing Release regarding agreements, contracts, or transactions that 
may be called, or documented using form contracts typically used for, 
swaps or security-based swaps with one modification in response to a 
commenter.\600\
---------------------------------------------------------------------------

    \600\ See infra note 606.
---------------------------------------------------------------------------

    As was noted in the Proposing Release,\601\ individuals and 
companies may generally use the term ``swap'' to refer to certain of 
their agreements, contracts, or transactions. For example, they may use 
the term ``swap'' to refer to an agreement to exchange real or personal 
property between the parties or to refer to an agreement for two 
companies that produce fungible products and with delivery obligations 
in different locations to perform each other's delivery obligations 
instead of their own.\602\ However, the name or label that the parties 
use to refer to a particular agreement, contract, or transaction is not 
determinative of whether it is a swap or security-based swap.\603\
---------------------------------------------------------------------------

    \601\ See Proposing Release at 29839.
    \602\ For example, a company obligated to deliver its product to 
a customer in Los Angeles would instead deliver the product in 
Albany to a different company's customer on behalf of that other 
company. In return, the company with the obligation to deliver a 
product to its customer in Albany would deliver the product instead 
in Los Angeles to the customer of the company obligated to deliver 
its product to that customer in Los Angeles.
    \603\ See, e.g., Haekel v. Refco, 2000 WL 1460078, at *4 (CFTC 
Sept. 29, 2000) (``[T]he labels that parties apply to their 
transactions are not necessarily controlling''); Reves v. Ernst & 
Young, 494 U.S. 56, 61 (1990) (stating that the purpose of the 
securities laws is ``to regulate investments, in whatever form they 
are made and by whatever name they are called'') (emphasis in 
original).
---------------------------------------------------------------------------

    It is not dispositive that the agreement, contract, or transaction 
is documented using an industry standard form agreement that is 
typically used for swaps and security-based swaps,\604\ but it may be a 
relevant factor.\605\ The key question is whether the agreement, 
contract, or transaction falls within the statutory definitions of the 
term ``swap'' or ``security-based swap'' (as further defined and 
interpreted pursuant to the final rules and interpretations herein) 
based on its terms and other characteristics. Even if one effect of an 
agreement is to reduce the risk faced by the parties (for example, the 
``swap'' of physical delivery obligations described above may reduce 
the risk of non-delivery), the agreement would not be a swap or 
security-based swap unless it otherwise meets one of those statutory 
definitions, as further defined by the Commissions. If the agreement, 
contract, or transaction satisfies the swap or security-based swap 
definitions, the fact that the parties refer to it by another name 
would not take it outside the Dodd-Frank Act regulatory regime. 
Conversely, if an agreement, contract, or transaction is not a swap or 
security-based swap, as those terms are defined in the CEA and the 
Exchange Act and the rules and regulations thereunder, the fact that 
the parties refer to it, or document it, as a swap or security-based 
swap will not subject that agreement, contract, or transaction to 
regulation as a swap or a security-based swap.
---------------------------------------------------------------------------

    \604\ As noted in the Proposing Release, the CFTC consistently 
has found that the form of a transaction is not dispositive in 
determining its nature, citing Grain Land, supra note 213, at *16 
(CFTC Nov. 25, 2003) (holding that contract substance is entitled to 
at least as much weight as form); In the Matter of First Nat'l 
Monetary Corp., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) 
] 22,698 at 30,974 (CFTC Aug. 7, 1985) (``When instruments have been 
determined to constitute the functional equivalent of futures 
contracts neither we nor the courts have hesitated to look behind 
whatever self-serving labels the instruments might bear.''); 
Stovall, supra note 63 (holding that the CFTC ``will not hesitate to 
look behind whatever label the parties may give to the 
instrument''). As also noted in the Proposing Release, the form of a 
transaction is not dispositive in determining whether an agreement, 
contract, or transaction falls within the regulatory regime for 
securities. See SEC v. Merch. Capital, LLC, 483 F.3d 747, 755 (11th 
Cir. 2007) (``The Supreme Court has repeatedly emphasized that 
economic reality is to govern over form and that the definitions of 
the various types of securities should not hinge on exact and 
literal tests.'') (quoting Williamson v. Tucker, 645 F.2d 404, 418 
(5th Cir. 1981)); Robinson v. Glynn, 349 F.3d 166, 170 (4th Cir. 
2003) (``What matters more than the form of an investment scheme is 
the `economic reality' that it represents. * * *'') (internal 
citation omitted); Caiola v. Citibank, N.A., New York, 295 F.3d 312, 
325 (2d Cir. 2002) (quoting United Housing Foundation v. Foreman, 
421 U.S. 837, 848 (1975) (``In searching for the meaning and scope 
of the word `security' * * * the emphasis should be on economic 
reality'')). See Proposing Release at 29839 n. 152.
    \605\ The Commissions note, though, that documentation is not 
controlling in evaluating whether an agreement, contract or 
transaction is a swap, security-based swap, or neither.

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[[Page 48261]]

Comments
    The Commissions requested comment regarding what agreements, 
contracts, or transactions that are not swaps or security-based swaps 
are documented using industry standard form agreements that are 
typically used for swaps and security-based swaps, and asked for 
examples thereof and details regarding their documentation, including 
why industry standard form agreements typically used for swaps and 
security-based swaps are used. One commenter stated its view that 
documentation can be a relevant factor in determining whether an 
agreement, contract or transaction is a swap or security-based 
swap.\606\ The Commissions are persuaded by the commenter and are 
modifying the interpretation to clarify that in determining whether an 
agreement, contract or transaction is a swap or security-based swap, 
documentation may be a relevant (but not dispositive) factor.
---------------------------------------------------------------------------

    \606\ See IECA Letter. This commenter noted that ``[e]ven though 
swaps are commonly documented on the ISDA Master Agreements without 
annexes, physical transactions under such agreements with power or 
natural gas annexes are not swaps because they are physically 
settled forward contracts that are exempt under 1a47(B)''). Id.
---------------------------------------------------------------------------

2. Transactions in Regional Transmission Organizations and Independent 
System Operators
    The CFTC declines to address the status of transactions in Regional 
Transmission Organizations (``RTOs'') and Independent System Operators 
(``ISOs''), including financial transmission rights (``FTRs'') and 
ancillary services, within this joint definitional rulemaking. As was 
noted in the Proposing Release, section 722 of the Dodd-Frank Act 
specifically addresses certain instruments and transactions regulated 
by FERC that also may be subject to CFTC jurisdiction. Section 722(f) 
added CEA section 4(c)(6),\607\ which provides that, if the CFTC 
determines that an exemption for FERC-regulated instruments or other 
specified electricity transactions would be in accordance with the 
public interest, then the CFTC shall exempt such instruments or 
transactions from the requirements of the CEA. Given that specific 
statutory directive, the treatment of these FERC-regulated instruments 
and transactions should be considered under the standards and 
procedures specified in section 722 of the Dodd-Frank Act for a public 
interest waiver, rather than through this joint rulemaking to further 
define the terms ``swap'' and ``security-based swap.'' \608\
---------------------------------------------------------------------------

    \607\ 7 U.S.C. 6(c)(6).
    \608\ The Commissions note that this approach should not be 
taken to suggest any finding by the Commissions as to whether or not 
FTRs or any other FERC-regulated instruments or transactions are 
swaps (or futures contracts).
---------------------------------------------------------------------------

    The CFTC notes that it has been engaged in discussions with a 
number of RTOs and ISOs regarding the possibility of a petition seeking 
an exemption pursuant to CEA section 4(c)(6) for certain RTO and ISO 
transactions. The CFTC also notes that the status of some RTO and ISO 
transactions may have been addressed in the interpretation above 
regarding embedded options and the forward exclusion from the swap 
definition,\609\ and/or indirectly through the CFTC's recent interim 
final rulemaking relating to trade options.\610\
---------------------------------------------------------------------------

    \609\ See supra part II.B.2(a).
    \610\ See supra note 317.
---------------------------------------------------------------------------

Comments
    The CFTC received a number of comments discussing transactions in 
RTOs and ISOs.\611\ These commenters argued that the CFTC should 
further define the term ``swap'' to exclude transactions executed or 
traded on RTOs and ISOs.\612\ One commenter argued that the CEA section 
4(c)(6) exemptive approach will leave regulatory ambiguity for market 
participants, since the CFTC might not grant an exemption, later revoke 
an existing exemption, grant a partial or conditional exemption, or 
limit an exemption to existing products.\613\ This commenter also noted 
that FERC has complete regulatory authority over RTOs and ISOs and 
their transactions, and that Congress expected the CFTC and FERC to 
avoid duplicative, unnecessary regulation.\614\ Another commenter 
argued that the CFTC should exclude RTO and ISO transactions in the 
same manner as insurance has been excluded.\615\ A third commenter 
stated that RTO and ISO transactions are commercial merchandising 
transactions and thus forwards or, alternatively, that defining them as 
swaps is inconsistent with the text, goals, and purpose of the Dodd-
Frank Act.\616\
---------------------------------------------------------------------------

    \611\ See COPE Letter; ETA Letter; and FERC Staff Letter.
    \612\ Id.
    \613\ See COPE Letter.
    \614\ Id.
    \615\ See ETA Letter.
    \616\ See FERC Staff Letter.
---------------------------------------------------------------------------

    By contrast, one commenter asserted that FTRs are in substance 
swaps and should be regulated as such.\617\
---------------------------------------------------------------------------

    \617\ See Better Markets Letter.
---------------------------------------------------------------------------

    Two commenters supported the CFTC's use of its section 722(f) 
authority to exempt FERC-regulated transactions and other transactions 
in RTOs or ISOs.\618\ As discussed above, section 722(f) of the Dodd-
Frank Act added new section 4(c)(6) to the CEA specifically addressing 
how the CFTC should approach certain instruments and transactions 
regulated by FERC that also may be subject to CFTC jurisdiction. The 
CFTC continues to believe, as was stated in the Proposing Release, that 
such an approach is the more appropriate means of considering issues 
relating to the instruments and transactions specified in CEA section 
4(c)(6). One commenter's argument that the CEA section 4(c)(6) 
exemptive approach will cause regulatory ambiguity is not a convincing 
basis on which to forego a process specifically designated by Congress 
for the issue at hand.\619\ The CFTC also believes that the ability to 
tailor exemptive relief, after notice and public comment, to the 
complex issues presented by transactions on RTOs and ISOs, is further 
reason to favor such an approach over the more general directive to 
further define the terms ``swap'' and ``security-based swap'' that is 
the subject of this rulemaking.
---------------------------------------------------------------------------

    \618\ See NEMA Letter and WGCEF Letter.
    \619\ See COPE Letter.
---------------------------------------------------------------------------

    In response to one commenter's contentions that FERC has complete 
regulatory authority over RTOs and ISOs and their transactions, and 
that Congress expected the CFTC and FERC to avoid duplicative, 
unnecessary regulation, the CFTC notes that Congress addressed this 
issue not by excluding RTO and ISO transactions from the comprehensive 
regime for swap regulation, but rather by enacting the exemptive 
process in CEA section 4(c)(6).
    And in response to another commenter's contention that the CFTC 
should exclude RTO and ISO transactions in the same manner as insurance 
has been excluded, the CFTC notes that Congress provided neither an 
exemptive process equivalent to CEA section 4(c)(6) for insurance, nor 
an energy market-equivalent to the McCarran-Ferguson Act.\620\
---------------------------------------------------------------------------

    \620\ 15 U.S.C. 1011-1015.
---------------------------------------------------------------------------

    As noted above, FERC staff opines that defining RTO and ISO 
transactions as swaps would be inconsistent with the text, goals, and 
purpose of the Dodd-Frank Act. The CFTC can consider concerns of the 
sort expressed by FERC staff in connection with any petition for a CEA 
section 4(c)(6) exemption that

[[Page 48262]]

may be submitted to the CFTC.\621\ Interested parties on all sides of 
the issue would receive an opportunity to comment on the scope and 
other aspects of any proposed exemptive relief at that time.
---------------------------------------------------------------------------

    \621\ CEA section 4(c)(6) requires the CFTC to determine that an 
exemption pursuant to such section ``is consistent with the public 
interest and the purposes of th[e CEA].'' 7 U.S.C. 6(c)(6).
---------------------------------------------------------------------------

III. The Relationship Between the Swap Definition and the Security-
Based Swap Definition

A. Introduction

    Title VII of the Dodd-Frank Act defines the term ``swap'' under the 
CEA,\622\ and also defines the term ``security-based swap'' under the 
Exchange Act.\623\ Pursuant to the regulatory framework established in 
Title VII, the CFTC has regulatory authority over swaps and the SEC has 
regulatory authority over security-based swaps. The Commissions are 
further defining the terms ``swap'' and ``security-based swap'' to 
clarify whether particular agreements, contracts, or transactions are 
swaps or security-based swaps based on characteristics including the 
specific terms and conditions of the instrument and the nature of, 
among other things, the prices, rates, securities, indexes, or 
commodities upon which the instrument is based.
---------------------------------------------------------------------------

    \622\ See section 1a(47) of the CEA, 7 U.S.C. 1a(47).
    \623\ See section 3(a)(68) of the Exchange Act, 15 U.S.C. 
78c(a)(68).
---------------------------------------------------------------------------

    Because the discussion below is focused on whether particular 
agreements, contracts, or transactions are swaps or security-based 
swaps, the Commissions use the term ``Title VII instrument'' in this 
release to refer to any agreement, contract, or transaction that is 
included in either the definition of the term ``swap'' or the 
definition of the term ``security-based swap.'' Thus, the term ``Title 
VII instrument'' is synonymous with ``swap or security-based swap.'' 
\624\
---------------------------------------------------------------------------

    \624\ In some cases, the Title VII instrument may be a mixed 
swap. Mixed swaps are discussed further in section IV below.
---------------------------------------------------------------------------

    The determination of whether a Title VII instrument is either a 
swap or a security-based swap should be made based on the facts and 
circumstances relating to the Title VII instrument prior to execution, 
but no later than when the parties offer to enter into the Title VII 
instrument.\625\ If the Title VII instrument itself is not amended, 
modified, or otherwise adjusted during its term by the parties, its 
characterization as a swap or security-based swap will not change 
during its duration because of any changes that may occur to the 
factors affecting its character as a swap or security-based swap.\626\
---------------------------------------------------------------------------

    \625\ The determination must be made no later than when the 
parties offer to enter into the Title VII instrument because persons 
are prohibited from offering to sell, offering to buy or purchase, 
or selling a security-based swap to any person who is not an ECP 
unless a registration statement is in effect as to the security-
based swap. See section 5(e) of the Securities Act. This analysis 
also would apply with respect to mixed swaps and security-based swap 
agreements. With respect to swaps, the determination also would need 
to be made no later than the time that provisions of the CEA and the 
regulations thereunder become applicable to a Title VII Instrument. 
For instance, certain duties apply to swaps prior to execution. See 
Daily Trading Records under Rule 23.202 under the CEA, 17 CFR 
23.202, and Subpart H of Part 23 of the CFTC's regulations, 17 CFR 
Part 23, Subpart H (Business Conduct Standards for Swap Dealers and 
Major Swap Participants Dealing with Counterparties, Including 
Special Entities).
    \626\ See infra part III.G.5(a), for a discussion regarding the 
evaluation of Title VII Instruments on security indexes that move 
from broad-based to narrow-based or narrow-based to broad-based.
---------------------------------------------------------------------------

    Classifying a Title VII instrument as a swap or security-based swap 
is straightforward for most instruments. However, the Commissions 
provided an interpretation in the Proposing Release to clarify the 
classification of swaps and security-based swaps in certain areas and 
to provide an interpretation regarding the use of certain terms and 
conditions in Title VII instruments. The Commissions are restating the 
interpretation set out in the Proposing Release with certain 
modifications to the interpretation regarding TRS.

B. Title VII Instruments Based on Interest Rates, Other Monetary Rates, 
and Yields

    Parties frequently use Title VII instruments to manage risks 
related to, or to speculate on, changes in interest rates, other 
monetary rates or amounts, or the return on various types of assets. 
Broadly speaking, Title VII instruments based on interest or other 
monetary rates would be swaps, whereas Title VII instruments based on 
the yield or value of a single security, loan, or narrow-based security 
index would be security-based swaps. However, market participants and 
financial professionals sometimes use the terms ``rate'' and ``yield'' 
in different ways. The Commissions proposed an interpretation in the 
Proposing Release regarding whether Title VII instruments that are 
based on interest rates, other monetary rates, or yields would be swaps 
or security-based swaps and are restating the interpretation, but with 
a modification to the list of examples of reference rates to include 
certain secured lending rates under money market rates.\627\ The 
Commissions find that this interpretation is an appropriate way to 
address Title VII instruments based on interest rates, other monetary 
rates, or yields and is designed to reduce costs associated with 
determining whether such instruments are swaps or security-based 
swaps.\628\
---------------------------------------------------------------------------

    \627\ These secured lending rates are the Eurepo, The Depository 
Trust & Clearing Corporation's General Collateral Finance Repo 
Index, the Repurchase Overnight Index Average Rate and the Tokyo 
Repo Rate.
    \628\ See supra part I, under ``Overall Economic 
Considerations''.
---------------------------------------------------------------------------

1. Title VII Instruments Based on Interest Rates or Other Monetary 
Rates That Are Swaps
    The Commissions believe that when payments exchanged under a Title 
VII instrument are based solely on the levels of certain interest rates 
or other monetary rates that are not themselves based on one or more 
securities, the instrument would be a swap and not a security-based 
swap.\629\ Often swaps on interest rates or other monetary rates 
require the parties to make payments based on the comparison of a 
specified floating rate (such as the London Interbank Offered Rate 
(``LIBOR'')) to a fixed rate of interest agreed upon by the parties. A 
rate swap also may require payments based on the differences between 
two floating rates, or it may require that the parties make such 
payments when any agreed-upon events with respect to interest rates or 
other monetary rates occur (such as when a specified interest rate 
crosses a threshold, or when the spread between two such rates reaches 
a certain point). The rates referenced for the parties' obligations are 
varied, and examples of such rates include the following:
---------------------------------------------------------------------------

    \629\ See infra part III.F, regarding the use of certain terms 
and conditions.
---------------------------------------------------------------------------

    Interbank Offered Rates: An average of rates charged by a group of 
banks for lending money to each other or other banks over various 
periods of time, and other similar interbank rates,\630\ including, but 
not limited to, LIBOR (regardless of currency); \631\ the Euro

[[Page 48263]]

Interbank Offered Rate (``Euribor''); the Canadian Dealer Offered Rate 
(``CDOR''); and the Tokyo Interbank Offered Rate (``TIBOR''); \632\
---------------------------------------------------------------------------

    \630\ Interbank lending rates are measured by surveys of the 
loan rates that banks offer other banks, or by other mechanisms. The 
periods of time for such loans may range from overnight to 12 months 
or longer.
     The interbank offered rates listed here are frequently called 
either a ``reference rate,'' the rate of ``reference banks,'' or by 
a designation that is specific to the service that quotes the rate. 
For some of the interbank offered rates listed here, there is a 
similar rate that is stated as an interbank bid rate, which is the 
average rate at which a group of banks bid to borrow money from 
other banks. For example, the bid rate similar to LIBOR is called 
LIBID.
    \631\ Today, LIBOR is used as a rate of reference for the 
following currencies: Australian Dollar, Canadian Dollar, Danish 
Krone, Euro, Japanese Yen, New Zealand Dollar, Pound Sterling, 
Swedish Krona, Swiss Franc, and U.S. Dollar.
    \632\ Other interbank offered rates include the following (with 
the country or city component of the acronym listed in parentheses): 
AIDIBOR (Abu Dhabi); BAIBOR (Buenos Aires); BKIBOR (Bangkok); 
BRAZIBOR (Brazil); BRIBOR/BRIBID (Btatislava); BUBOR (Budapest); 
CHIBOR (China); CHILIBOR (Chile); CIBOR (Copenhagen); COLIBOR 
(Columbia); HIBOR (Hong Kong); JIBAR (Johannesburg); JIBOR 
(Jakarta); KAIBOR (Kazakhstan); KIBOR (Karachi); KLIBOR (Kuala 
Lumpur); KORIBOR ((South) Korea); MEXIBOR (Mexico); MIBOR (Mumbai); 
MOSIBOR (Moscow); NIBOR (Norway); PHIBOR (Philippines); PRIBOR 
(Prague); REIBOR/REIBID (Reykjavik); RIGIBOR/RIGIBID (Riga); SHIBOR 
(Shanghai); SIBOR (Singapore); SOFIBOR (Sofia); STIBOR (Stockholm); 
TAIBOR (Taiwan); TELBOR (Tel Aviv); TRLIBOR and TURKIBOR (Turkey); 
VILIBOR (Vilnius); VNIBOR (Vietnam); and WIBOR (Warsaw).
---------------------------------------------------------------------------

    Money Market Rates: A rate established or determined based on 
actual lending or money market transactions, including, but not limited 
to, the Federal Funds Effective Rate; the Euro Overnight Index Average 
(``EONIA'' or ``EURONIA'') (which is the weighted average of overnight 
unsecured lending transactions in the Euro-area interbank market); the 
EONIA Swap Index; the Eurepo (the rate at which, at 11.00 a.m. Brussels 
time, one bank offers, in the euro-zone and worldwide, funds in euro to 
another bank if in exchange the former receives from the latter the 
best collateral within the most actively-traded European repo market); 
the Australian dollar RBA 30 Interbank Overnight Cash Rate; the 
Canadian Overnight Repo Rate Average (``CORRA''); The Depository Trust 
& Clearing Corporation's General Collateral Finance (``GCF'') Repo 
Index (an average of repo rates collateralized by U.S. Treasury and 
certain other securities); the Mexican interbank equilibrium interest 
rate (``TIIE''); the NZD Official Cash Rate; the Sterling Overnight 
Interbank Average Rate (``SONIA'') (which is the weighted average of 
unsecured overnight cash transactions brokered in London by the 
Wholesale Markets Brokers' Association (``WMBA'')); the Repurchase 
Overnight Index Average Rate (``RONIA'') (which is the weighted average 
rate of all secured overnight cash transactions brokered in London by 
WMBA); the Swiss Average Rate Overnight (``SARON''); the Tokyo 
Overnight Average Rate (``TONAR'') (which is based on uncollateralized 
overnight average call rates for interbank lending); and the Tokyo Repo 
Rate (average repo rate of active Japanese repo market participants).
    Government Target Rates: A rate established or determined based on 
guidance established by a central bank including, but not limited to, 
the Federal Reserve discount rate, the Bank of England base rate and 
policy rate, the Canada Bank rate, and the Bank of Japan policy rate 
(also known as the Mutan rate);
    General Lending Rates: A general rate used for lending money, 
including, but not limited to, a prime rate, rate in the commercial 
paper market, or any similar rate provided that it is not based on any 
security, loan, or group or index of securities;
    Indexes: A rate derived from an index of any of the foregoing or 
following rates, averages, or indexes, including but not limited to a 
constant maturity rate (U.S. Treasury and certain other rates),\633\ 
the interest rate swap rates published by the Federal Reserve in its 
``H.15 Selected Interest Rates'' publication, the ISDAFIX rates, the 
ICAP Fixings, a constant maturity swap, or a rate generated as an 
average (geometric, arithmetic, or otherwise) of any of the foregoing, 
such as overnight index swaps (``OIS'')--provided that such rates are 
not based on a specific security, loan, or narrow-based group or index 
of securities;
---------------------------------------------------------------------------

    \633\ A Title VII instrument based solely on the level of a 
constant maturity U.S. Treasury rate would be a swap because U.S. 
Treasuries are exempted securities that are excluded from the 
security-based swap definition. Conversely, a Title VII instrument 
based solely on the level of a constant maturity rate on a narrow-
based index of non-exempted securities under the security-based swap 
definition would be a security-based swap.
---------------------------------------------------------------------------

    Other Monetary Rates: A monetary rate including, but not limited 
to, the Consumer Price Index (``CPI''), the rate of change in the money 
supply, or an economic rate such as a payroll index; and
    Other: The volatility, variance, rate of change of (or the spread, 
correlation or difference between), or index based on any of the 
foregoing rates or averages of such rates, such as forward spread 
agreements, references used to calculate the variable payments in index 
amortizing swaps (whereby the notional principal amount of the 
agreement is amortized according to the movement of an underlying 
rate), or correlation swaps and basis swaps, including but not limited 
to, the ``TED spread'' \634\ and the spread or correlation between 
LIBOR and an OIS.
---------------------------------------------------------------------------

    \634\ The TED spread is the difference between the interest 
rates on interbank loans and short-term U.S. government debt 
(Treasury bills or ``T-bills''). The latter are exempted securities 
that are excluded from the statutory definition of the term 
``security-based swap.'' Thus, neither any aspect of U.S. Treasuries 
nor interest rates on interbank loans can form the basis of a 
security-based swap. For this reason, a Title VII instrument on a 
spread between interbank loan rates and T-bill rates also would be a 
swap, not a security-based swap.
---------------------------------------------------------------------------

    As discussed above, the Commissions believe that when payments 
under a Title VII instrument are based solely on any of the foregoing, 
such Title VII instrument would be a swap.
Comments
    Two commenters believed that constant maturity swaps always should 
be treated as swaps, rather than mixed swaps, because they generally 
are viewed by market participants as rates trades instead of trades on 
securities.\635\ According to the commenters, the ``bulk'' of constant 
maturity swaps are based on exempted securities, but the commenters 
noted that the constant maturity leg may be based on a number of 
different rates or yields, including, among other things, U.S. Treasury 
yields, Treasury auction rates, yields on debt of foreign governments, 
and debt related to indices of mortgage-backed securities.\636\ As 
discussed above, the Commissions are adopting the interpretation as 
proposed. The statutory language of the swap and security-based swap 
definitions explicitly states that a Title VII instrument that is based 
on a non-exempted security should be a security-based swap and not a 
swap.\637\
---------------------------------------------------------------------------

    \635\ See CME Letter and SIFMA Letter.
    \636\ Id.
    \637\ See supra note 633.
---------------------------------------------------------------------------

2. Title VII Instruments Based on Yields
    The Commissions proposed an interpretation in the Proposing Release 
clarifying the status of Title VII instruments in which one of the 
underlying references of the instrument is a ``yield.'' The Commissions 
received no comments on the interpretation set out in the Proposing 
Release regarding Title VII instruments based on yields and are 
restating the interpretation without modification. In cases when a 
``yield'' is calculated based on the price or changes in price of a 
debt security, loan, or narrow-based security index, it is another way 
of expressing the price or value of a debt security, loan, or narrow-
based security index. For example, debt securities often are quoted and 
traded on a yield basis rather than on a dollar price, where the yield 
relates to a specific date, such as the date of maturity of the debt 
security (i.e., yield to maturity) or the date upon which the debt 
security may be redeemed or called by the issuer (e.g., yield to first 
whole issue call).\638\
---------------------------------------------------------------------------

    \638\ See, e.g., Securities Confirmations, 47 FR 37920 (Aug. 27, 
1982).
---------------------------------------------------------------------------

    Except in the case of certain exempted securities, when one of the 
underlying

[[Page 48264]]

references of the Title VII instrument is the ``yield'' of a debt 
security, loan, or narrow-based security index in the sense where the 
term ``yield'' is used as a proxy for the price or value of the debt 
security loan, or narrow-based security index, the Title VII instrument 
would be a security-based swap. And, as a result, in cases where the 
underlying reference is a point on a ``yield curve'' generated from the 
different ``yields'' on debt securities in a narrow-based security 
index (e.g., a constant maturity yield or rate), the Title VII 
instrument would be a security-based swap. However, where certain 
exempted securities, such as U.S. Treasury securities, are the only 
underlying reference of a Title VII instrument involving securities, 
the Title VII instrument would be a swap. Title VII instruments based 
on exempted securities are discussed further below.
    The above interpretation would not apply in cases where the 
``yield'' referenced in a Title VII instrument is not based on a debt 
security, loan, or narrow-based security index of debt securities but 
rather is being used to reference an interest rate or monetary rate as 
outlined above in subsection one of this section. In these cases, this 
``yield'' reference would be considered equivalent to a reference to an 
interest rate or monetary rate and the Title VII instrument would be, 
under the interpretation in this section, a swap (or mixed swap 
depending on other references in the instrument).
3. Title VII Instruments Based on Government Debt Obligations
    The Commissions provided an interpretation in the Proposing Release 
regarding instances in which the underlying reference of the Title VII 
instrument is a government debt obligation. The Commissions received no 
comments on the interpretation provided regarding instances in which 
the underlying reference of the Title VII instrument is a government 
debt obligation and are restating such interpretation without 
modification.
    The security-based swap definition specifically excludes any 
agreement, contract, or transaction that meets the definition of a 
security-based swap only because it ``references, is based upon, or 
settles through the transfer, delivery, or receipt of an exempted 
security under [section 3(a)(12) of the Exchange Act], as in effect on 
the date of enactment of the Futures Trading Act of 1982 (other than 
any municipal security as defined in [section 3(a)(29) of the Exchange 
Act] * * *), unless such agreement, contract, or transaction is of the 
character of, or is commonly known in the trade as, a put, call, or 
other option.'' \639\
---------------------------------------------------------------------------

    \639\ Section 3(a)(68)(C) of the Exchange Act, 15 U.S.C. 
76c(a)(68)(C).
---------------------------------------------------------------------------

    As a result of this exclusion in the security-based swap definition 
for ``exempted securities,''\640\ if the only underlying reference of a 
Title VII instrument involving securities is, for example, the price of 
a U.S. Treasury security and the instrument does not have any other 
underlying reference involving securities, then the instrument would be 
a swap. Similarly, if the Title VII instrument is based on the 
``yield'' of a U.S. Treasury security and does not have any other 
underlying reference involving securities, then the instrument also 
would be a swap, regardless of whether the term ``yield'' is a proxy 
for the price of the security.
---------------------------------------------------------------------------

    \640\ As of January 11, 1983, the date of enactment of the 
Futures Trading Act of 1982, Public Law 97-444, 96 Stat. 2294, 
section 3(a)(12) of the Exchange Act, 15 U.S.C. 78c(a)(12), provided 
that, among other securities, ``exempted securities'' include: (i) 
Securities which are direct obligations of, or obligations 
guaranteed as to principal or interest by, the United States; (ii) 
certain securities issued or guaranteed by corporations in which the 
United States has a direct or indirect interest as designated by the 
Secretary of the Treasury; and (iii) certain other securities as 
designated by the SEC in rules and regulations.
---------------------------------------------------------------------------

    Foreign government securities, by contrast, were not ``exempted 
securities'' as of the date of enactment of the Futures Trading Act of 
1982 \641\ and thus do not explicitly fall within this exclusion from 
the security-based swap definition. Therefore, if the underlying 
reference of the Title VII instrument is the price, value, or ``yield'' 
(where ``yield'' is a proxy for price or value) of a foreign government 
security, or a point on a yield curve derived from a narrow-based 
security index composed of foreign government securities, then the 
instrument is a security-based swap.
---------------------------------------------------------------------------

    \641\ Public Law 97-444, 96 Stat. 2294 (1983).
---------------------------------------------------------------------------

C. Total Return Swaps

    The Commissions are restating the interpretation regarding TRS set 
out in the Proposing Release with certain changes with respect to 
quanto and compo equity TRS and loan TRS based on two or more loans, 
and to reflect that TRS can overlie reference items other than 
securities, loans, and indexes of securities or loans.\642\ The 
Commissions find that this interpretation is an appropriate way to 
address TRS and is designed to reduce the cost associated with 
determining whether a TRS is a swap or a security-based swap.\643\
---------------------------------------------------------------------------

    \642\ While this guidance focuses on TRS overlying securities 
and loans, TRS also may overlie other commodities. Such TRS may be 
structured differently due to the nature of the underlying.
    \643\ See supra part I, under ``Overall Economic 
Considerations.''
---------------------------------------------------------------------------

    As was described in the Proposing Release,\644\ a TRS is a Title 
VII instrument in which one counterparty, the seller of the TRS, makes 
a payment that is based on the price appreciation and income from an 
underlying security or security index.\645\ A TRS also can overlie a 
single loan, two or more loans and other underliers. The other 
counterparty, the buyer of the TRS, makes a financing payment that is 
often based on a variable interest rate, such as LIBOR (or other 
interbank offered rate or money market rate, as described above), as 
well as a payment based on the price depreciation of the underlying 
reference. The ``total return'' consists of the price appreciation or 
depreciation, plus any interest or income payments.\646\ Accordingly, 
where a TRS is based on a single security or loan, or a narrow-based 
security index, the TRS would be a security-based swap.\647\
---------------------------------------------------------------------------

    \644\ See Proposing Release at 29842.
    \645\ Where the underlying security is an equity security, a TRS 
is also known as an ``equity swap.'' A bond may also be the 
underlying security of a TRS.
    \646\ If the total return is negative, the seller receives this 
amount from the buyer. TRS can be used to synthetically reproduce 
the payoffs of a position. For example, two counterparties may enter 
into a 3-year TRS where the buyer of the TRS receives the positive 
total return on XYZ security, if any, and the seller of the TRS 
receives LIBOR plus 30 basis points and the absolute value of the 
negative total return on XYZ security, if any.
    \647\ However, if the underlying reference of the TRS is a 
broad-based security index, it is a swap (and an SBSA) and not a 
security-based swap. In addition, a TRS on an exempted security, 
such as a U.S. Treasury, under section 3(a)(12) of the Exchange Act, 
15 U.S.C. 78c(a)(12), as in effect on the date of enactment of the 
Futures Trading Act of 1982 (other than any municipal security as 
defined in section 3(a)(29) of the Exchange Act, 15 U.S.C. 
78c(a)(29), as in effect on the date of enactment of the Futures 
Trading Act of 1982), is a swap (and an SBSA), and not a security-
based swap. Similarly, and as discussed in more detail below, an 
LTRS based on two or more loans that are not securities (``non-
security loans'') are swaps, and not security-based swaps.
---------------------------------------------------------------------------

    In addition, the Commissions are providing a final interpretation 
providing that, generally, the use of a variable interest rate in the 
TRS buyer's payment obligations to the seller is incidental to the 
purpose of, and the risk that the counterparties assume in, entering 
into the TRS, because such payments are a form of financing reflecting 
the seller's (typically a security-based swap dealer) cost of financing 
the position or a related hedge, allowing the TRS buyer to receive 
payments based on the price appreciation and income of a security or 
security index without purchasing the security or security index. As 
stated in

[[Page 48265]]

the Proposing Release, the Commissions believe that when such interest 
rate payments act merely as a financing component in a TRS, or in any 
other security-based swap, the inclusion of such interest rate terms 
would not cause the TRS to be characterized as a mixed swap.\648\ 
Financing terms may also involve adding or subtracting a spread to or 
from the financing rate,\649\ or calculating the financing rate in a 
currency other than that of the underlying reference security or 
security index.\650\
---------------------------------------------------------------------------

    \648\ See infra part IV.
    \649\ See, e.g., Moorad Chowdry, ``Total Return Swaps: Credit 
Derivatives and Synthetic Funding Instruments,'' at 3-4 (noting that 
the spread to the TRS financing rate is a function of: The credit 
rating of the counterparty paying the financing rate; the amount, 
value, and credit quality of the reference asset; the dealer's 
funding costs; a profit margin; and the capital charge associated 
with the TRS), available at http://www.yieldcurve.com/Mktresearch/LearningCurve/TRS.pdf.
    \650\ For example, a security-based swap on an equity security 
priced in U.S. dollars in which payments are made in Euros based on 
the U.S. dollar/Euro spot rate at the time the payment is made would 
not be a mixed swap. As the Commissions stated in the Proposing 
Release, under these circumstances, the currency is merely 
referenced in connection with the method of payment, and the 
counterparties are not hedging the risk of changes in currency 
exchange rates during the term of the security-based swap See 
Proposing Release at 29842, n. 176.
---------------------------------------------------------------------------

    However, where such payments incorporate additional elements that 
create additional interest rate or currency exposures that are 
unrelated to the financing of the security-based swap, or otherwise 
shift or limit risks that are related to the financing of the security-
based swap, those additional elements may cause the security-based swap 
to be a mixed swap. For example, where the counterparties embed 
interest-rate optionality (e.g., a cap, collar, call, or put) into the 
terms of a security-based swap in a manner designed to shift or limit 
interest rate exposure, the inclusion of these terms would cause the 
TRS to be both a swap and a security-based swap (i.e., a mixed swap). 
Similarly, if a TRS is also based on non-security-based components 
(such as the price of oil, or a currency), the TRS would also be a 
mixed swap.\651\
---------------------------------------------------------------------------

    \651\ See Mixed Swaps, infra part IV.
---------------------------------------------------------------------------

    The Commissions also are providing an additional interpretation 
regarding a quanto equity swap, in response to comments raised by one 
commenter,\652\ and for illustrative purposes, a similar but 
contrasting product, a compo equity swap. A quanto equity swap, which 
``can provide a U.S. investor with currency-protected exposure to a 
non-U.S. equity index by translating the percentage equity return in 
the currency of such non-U.S. equity index into U.S. dollars,'' \653\ 
can be described as:
---------------------------------------------------------------------------

    \652\ See SIFMA Letter.
    \653\ Id.

    An equity swap in which [(1)] the underlying is denominated in a 
currency (the foreign currency) other than that in which the equity 
swap is denominated (the domestic currency) * * * [and (2) t]he 
final value of the underlying is denominated in the foreign currency 
and is converted into the domestic currency using the exchange rate 
prevailing at inception[,] result[ing in] the investor * * * not 
[being] exposed to currency risk.\654\
---------------------------------------------------------------------------

    \654\ Handbook of Corporate Equity Derivatives and Equity 
Capital Markets (``Corporate Equity Derivatives Handbook''), Sec.  
1.2.10, at 23, available at http://media.wiley.com/product_data/excerpt/05/11199759/1119975905-83.pdf last visited May 4, 2012.

    While a quanto equity swap, therefore, effectively ``exposes the 
dealer on the foreign leg of the correlation product to a variable 
notional principal amount that changes whenever the exchange rate or 
the foreign index fluctuates,'' \655\ such exposure results from the 
choice of hedges for the quanto equity swap, not from the cash flows of 
the quanto equity swap itself.\656\ Thus, that exposure could be viewed 
as created in the seller by the act of entering into the quanto equity 
swap, rather than as a transfer between the parties, as is required by 
the third prong of the statutory swap definition. Consequently, the 
dealer's exchange rate exposure could be seen as incidental to the 
securities exposure desired by the party initiating the quanto equity 
swap.
---------------------------------------------------------------------------

    \655\ James M. Mahoney, Correlation Products and Risk Management 
Issues, FRBNY Economic Policy Review/October 1995 at 2, available at 
http://www.ny.frb.org/research/epr/95v01n3/9510maho.pdf last visited 
May 4, 2012.
    \656\ While applicable in general, this logic, which merely 
expands upon the principle that the character of a Title VII 
instrument as either a swap or a security-based swap should follow 
the underlying factors which are incorporated into the cash flows of 
the instrument--a security, yield, loan, or other trigger for SEC 
jurisdiction or as a commodity triggering CFTC jurisdiction (or both 
for joint jurisdiction), should not be extrapolated to other Title 
VII instruments, for which other principles may override.
---------------------------------------------------------------------------

    The Commissions view a quanto equity swap as a security-based swap, 
and not a mixed swap, where (i) the purpose of the quanto equity swap 
is to transfer exposure to the return of a security or security index 
without transferring exposure to any currency or exchange rate risk; 
and (ii) any exchange rate or currency risk exposure incurred by the 
dealer due to a difference in the currency denomination of the quanto 
equity swap and of the underlying security or security index is 
incidental to the quanto equity swap and arises from the instrument(s) 
the dealer chooses to use to hedge the quanto equity swap and is not a 
direct result of any expected payment obligations by either party under 
the quanto equity swap.\657\
---------------------------------------------------------------------------

    \657\ Although the SIFMA Letter describes quanto equity swaps in 
terms of equity indexes, if the underlying reference of a quanto 
equity swap is a single security, the result would be the same. The 
Commissions also note that if a security index underlying a quanto 
equity swap is not narrow-based, the quanto equity swap is a swap. 
In that event, it is not a mixed swap because no element of the 
quanto equity swap is a security-based swap and, to be a mixed swap, 
a Title VII instrument must have both swap and security-based swap 
components.
---------------------------------------------------------------------------

    By contrast, in a compo equity swap, the parties assume exposure 
to, and the total return is calculated based on, both the performance 
of specified foreign stocks and the change in the relevant exchange 
rate.\658\ Because the counterparty initiating a transaction can choose 
to avoid currency exposure by entering into a quanto equity swap, the 
currency exposure obtained via a compo equity swap is not incidental to 
the equity exposure for purposes of determining mixed swap status. In 
fact, investors seeking synthetic exposure to foreign securities via a 
TRS may also be seeking exposure to the exchange rate between the 
currencies, as evidenced by the fact that a number of mutual funds 
exist in both hedged and unhedged versions to provide investors 
exposure to the same foreign securities with or without the attendant 
currency

[[Page 48266]]

exposure.\659\ Consequently, a compo equity swap is a mixed swap.\660\
---------------------------------------------------------------------------

    \658\ See generally Corporate Equity Derivatives Handbook, supra 
note 654, Sec.  1.2.9, at 21-23.
    \659\ See, e.g., Descriptive Brochure: The Tweedy, Browne Global 
Value Fund II--Currency Unhedged at 1, available at http://www.tweedy.com/resources/gvf2/TBGVF-II_verJuly2011.pdf (last 
visited May 4, 2012) (comparing the Tweedy, Browne Global Value Fund 
II--Currency Unhedged and the Tweedy, Browne Global Value Fund 
(which hedges its currency exposure) and stating that ``[t]he only 
material difference [between the funds] is that the Unhedged Global 
Value Fund generally does not hedge currency risk [and] is designed 
for long-term value investors who wish to focus their investment 
exposure on foreign stock markets, and their associated non-U.S. 
currencies'' and ``[b]y establishing the Tweedy, Browne Global Value 
Fund II--Currency Unhedged, we were acknowledging that many 
investors may view exposure to foreign currency as another form of 
diversification when investing outside the U.S., and/or may have 
strong opinions regarding the future direction of the U.S. 
dollar.''). See also the PIMCO Foreign Bond Fund (Unhedged) Fact 
Sheet at 1 (stating that ``[t]he fund seeks to capture the returns 
of non-U.S. bonds including potential returns due to changes in 
exchange rates. In a declining dollar environment foreign currency 
appreciation may augment the returns generated by investments in 
foreign bonds.''), available at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(Unhedged)%20Institutional.pdf last visited 
May 4, 2012 and the PIMCO Foreign Bond Fund (U.S. Dollar-Hedged) 
INSTL Fact Sheet at 1 (stating that ``[t]he fund seeks to capture 
the returns of non-U.S. bonds but generally hedges out most currency 
exposure in order to limit the volatility of returns.''), available 
at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(U.S.%20Dollar-
Hedged)%20Institutional.pdf (last visited May 4, 2012).
    \660\ Such swaps are examples of swaps with payments that 
``incorporate additional elements that create additional * * * 
currency exposures * * * unrelated to the financing of the security-
based swap * * * that may cause the security-based swap to be a 
mixed swap.'' See Proposing Release at 29842.
---------------------------------------------------------------------------

    In response to comments,\661\ the Commissions also are providing an 
interpretation with respect to the treatment of loan TRS (``LTRS'') on 
two or more loans. As noted above, the second prong of the security-
based swap definition includes a swap that is based on ``a single 
security or loan, including any interest therein or on the value 
thereof.'' Thus, an LTRS based on a single loan, as mentioned above, is 
a security-based swap. The Commissions believe, however, that an LTRS 
based on two or more non-security loans are swaps, and not security-
based swaps.\662\ An LTRS on a group or index of such non-security 
loans is not covered by the first prong of the security-based swap 
definition--swaps based on a narrow-based security index--because the 
definition of the term ``narrow-based security index'' in both the CEA 
and the Exchange Act only applies to securities, and not to non-
security loans.\663\ An LTRS, moreover, is not covered by the third 
prong of the security-based swap definition because it is based on the 
total return of such loans, and not events related thereto. 
Accordingly, an LTRS on two or more loans that are non-security loans 
is a swap and not a security-based swap.\664\
---------------------------------------------------------------------------

    \661\ See infra note 667 and accompanying text.
    \662\ Depending on the facts and circumstances loans may be 
notes or evidences of indebtedness that are securities. See section 
3(a)(10) of the Exchange Act. In this section, the Commissions 
address only groups or indexes of loans that are not securities.
    \663\ See CEA section 1a(35), 7 U.S.C. 1a(35), and section 
3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55).
    \664\ The same would be true with respect to swaps (e.g., 
options, CFDs, NDFs), other than LTRS or loan index credit default 
swaps, on two or more loans that are not securities.
---------------------------------------------------------------------------

Comments
    The Commissions received three comments with respect to the 
interpretation provided on TRS in the Proposing Release.\665\ One of 
these commenters addressed the Commissions' interpretation on security-
based TRS.\666\ The other two commenters requested that the Commissions 
clarify the treatment of LTRS on two or more loans.\667\
---------------------------------------------------------------------------

    \665\ See July LSTA Letter; Letter from David Lucking, Allen & 
Overy LLP, dated May 26, 2011 (``Allen & Overy Letter''); and SIFMA 
Letter.
    \666\ See SIFMA Letter.
    \667\ See Allen & Overy Letter and July LSTA Letter.
---------------------------------------------------------------------------

    One commenter asserted that the terms of a TRS that create interest 
rate or currency exposures incidental to the primary purpose of the TRS 
should not cause a transaction that otherwise would be deemed to be a 
security-based swap to be characterized as a mixed swap.\668\ This 
commenter agreed with the Commissions that the scope of the mixed swap 
category of Title VII instruments is intended to be narrow and that, 
when variable interest rates are used for financing purposes incidental 
to counterparties' purposes, and risks assumed, in entering into a TRS, 
the TRS is a security-based swap and not a mixed swap.\669\
---------------------------------------------------------------------------

    \668\ See SIFMA Letter.
    \669\ Id.
---------------------------------------------------------------------------

    This commenter also opined that the Commissions' interpretation 
that ``where such payments incorporate additional elements that create 
additional interest rate or currency exposures * * * unrelated to the 
financing of the [TRS], or otherwise shift or limit risks that are 
related to the financing of the [TRS], those additional elements may 
cause the [TRS] to be a mixed swap'' could be seen as requiring a 
quantitative analysis to determine whether a reference to interest 
rates or currencies in a TRS is solely for financing purposes or 
creates additional exposure that might be construed as extending beyond 
those purposes.\670\
---------------------------------------------------------------------------

    \670\ Id. SIFMA added that such a determination could require 
market participants to determine whether a specific interest rate or 
spread referenced in the TRS is sufficiently in line with market 
rates to constitute a financing leg of a transaction under the 
proposed test. SIFMA continues by noting that there are a number of 
examples where a TRS can provide for some interest rate or currency 
exposure incidental to the primary purpose of the TRS, describing a 
quanto equity swap as an example.
---------------------------------------------------------------------------

    The Commissions are clarifying that a quantitative analysis is not 
necessarily required in order to determine whether a TRS is a mixed 
swap. Any analysis, quantitative or qualitative, clearly demonstrating 
the nature of a payment (solely financing-related, unrelated to 
financing or a combination of the two) can suffice.\671\
---------------------------------------------------------------------------

    \671\ To the extent a market participant is uncertain as to the 
results of such an analysis, it may seek informal guidance from the 
Commissions' staffs or use the process established in this release, 
see infra part VI, for seeking formal guidance from the Commissions 
as to the nature of a Title VII instrument as a swap, security-based 
swap or mixed swap.
---------------------------------------------------------------------------

    The Commissions also are clarifying that market participants are 
not necessarily required to compare their financing rates to market 
financing rates in order to determine whether the financing leg of a 
TRS is merely a financing leg or is sufficient to render the TRS a 
mixed swap. Because a number of factors can influence how a particular 
TRS is structured,\672\ the Commissions cannot provide an 
interpretation applicable to all situations. If the financing leg of a 
TRS reflects the dealer's financing costs on a one-to-one basis, the 
Commissions would view such leg as a financing leg. Adding a spread 
would not alter that conclusion if the spread is consistent with the 
dealer's course of dealing generally, with respect to a particular type 
of TRS or with respect to a particular counterparty. The Commissions 
believe that this would be the case even if the spread is ``off-
market,'' if the deviance from a market spread is explained by factors 
unique to the dealer (e.g., the dealer has high financing costs), to 
the TRS (e.g., the underlying securities are highly illiquid, so 
financing them is more costly than would be reflected in a ``typical'' 
market spread for other TRS) or to then-current market conditions 
(e.g., a share repurchase might make shares harder

[[Page 48267]]

for a dealer to procure in order to hedge its obligations under a TRS 
to pay its counterparty the capital appreciation of a security, 
resulting in higher financing costs due to the decrease in shares 
outstanding, assuming demand for the shares does not change). If the 
spread is designed to provide exposure to an underlying reference other 
than securities, however, rather than to reflect financing costs, such 
a TRS is a mixed swap.
---------------------------------------------------------------------------

    \672\ For example, the Commissions would expect a dealer 
perceived by the market to constitute a higher counterparty risk to 
have higher funding costs generally, which might affect its TRS 
financing costs. To the extent such a dealer passed through its 
higher TRS financing costs to its TRS counterparty, such a pass-
through simply would reflect the dealer's specific circumstances, 
and would not transform the TRS from a security-based swap into a 
mixed swap.
---------------------------------------------------------------------------

    Market participants are better positioned than are the Commissions 
to determine what analysis, and what supporting information and 
materials, best establish whether the nature of a particular payment 
reflects financing costs alone, or something more. Moreover, the 
Commissions expect that a dealer would know if the purpose of the 
payment(s) in question is to cover its cost of financing a position or 
a related hedge.\673\ In such cases, a detailed analysis should not be 
necessary.
---------------------------------------------------------------------------

    \673\ The Commissions expect that dealers know their financing 
costs and can readily explain the components of the financing leg 
paid by their TRS counterparties.
---------------------------------------------------------------------------

    One commenter noted the nature of quanto equity swaps as TRS and 
maintained that such a transaction ``is equivalent to a financing of a 
long position in the underlying non-U.S. equity index[]'' and that the 
currency protection is incidental to the financing element, which is 
the primary purpose of the TRS.\674\ As discussed above, the 
Commissions have provided a final interpretation regarding the 
appropriate classification of Title VII instruments that are quanto 
equity swaps and compo equity swaps.
---------------------------------------------------------------------------

    \674\ Id. SIFMA distinguished quanto equity swaps from the 
examples of mixed swaps that the Commissions provided in the 
Proposing Release, characterizing them as ``very different.''
---------------------------------------------------------------------------

    Two commenters requested that the Commissions clarify the status of 
LTRS on two or more loans.\675\ Both commenters stated that while the 
statutory definition of the term ``security-based swap'' provides that 
swaps based on a single loan are security-based swaps, it does not 
explicitly provide whether swaps on indexes of loans are security-based 
swaps.\676\ They requested clarification regarding the treatment of 
loan based swaps, including both LTRS and loan index credit default 
swaps.\677\
---------------------------------------------------------------------------

    \675\ See Allen & Overy Letter and July LSTA Letter.
    \676\ See Allen & Overy Letter. Allen & Overy notes that a Title 
VII Instrument that references two securities is a security-based 
swap. It believes that treating an LTRS on two or more loans as a 
swap would result in functionally and potentially economically 
similar products being treated in an arbitrarily different way, 
contrary to the spirit of the Dodd-Frank Act.
    \677\ The Commissions address the comments regarding loan index 
credit default swaps below. See infra note 768 and accompanying 
text.
---------------------------------------------------------------------------

    The Commissions have provided the final interpretation discussed 
above regarding LTRS based on two or more loans that are not 
securities. The Commissions acknowledge that this interpretation 
results in different treatment for an LTRS on two non-security loans (a 
swap), as opposed to a Title VII instrument based on two securities (a 
security-based swap). This result, however, is dictated by the statute.

D. Security-Based Swaps Based on a Single Security or Loan and Single-
Name Credit Default Swaps

    The Commissions provided an interpretation in the Proposing Release 
regarding security-based swaps based on a single security or loan and 
single-name CDS \678\ and are restating such interpretation with 
certain modifications in response to commenters.\679\ The second prong 
of the statutory security-based swap definition includes a swap that is 
based on ``a single security or loan, including any interest therein or 
on the value thereof.'' \680\ The Commissions believe that under this 
prong of the security-based swap definition, a single-name CDS that is 
based on a single reference obligation would be a security-based swap 
because it would be based on a single security or loan (or any interest 
therein or on the value thereof).
---------------------------------------------------------------------------

    \678\ See Proposing Release at 29843.
    \679\ See infra note 689 and accompanying text.
    \680\ Section 3(a)(68)(A)(ii)(II) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(A)(ii)(II). The first prong of the security-based swap 
definition is discussed below. See infra part III.G.
---------------------------------------------------------------------------

    In addition, the third prong of the security-based swap definition 
includes a swap that is based on the occurrence of an event relating to 
a ``single issuer of a security,'' provided that such event ``directly 
affects the financial statements, financial condition, or financial 
obligations of the issuer.'' \681\ This provision applies generally to 
event-triggered swap contracts. With respect to a CDS, such events 
could include, for example, the bankruptcy of an issuer, a default on 
one of an issuer's debt securities, or the default on a non-security 
loan of an issuer.\682\
---------------------------------------------------------------------------

    \681\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15 
U.S.C. 78c(a)(68)(A)(ii)(III).
    \682\ The Commissions understand that in the context of credit 
derivatives on asset-backed securities or MBS, the events include 
principal writedowns, failure to pay principal and interest 
shortfalls.
---------------------------------------------------------------------------

    The Commissions believe that if the payout on a CDS on a single 
issuer of a security is triggered by the occurrence of an event 
relating to that issuer, the CDS is a security-based swap under the 
third prong of the statutory security-based swap definition.\683\
---------------------------------------------------------------------------

    \683\ The Commissions understand that some single-name CDS now 
trade with fixed coupon payments expressed as a percentage of the 
notional amount of the transaction and payable on a periodic basis 
during the term of the transaction. See Markit, ``The CDS Big Bang: 
Understanding the Changes to the Global CDS Contract and North 
American Conventions,'' 3, available at http://www.markit.com/cds/announcements/resource/cds_big_bang.pdf. The Commissions are 
restating their view that the existence of such single-name CDS does 
not change their interpretation.
---------------------------------------------------------------------------

    In relation to aggregations of transactions under a single ISDA 
Master Agreement,\684\ the Commissions are revising the example that 
was included in the Proposing Release referring to single-name CDS to 
clarify that the interpretation regarding aggregations of transactions 
is non-exclusive and thus not limited to either CDS or single-reference 
instruments.\685\
---------------------------------------------------------------------------

    \684\ See Proposing Release at 29843.
    \685\ See infra note 689 and accompanying text.
---------------------------------------------------------------------------

    The Commissions believe that each transaction under an ISDA Master 
Agreement would need to be analyzed to determine whether it is a swap 
or security-based swap. For example, the Commissions believe that a 
number of Title VII instruments that are executed at the same time and 
that are documented under one ISDA Master Agreement, but in which a 
separate confirmation is sent for each instrument, should be treated as 
an aggregation of such Title VII instruments, each of which must be 
analyzed separately under the swap and security-based swap 
definitions.\686\ The Commissions believe that, as a practical and 
economic matter, each such Title VII instrument would be a separate and 
independent transaction. Thus, such an aggregation of Title VII 
instruments would not constitute a Title VII instrument based on one 
``index or group'' \687\ under the security-based swap definition but 
instead would constitute multiple Title VII instruments. The 
Commissions find that this interpretation is an appropriate way to 
address CDS, TRS or other Title VII instruments referencing a single 
security or loan or entity that is documented under a Master Agreement 
or Master Confirmation and is designed to reduce the cost associated 
with determining

[[Page 48268]]

whether such instruments are swaps or security-based swaps.\688\
---------------------------------------------------------------------------

    \686\ See infra note 691.
    \687\ The security-based swap definition further defines ``index 
to include an ``index or group of securities.'' See section 
3(a)(68)(E) of the Exchange Act, 15 U.S.C. 78c(a)(68)(E).
    \688\ See supra part I, under ``Overall Economic 
Considerations''.
---------------------------------------------------------------------------

Comments
    The Commissions received two comments regarding the interpretation 
regarding aggregation of Title VII instruments under a single ISDA 
Master Agreement. One commenter requested that the Commissions clarify 
that the interpretation applies to other types of instruments, such as 
TRS, in addition to CDS.\689\ The commenter also stated that the 
interpretation should be helpful with respect to use of a ``Master 
Confirmation'' structure, which the commenter described as use of 
general terms in a ``Master Confirmation'' that apply to a number of 
instruments with separate underlying references but for which a 
separate ``Supplemental Confirmation'' is sent for each separate 
component.\690\
---------------------------------------------------------------------------

    \689\ See July LSTA Letter.
    \690\ Id.
---------------------------------------------------------------------------

    A second commenter agreed with the Commissions' interpretation that 
a number of single-name CDS that are executed at the same time and that 
are documented under one ISDA Master Agreement, but in which a separate 
confirmation is sent for each CDS, should not be treated as a single 
index CDS and stated that this approach is consistent with market 
practice.\691\
---------------------------------------------------------------------------

    \691\ See Letter from Richard M. McVey, Chairman and Chief 
Executive Officer, MarketAxess Holdings, Inc. (``MarketAxess''), 
July 22, 2011 (``MarketAxess Letter'').
---------------------------------------------------------------------------

    As discussed above, in response to comments the Commissions are 
expanding the example so it is clear that it applies beyond just 
CDS.\692\
---------------------------------------------------------------------------

    \692\ The Commissions believe, based on the July LSTA Letter, 
that the ``Master Confirmation'' structure the commenter described 
is the same general structure as the aggregation of single-name CDS 
the Commissions provided as an example in the Proposing Release, but 
that a ``Master Confirmation'' structure may not be limited to 
single-reference instruments or to CDS and instead may be used for a 
broader range of instruments. See July LSTA Letter. The Commissions 
note that the following are examples of ``Master Confirmation'' 
structure to which the interpretive guidance would apply: 2009 
Americas Master Equity Derivatives Confirmation Agreement, Stand-
alone 2007 Americas Master Variance Swap Confirmation Agreement, and 
2004 Americas Interdealer Master Equity Derivatives Confirmation 
Agreement and March 2004 Canadian Supplement to the Master 
Confirmation. The Commissions believe the broader example in this 
release provides the clarification the commenter requested.
---------------------------------------------------------------------------

E. Title VII Instruments Based on Futures Contracts

    The Commissions proposed an interpretation in the Proposing Release 
regarding the treatment, generally, of swaps based on futures 
contracts.\693\ The Commissions are restating the interpretation they 
provided in the Proposing Release without modification. The Commissions 
also discussed in the Proposing Release the unique circumstance 
involving certain futures contracts on foreign government debt 
securities and requested comment as to how Title VII instruments on 
these futures contracts should be treated.\694\ In response to 
commenters,\695\ the Commissions are adopting a rule regarding the 
treatment of Title VII instruments on certain futures contracts on 
foreign government debt securities.\696\
---------------------------------------------------------------------------

    \693\ See Proposing Release at 29843-44.
    \694\ Id.
    \695\ See infra note 718 and accompanying text.
    \696\ See rule 1.3(bbbb) under the CEA and rule 3a68-5 under the 
Exchange Act.
---------------------------------------------------------------------------

    A Title VII instrument that is based on a futures contract will 
either be a swap or a security-based swap, or both (i.e., a mixed 
swap), depending on the nature of the futures contract, including the 
underlying reference of the futures contract. Thus, a Title VII 
instrument where the underlying reference is a security future is a 
security-based swap.\697\ In general, a Title VII instrument where the 
underlying reference is a futures contract that is not a security 
future is a swap.\698\ As the Commissions noted in the Proposing 
Release,\699\ Title VII instruments involving certain futures contracts 
on foreign government debt securities present a unique circumstance, 
which is discussed below.
---------------------------------------------------------------------------

    \697\ A security future is defined in both the CEA and the 
Exchange Act as a futures contract on a single security or a narrow-
based security index, including any interest therein or based on the 
value thereof, except an exempted security under section 3(a)(12) of 
the Exchange Act, 15 U.S.C. 78c(a)(12), as in effect on the date of 
enactment of the Futures Trading Act of 1982 (other than any 
municipal security as defined in section 3(a)(29) of the Exchange 
Act, 15 U.S.C. 78c(a)(29), as in effect on the date of enactment of 
the Futures Trading Act of 1982).
    The term security future does not include any agreement, 
contract, or transaction excluded from the CEA under sections 2(c), 
2(d), 2(f), or 2(g) of the CEA, 7 U.S.C. 2(c), 2(d), 2(f), or 2(g), 
as in effect on the date of enactment of the Commodity Futures 
Modernization Act of 2000 (``CFMA'') or Title IV of the CFMA. See 
section 1a(44) of the CEA, 7 U.S.C. 1a(44), and section 3(a)(55) of 
the Exchange Act, 15 U.S.C. 78c(a)(55).
    \698\ Depending on the underlying reference of the futures 
contract, though, such swaps could be SBSAs. For example, a swap on 
a future on the S&P 500 index would be an SBSA.
    \699\ See Proposing Release at 29843.
---------------------------------------------------------------------------

    Rule 3a12-8 under the Exchange Act exempts certain foreign 
government debt securities, for purposes only of the offer, sale, or 
confirmation of sale of futures contracts on such foreign government 
debt securities, from all provisions of the Exchange Act which by their 
terms do not apply to an ``exempted security,'' subject to certain 
conditions.\700\ To date, the SEC has enumerated within rule 3a12-8 the 
debt securities of 21 foreign governments solely for purposes of 
futures trading (``21 enumerated foreign governments'').\701\
---------------------------------------------------------------------------

    \700\ Specifically, rule 3a12-8 under the Exchange Act requires 
as a condition to the exemption that the foreign government debt 
securities not be registered under the Securities Act (or be the 
subject of any American depositary receipt registered under the 
Securities Act) and that futures contracts on such foreign 
government debt securities ``require delivery outside the United 
States, [and] any of its possessions or territories, and are traded 
on or through a board of trade, as defined in [section 2 of the CEA, 
7 U.S.C. 2].'' See rules 3a12-8(a)(2) and 3a12-8(b) under the 
Exchange Act, 17 CFR 240.3a12-8(a)(2) and 240.3a12-8(b). These 
conditions were ``designed to minimize the impact of the exemption 
on securities distribution and trading in the United States. * * *'' 
See Exemption for Certain Foreign Government Securities for Purposes 
of Futures Trading, 49 FR 8595 (Mar. 8, 1984) at 8596-97 (citing 
Futures Trading Act of 1982).
    \701\ See rule 3a12-8(a)(1) under the Exchange Act (designating 
the debt securities of the governments of the United Kingdom, 
Canada, Japan, Australia, France, New Zealand, Austria, Denmark, 
Finland, the Netherlands, Switzerland, Germany, Ireland, Italy, 
Spain, Mexico, Brazil, Argentina, Venezuela, Belgium, and Sweden).
---------------------------------------------------------------------------

    The Commissions recognize that as a result of rule 3a12-8, futures 
contracts on the debt securities of the 21 enumerated foreign 
governments that satisfy the conditions of rule 3a12-8 are subject to 
the CFTC's exclusive jurisdiction and are not considered security 
futures. As a result, applying the interpretation above to a Title VII 
instrument that is based on a futures contract on the debt securities 
of these 21 enumerated foreign governments would mean that the Title 
VII instrument would be a swap.\702\ The Commissions note, however, 
that the conditions in rule 3a12-8 were established specifically for 
purposes of the offer and sale of ``qualifying foreign futures 
contracts'' (as defined in rule 3a12-8) \703\ on the debt securities of 
the 21 enumerated foreign governments,\704\ not Title VII instruments 
based on futures contracts on the debt securities

[[Page 48269]]

of the 21 enumerated governments. Further, the Commissions note that 
the Dodd-Frank Act did not exclude swaps on foreign government debt 
securities generally from the definition of the term ``security-based 
swap.'' Accordingly, a Title VII instrument that is based directly on 
foreign government debt securities, including those of the 21 
enumerated governments, is a security-based swap or a swap under the 
same analysis as any other Title VII instruments based on securities.
---------------------------------------------------------------------------

    \702\ The Commissions note, by contrast, that a Title VII 
instrument that is based on the price or value of, or settlement 
into, a futures contract on the debt securities of one of the 21 
enumerated foreign governments and that also has the potential to 
settle directly into such debt securities would be a security-based 
swap and, depending on other features of the Title VII instrument, 
possibly a mixed swap.
    \703\ Rule 3a12-8(b) under the Exchange Act defines ``qualifying 
foreign futures contracts'' as ``contracts for the purchase or sale 
of a designated foreign government security for future delivery, as 
`future delivery' is defined in 7 U.S.C. 2, provided such contracts 
require delivery outside the United States, any of its possessions 
or territories, and are traded on or through a board of trade, as 
defined at 7 U.S.C. 2.'' 17 CFR 240.3a12-8(b).
    \704\ See supra note 700.
---------------------------------------------------------------------------

    The Commissions indicated in the Proposing Release that they would 
evaluate whether Title VII instruments based on futures contracts on 
the debt securities of the 21 enumerated foreign governments that 
satisfy the conditions of rule 3a12-8 should be characterized as swaps, 
security-based swaps, or mixed swaps.\705\ In response to 
commenters,\706\ the Commissions are adopting rule 1.3(bbbb) under the 
CEA and rule 3a68-5 under the Exchange Act, which address the treatment 
of these Title VII instruments.
---------------------------------------------------------------------------

    \705\ See Proposing Release at 29844.
    \706\ See infra note 718 and accompanying text.
---------------------------------------------------------------------------

    The final rules provide that a Title VII instrument that is based 
on or references a qualifying foreign futures contract on the debt 
securities of one or more of the 21 enumerated foreign governments is a 
swap and not a security-based swap, provided that the Title VII 
instrument satisfies the following conditions:
     The futures contract on which the Title VII instrument is 
based or that is referenced is a qualifying foreign futures contract 
(as defined in rule 3a12-8) \707\ on the debt securities of any one or 
more of the 21 enumerated foreign governments that satisfies the 
conditions of rule 3a12-8;
---------------------------------------------------------------------------

    \707\ See supra note 703.
---------------------------------------------------------------------------

     The Title VII instrument is traded on or through a board 
of trade (as defined in section 1a(6) of the CEA);
     The debt securities on which the qualifying foreign 
futures contract is based or referenced and any security used to 
determine the cash settlement amount pursuant to the fourth condition 
below are not covered by an effective registration statement under the 
Securities Act or the subject of any American depositary receipt 
covered by an effective registration statement under the Securities 
Act;
     The Title VII instrument may only be cash settled; and
     The Title VII instrument is not entered into by the issuer 
of the securities upon which the qualifying foreign futures contract is 
based or referenced (including any security used to determine the cash 
payment due on settlement of such Title VII instrument), an affiliate 
(as defined in the Securities Act and the rules and regulations 
thereunder) \708\ of the issuer, or an underwriter with respect to such 
securities.
---------------------------------------------------------------------------

    \708\ See, e.g., rule 405 under the Securities Act, 17 CFR 
230.405.
---------------------------------------------------------------------------

    Under the first condition, the final rules provide that the futures 
contract on which the Title VII instrument is based or referenced must 
be a qualifying foreign futures contract that satisfies the conditions 
of rule 3a12-8 and may only be based on the debt of any one or more of 
the enumerated 21 foreign governments. If the conditions of rule 3a12-8 
are not satisfied, then there cannot be a qualifying foreign futures 
contract, the futures contract is a security future, and a swap on such 
a security future is a security-based swap.
    The second condition of the final rules provides that the Title VII 
instrument on the qualifying foreign futures contract must itself be 
traded on or through a board of trade because a qualifying foreign 
futures contract on the debt securities of one or more of the 21 
enumerated foreign governments itself is required to be traded on a 
board of trade. The Commissions believe that swaps on such futures 
contracts should be traded subject to rules applicable to such futures 
contracts themselves.
    The third condition of the final rules provides that the debt 
securities on which the qualifying foreign futures contract is based or 
referenced and any security used to determine the cash settlement 
amount pursuant to the fourth condition cannot be registered under the 
Securities Act or be the subject of any American depositary receipt 
registered under the Securities Act. This condition is intended to 
prevent circumvention of registration and disclosure requirements of 
the Securities Act applicable to foreign government issuances of their 
securities. This condition is similar to a condition included in rule 
3a12-8.\709\
---------------------------------------------------------------------------

    \709\ See supra note 700.
---------------------------------------------------------------------------

    The fourth condition of the final rules provides that the Title VII 
instrument must be cash settled. Although, as the Commissions 
recognize, rule 3a12-8 permits a qualifying foreign futures contract to 
be physically settled so long as delivery is outside the United States, 
any of its possessions or territories,\710\ in the context of Title VII 
instruments, only cash settled Title VII instruments based on 
qualifying foreign futures contracts on the debt securities of the 21 
enumerated foreign governments will be considered swaps. The 
Commissions believe that this condition is appropriate in order to 
provide consistent treatment of Title VII instruments based on 
qualifying foreign futures contracts on the debt securities of the 21 
enumerated foreign governments with the Commissions' treatment of swaps 
and security-based swaps generally.\711\
---------------------------------------------------------------------------

    \710\ Id.
    \711\ See infra part III.H.
---------------------------------------------------------------------------

    The fifth condition of the final rules provides that for a Title 
VII instrument to be a swap under such rules, it cannot be entered into 
by the issuer of the securities upon which the qualifying foreign 
futures contract is based or referenced (including any security used to 
determine the cash payment due on settlement of such Title VII 
instrument), an affiliate of the issuer, or an underwriter of the 
issuer's securities. The Commissions have included this condition to 
address the concerns raised by the SEC in the Proposing Release that 
the characterization of a Title VII instrument that is based on a 
futures contract on the debt securities of one of the 21 enumerated 
foreign governments may affect Federal securities law provisions 
relating to the distribution of the securities upon which the Title VII 
instrument is based or referenced.\712\
---------------------------------------------------------------------------

    \712\ See Proposing Release at 29844.
---------------------------------------------------------------------------

    The Dodd-Frank Act included provisions that would not permit 
issuers, affiliates of issuers, or underwriters to use security-based 
swaps to offer or sell the issuers' securities underlying a security-
based swap without complying with the requirements of the Securities 
Act.\713\ This provision applies regardless of whether the Title VII 
instrument allows the parties to physically settle any such security-
based swap. In addition, the Dodd-Frank Act provided that any offer or 
sale of security-based swaps to non-ECPs would have to be registered 
under the Securities Act.\714\ For example, if a Title VII instrument 
that is based on a futures contract on the debt securities of one of 
the 21 enumerated foreign governments is characterized as a swap, and 
not a security-based swap, then the provisions of the Dodd-Frank Act 
enacted to ensure that there could not be offers and sales of 
securities made without compliance with the Securities Act, either by 
issuers, their affiliates, or underwriters or to non-ECPs, would not 
apply to such swap transactions.
---------------------------------------------------------------------------

    \713\ See section 2(a)(3) of the Securities Act, 15 U.S.C. 
77b(a)(3), as amended by the Dodd-Frank Act.
    \714\ See section 5 of the Securities Act, 15 U.S.C. 77e, as 
amended by the Dodd-Frank Act.
---------------------------------------------------------------------------

    Only those Title VII instruments that are based on qualifying 
foreign futures contracts on the debt securities of the 21

[[Page 48270]]

enumerated foreign governments and that satisfy these five conditions 
will be swaps, not security-based swaps. The Commissions note that the 
final rules are intended to provide consistent treatment (other than 
with respect to method of settlement) of qualifying foreign futures 
contracts and Title VII instruments based on qualifying foreign futures 
contracts on the debt securities of the 21 enumerated foreign 
governments.\715\ The Commissions understand that many of the 
qualifying foreign futures contracts on the debt securities of the 21 
enumerated foreign governments trade with substantial volume through 
foreign trading venues under the conditions set forth in rule 3a12-8 
\716\ and permitting swaps on such futures contracts subject to similar 
conditions would not raise concerns that such swaps could be used to 
circumvent the conditions of rule 3a12-8 and the Federal securities 
laws concerns that such conditions are intended to protect.\717\ 
Further, providing consistent treatment for qualifying foreign futures 
contracts on the debt securities of the 21 enumerated foreign 
governments and Title VII instruments based on futures contracts on the 
debt securities of the 21 enumerated foreign governments will allow 
trading of these instruments through designated contract markets on 
which such futures are listed.
---------------------------------------------------------------------------

    \715\ The Commissions note that the final rules provide 
consistent treatment of qualifying foreign futures contracts on the 
debt securities of the 21 enumerated foreign governments and Title 
VII instruments based on qualifying foreign futures contracts on the 
debt securities of the 21 enumerated foreign governments unless the 
Title VII instrument is entered into by the issuer of the securities 
upon which the qualifying foreign futures contract is based or 
referenced (including any security used to determine the cash 
payment due on settlement of such Title VII instrument), an 
affiliate of the issuer, or an underwriter with respect to such 
securities.
    \716\ For the quarter that ended December 31, 2011, the trading 
volume reported to the CFTC of qualifying foreign futures contracts 
on the debt securities of the 21 enumerated foreign governments made 
available for trading by direct access from the U.S. on foreign 
trading venues granted direct access no-action relief by the CFTC 
that exceeded 100,000 contracts per quarter from the U.S. were as 
follows: (i) 7,985,959 contracts for 3 Year Treasury Bond Futures on 
the Australian Securities Exchange's ASX Trade24 platform; (ii) 
1,872,592 contracts for 10-Year Government of Canada Bond Futures on 
the Bourse de Montreal; (iii) 47,874,911 contracts for Euro Bund 
Futures on Eurex Deutschland (``Eurex''); (iv) 26,434,713 contracts 
for Euro Bobl Futures on Eurex; (v) 30,489,427 contracts for Euro 
Schatz Futures on Eurex; and (vi) 8,292,222 contracts for Long Gilt 
Futures on the NYSE LIFFE.
    \717\ See supra note 712 and accompanying text.
---------------------------------------------------------------------------

    The Commissions recognize that the rules may result in a different 
characterization of a Title VII instrument that is based directly on a 
foreign government debt security and one that is based on a qualifying 
foreign futures contract on a debt security of one of the 21 enumerated 
foreign governments. However, the Commissions note that this is the 
case today (i.e., different treatments) with respect to other 
instruments subject to CFTC regulation and/or SEC regulation, such as 
futures on broad-based security indexes and futures on a single 
security or narrow-based security index.
Comments
    Commenters did not address the interpretation as it applied to 
Title VII instruments based on futures contracts generally. Two 
commenters addressed Title VII instruments based on futures contracts 
on debt securities of the 21 enumerated foreign governments.\718\ Both 
commenters requested that the Commissions treat these Title VII 
instruments as swaps.\719\ The Commissions agree that these instruments 
should be treated as swaps under certain conditions and, therefore, are 
adopting rule 1.3(bbbb) under the CEA and rule 3a68-5 under the 
Exchange Act as discussed above to treat Title VII instruments based on 
qualifying foreign futures contracts on the debt securities of the 21 
enumerated foreign governments as swaps, provided such Title VII 
instruments satisfy certain conditions.
---------------------------------------------------------------------------

    \718\ See CME Letter and SIFMA Letter.
    \719\ Id. Both commenters stated their belief that the range of 
factors considered by the SEC in designating the debt securities of 
the 21 enumerated foreign governments as exempted securities 
indicated that there is sufficient disclosure about the 21 
enumerated foreign governments and their securities such that the 
further disclosure should not be necessary. Both commenters also 
indicated that subjecting futures contracts on the debt securities 
of the 21 enumerated foreign governments to CFTC regulation, while 
subjecting Title VII instruments based on these futures contracts to 
SEC regulation, would be problematic. Id.
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F. Use of Certain Terms and Conditions in Title VII Instruments

    The Commissions provided an interpretation in the Proposing Release 
regarding the use of certain fixed terms in Title VII instruments and 
are restating that interpretation without modification.\720\ The 
Commissions are aware that market participants' setting of certain 
fixed terms or conditions of Title VII instruments may be informed by 
the value or level of a security, rate, or other commodity at the time 
of the execution of the instrument. The Commissions believe that, in 
evaluating whether a Title VII instrument with such a fixed term or 
condition is a swap or security-based swap, the nature of the security, 
rate, or other commodity that informed the setting of such fixed term 
or condition should not itself impact the determination of whether the 
Title VII instrument is a swap or a security-based swap, provided that 
the fixed term or condition is set at the time of execution and the 
value or level of that fixed term or condition may not vary over the 
life of the Title VII instrument.\721\
---------------------------------------------------------------------------

    \720\ See Proposing Release at 29845.
    \721\ This interpretation relates solely to the determination 
regarding whether a Title VII instrument is a swap or security-based 
swap. The Commissions are not expressing a view regarding whether 
such Title VII instrument would be a security-based swap agreement.
---------------------------------------------------------------------------

    For example, a Title VII instrument, such as an interest rate swap, 
in which floating payments based on three-month LIBOR are exchanged for 
fixed rate payments of five percent would be a swap, and not a 
security-based swap, even if the five percent fixed rate was informed 
by, or quoted based on, the yield of a security, provided that the five 
percent fixed rate was set at the time of execution and may not vary 
over the life of the Title VII instrument.\722\ Another example would 
be where a private sector or government borrower that issues a five-
year, amortizing $100 million debt security with a semi-annual coupon 
of LIBOR plus 250 basis points also, at the same time, chooses to enter 
into a five-year interest rate swap on $100 million notional in which 
this same borrower, using the same amortization schedule as the debt 
security, receives semi-annual payments of LIBOR plus 250 basis points 
in exchange for five percent fixed rate payments. The fact that the 
specific terms of the interest rate swap (e.g., five-year, LIBOR plus 
250 basis points, $100 million notional, fixed amortization schedule) 
were set at the time of execution to match related terms of a debt 
security does not cause the interest rate swap to become a security-
based swap. However, if the interest rate swap contained additional 
terms that were in fact contingent on a characteristic of the debt 
security that may change in the future, such as an adjustment to future 
interest rate swap payments based on the future price or yield of the 
debt security, then this Title VII instrument would be a security-based 
swap that would be a mixed swap.
---------------------------------------------------------------------------

    \722\ However, to the extent the fixed term or condition is set 
at a future date or at a future value or level of a security, rate, 
or other commodity rather than the value or level of such security, 
rate, or other commodity at the time of execution of the Title VII 
instrument, the discussion above would not apply, and the nature of 
the security, rate, or other commodity used in determining the terms 
or conditions would be considered in evaluating whether the Title 
VII instrument is a swap or security-based swap.

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[[Page 48271]]

Comments
    One commenter agreed with the Commissions' interpretation 
generally, but believed that the Commissions should broaden the 
interpretation to allow a swap to reflect ``resets,'' or changes in the 
referenced characteristic of a security, where those ``resets'' or 
changes are ``intended to effect a purpose other than transmitting the 
risk of changes in the characteristic itself,'' without causing a Title 
VII instrument that is not a security-based swap to become a security-
based swap.\723\
---------------------------------------------------------------------------

    \723\ See ISDA Letter.
---------------------------------------------------------------------------

    The Commissions are not expanding the interpretation to allow 
``resets'' of a fixed rate derived from a security. The interpretation 
is consistent with the statutory swap and security-based swap 
definitions. The Commissions believe that a Title VII instrument based 
on a rate that follows a security, and that may ``reset'' or change in 
the future based on changes in that security, is a security-based swap. 
Further, any amendment or modification of a material term of a Title 
VII instrument would result in a new Title VII instrument and a 
corresponding reassessment of the instrument's status as either a swap 
or a security-based swap.\724\
---------------------------------------------------------------------------

    \724\ See infra part III.G.5(a).
---------------------------------------------------------------------------

G. The Term ``Narrow-Based Security Index'' in the Security-Based Swap 
Definition

1. Introduction
    As noted above, a Title VII instrument in which the underlying 
reference of the instrument is a ``narrow-based security index'' is a 
security-based swap subject to regulation by the SEC, whereas a Title 
VII instrument in which the underlying reference of the instrument is a 
security index that is not a narrow-based security index (i.e., the 
index is broad-based) is a swap subject to regulation by the CFTC. The 
Commissions proposed an interpretation and rules regarding usage of the 
term ``narrow-based security index'' in the security-based swap 
definition, including:
     The existing criteria for determining whether a security 
index is a narrow-based security index and the applicability of past 
guidance of the Commissions regarding those criteria to Title VII 
instruments;
     New criteria for determining whether a CDS where the 
underlying reference is a group or index of entities or obligations of 
entities (typically referred to as an ``index CDS'') is based on an 
index that is a narrow-based security index;
     The meaning of the term ``index'';
     Rules governing the tolerance period for Title VII 
instruments on security indexes traded on DCMs, SEFs, foreign boards of 
trade (``FBOTs''), security-based SEFs, or NSEs, where the security 
index temporarily moves from broad-based to narrow-based or from 
narrow-based to broad-based; and
     Rules governing the grace period for Title VII instruments 
on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs, 
or NSEs, where the security index moves from broad-based to narrow-
based or from narrow-based to broad-based and the move is not 
temporary.\725\
---------------------------------------------------------------------------

    \725\ See Proposing Release at 29845-58.
---------------------------------------------------------------------------

    As discussed below, the Commissions are restating the 
interpretation set forth in the Proposing Release with certain further 
clarifications and adopting the rules as proposed with certain 
modifications.
2. Applicability of the Statutory Narrow-Based Security Index 
Definition and Past Guidance of the Commissions to Title VII 
Instruments
    The Commissions provided an interpretation in the Proposing Release 
regarding the applicability of the statutory definition of the term 
``narrow-based security index'' and past guidance of the Commissions 
relating to such term to Title VII instruments.\726\ The Commissions 
are restating the interpretation set out in the Proposing Release 
without modification.
---------------------------------------------------------------------------

    \726\ See Proposing Release at 29845-48.
---------------------------------------------------------------------------

    As defined in the CEA and Exchange Act,\727\ an index is a narrow-
based security index if, among other things, it meets any one of the 
following four criteria:
---------------------------------------------------------------------------

    \727\ Sections 3(a)(55)(B) and (C) of the Exchange Act, 15 
U.S.C. 78c(a)(55)(B) and (C), include a definition of ``narrow-based 
security index'' in the same paragraph as the definition of security 
future. See also sections 1a(35)(A) and (B) of the CEA, 7 U.S.C. 
1a(35)(A) and (B). A security future is a contract for future 
delivery on a single security or narrow-based security index 
(including any interest therein or based on the value thereof). See 
section 3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55), and 
section 1a(44) of the CEA, 7 U.S.C. 1a(44).
---------------------------------------------------------------------------

     It has nine or fewer component securities;
     A component security comprises more than 30 percent of the 
index's weighting;
     The five highest weighted component securities in the 
aggregate comprise more than 60 percent of the index's weighting; or
     The lowest weighted component securities comprising, in 
the aggregate, 25 percent of the index's weighting have an aggregate 
dollar value of average daily trading volume of less than $50,000,000 
(or in the case of an index with more than 15 component securities, 
$30,000,000), except that if there are two or more securities with 
equal weighting that could be included in the calculation of the lowest 
weighted component securities comprising, in the aggregate, 25 percent 
of the index's weighting, such securities shall be ranked from lowest 
to highest dollar value of average daily trading volume and shall be 
included in the calculation based on their ranking starting with the 
lowest ranked security.\728\
---------------------------------------------------------------------------

    \728\ See section 3(a)(55)(B) of the Exchange Act, 15 U.S.C. 
78c(a)(55)(B). See also sections 1a(35)(A) and (B) of the CEA, 7 
U.S.C. 1a(35)(A) and (B).
---------------------------------------------------------------------------

    The first three criteria apply to the number and concentration of 
the ``component securities'' in the index. The fourth criterion applies 
to the average daily trading volume of an index's ``component 
securities.'' \729\
---------------------------------------------------------------------------

    \729\ The narrow-based security index definition in the CEA and 
Exchange Act also excludes from its scope security indexes that 
satisfy certain specified criteria. See sections 3(a)(55)(C)(i)-(vi) 
of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(i)-(vi), and sections 
1a(35)(B)(i)-(vi) of the CEA, 7 U.S.C. 1a(35)(B)(i)-(vi).
---------------------------------------------------------------------------

    This statutory narrow-based security index definition focuses on 
indexes composed of equity securities and certain aspects of the 
definition, in particular the evaluation of average daily trading 
volume, are designed to take into account the trading patterns of 
individual stocks.\730\ However, the Commissions, pursuant to authority 
granted in the CEA and the Exchange Act,\731\ previously have extended 
the definition to other categories of indexes but modified the 
definition to take into account the characteristics of those other 
categories. Specifically, the Commissions have previously provided 
guidance regarding the application of the narrow-based security index 
definition to futures contracts on volatility indexes \732\ and debt 
security indexes.\733\ Today, then, there exists guidance for 
determining what constitutes a narrow-based security index.
---------------------------------------------------------------------------

    \730\ See Joint Order Excluding Indexes Comprised of Certain 
Index Options From the Definition of Narrow-Based Security Index, 69 
FR 16900 (Mar. 31, 2004) (``March 2004 Index Options Joint Order'').
    \731\ See section 1a(35)(B)(vi) of the CEA, 7 U.S.C. 
1a(35)(B)(vi), and section 3(a)(55)(C)(vi) of the Exchange Act, 15 
U.S.C. 78c(a)(55)(C)(vi).
    \732\ See March 2004 Index Options Joint Order.
    \733\ See Joint Final Rules: Application of the Definition of 
Narrow-Based Security Index to Debt Securities Indexes and Security 
Futures on Debt Securities, 71 FR 39434 (Jul. 13, 2006) (``July 2006 
Debt Index Release'').
---------------------------------------------------------------------------

    Volatility indexes are indexes composed of index options. The 
Commissions issued a joint order in

[[Page 48272]]

2004 to define when a volatility index is not a narrow-based security 
index. Under this joint order, a volatility index is not a narrow-based 
security index if the index meets all of the following criteria:
     The index measures the magnitude of changes (as calculated 
in accordance with the order) in the level of an underlying index that 
is not a narrow-based security index pursuant to the statutory criteria 
for equity indexes discussed above;
     The index has more than nine component securities, all of 
which are options on the underlying index;
     No component security of the index comprises more than 30 
percent of the index's weighting;
     The five highest weighted component securities of the 
index in the aggregate do not comprise more than 60 percent of the 
index's weighting;
     The average daily trading volume of the lowest weighted 
component securities in the underlying index (those comprising, in the 
aggregate, 25 percent of the underlying index's weighting) have a 
dollar value of more than $50,000,000 (or $30,000,000 in the case of an 
underlying index with 15 or more component securities), except if there 
are 2 or more securities with equal weighting that could be included in 
the calculation of the lowest weighted component securities comprising, 
in the aggregate, 25 percent of the underlying index's weighting, such 
securities shall be ranked from lowest to highest dollar value of 
average daily trading volume and shall be included in the calculation 
based on their ranking starting with the lowest ranked security;
     Options on the underlying index are listed and traded on 
an NSE registered under section 6(a) of the Exchange Act; \734\ and
---------------------------------------------------------------------------

    \734\ 15 U.S.C. 78f(a).
---------------------------------------------------------------------------

     The aggregate average daily trading volume in options on 
the underlying index is at least 10,000 contracts calculated as of the 
preceding 6 full calendar months.\735\
---------------------------------------------------------------------------

    \735\ See March 2004 Index Options Joint Order. In 2009, the 
Commissions issued a joint order that provided that, instead of the 
index options having to be listed on an NSE, the index options must 
be listed on an exchange and pricing information for the index 
options, and the underlying index, must be computed and disseminated 
in real time through major market data vendors. See Joint Order To 
Exclude Indexes Composed of Certain Index Options From the 
Definition of Narrow-Based Security Index, 74 FR 61116 (Nov. 23, 
2009) (expanding the criteria necessary for exclusion under the 
March 2004 Index Options Joint Order to apply to volatility indexes 
for which pricing information for the underlying broad-based 
security index, and the options that compose such index, is current, 
accurate, and publicly available).
---------------------------------------------------------------------------

    With regard to debt security indexes, the Commissions issued joint 
rules in 2006 (``July 2006 Debt Index Rules'') to define when an index 
of debt securities \736\ is not a narrow-based security index. The 
first three criteria of that definition are similar to the statutory 
definition for equities and the order regarding volatility indexes in 
that a debt security index would not be narrow-based if:
---------------------------------------------------------------------------

    \736\ Under the rules, debt securities include notes, bonds, 
debentures or evidence of indebtedness. See rule 41.15(a)(1)(i) 
under the CEA, 17 CFR 41.15(a)(1)(i) and rule 3a55-4(a)(1)(i) under 
the Exchange Act, 17 CFR 240.3a55-4(a)(1)(i). See also July 2006 
Debt Index Release.
---------------------------------------------------------------------------

     It is comprised of more than nine debt securities that are 
issued by more than nine non-affiliated issuers;
     The securities of any issuer included in the index do not 
comprise more than 30 percent of the index's weighting; and
     The securities of any five non-affiliated issuers in the 
index do not comprise more than 60 percent of the index's weighting.
    In the July 2006 Debt Index Rules, instead of the statutory average 
daily trading volume test, however, the Commissions adopted a public 
information availability requirement. Under this requirement, assuming 
the aforementioned number and concentration criteria were satisfied, a 
debt security index would not be a narrow-based security index if the 
debt securities or the issuers of debt securities in the index met any 
one of the following criteria:
     The issuer of the debt security is required to file 
reports pursuant to section 13 or section 15(d) of the Securities 
Exchange Act of 1934; \737\
---------------------------------------------------------------------------

    \737\ 15 U.S.C. 78m or 78o(d).
---------------------------------------------------------------------------

     The issuer of the debt security has a worldwide market 
value of its outstanding common equity held by non-affiliates of $700 
million or more;
     The issuer of the debt security has outstanding securities 
that are notes, bonds, debentures, or evidence of indebtedness having a 
total remaining principal amount of at least $1 billion;
     The security is an exempted security as defined in section 
3(a)(12) of the Securities Exchange Act of 1934 \738\ and the rules 
promulgated thereunder; or
---------------------------------------------------------------------------

    \738\ 15 U.S.C. 78c(a)(12).
---------------------------------------------------------------------------

     The issuer of the security is a government of a foreign 
country or a political subdivision of a foreign country.\739\
---------------------------------------------------------------------------

    \739\ See July 2006 Debt Index Rules. The July 2006 Debt Index 
Rules also provided that debt securities in the index must satisfy 
certain minimum outstanding principal balance criteria, established 
certain exceptions to these criteria and the public information 
availability requirement, and provided for the treatment of indexes 
that include exempted securities (other than municipal securities).
---------------------------------------------------------------------------

    In the Dodd-Frank Act, Congress included the term ``narrow-based 
security index'' in the security-based swap definition, and thus the 
statutory definition of the term ``narrow-based security index'' \740\ 
also applies in distinguishing swaps (on security indexes that are not 
narrow-based, also known as ``broad-based'') and security-based swaps 
(on narrow-based security indexes).\741\ The Commissions have 
determined that their prior guidance with respect to what constitutes a 
narrow-based security index in the context of volatility indexes \742\ 
and debt security indexes \743\ applies in determining whether a Title 
VII instrument is a swap or a security-based swap, except as the rules 
the Commissions are adopting provide for other treatment with respect 
to index CDS as discussed below.\744\
---------------------------------------------------------------------------

    \740\ See sections 3(a)(55)(B) and (C) of the Exchange Act, 15 
U.S.C. 78c(a)(55)(B) and (C). See also sections 1a(35)(A) and (B) of 
the CEA, 7 U.S.C. 1a(35)(A) and (B).
    \741\ The statutory definition of the term ``narrow-based 
security index'' for equities, and the Commissions' subsequent 
guidance as to what constitutes a narrow-based security index with 
respect to volatility and debt indexes, is applicable in the context 
of distinguishing between futures contracts and security futures 
products.
    \742\ See March 2004 Index Options Joint Order.
    \743\ See July 2006 Debt Index Rules.
    \744\ See infra part III.G.3.
---------------------------------------------------------------------------

    To make clear that the Commissions are applying the prior guidance 
and rules to Title VII instruments, the Commissions are adopting rules 
to further define the term ``narrow-based security index'' in the 
security-based swap definition. Under paragraph (1) of rule 1.3(yyy) 
under the CEA and paragraph (a) of rule 3a68-3 under the Exchange Act, 
for purposes of the security-based swap definition, the term ``narrow-
based security index'' has the same meaning as the statutory definition 
set forth in section 1a(35) of the CEA and section 3(a)(55) of the 
Exchange Act,\745\ and the rules, regulations, and orders issued by the 
Commissions relating to such definition. As a result, except as the 
rules the Commissions are adopting provide for other treatment with 
respect to index CDS as discussed below,\746\ market participants 
generally may use the Commissions' past guidance in determining whether 
certain Title VII instruments based on a security index are swaps or 
security-based swaps.
---------------------------------------------------------------------------

    \745\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).
    \746\ See infra part III.G.3.
---------------------------------------------------------------------------

    The Commissions also are providing an interpretation and adopting 
additional rules establishing criteria for indexes composed of 
securities, loans, or issuers of securities referenced by an

[[Page 48273]]

index CDS.\747\ The interpretation and rules also address the 
definition of an ``index'' \748\ and the treatment of broad-based 
security indexes that become narrow-based and narrow-based indexes that 
become broad-based, including rule provisions regarding tolerance and 
grace periods for swaps on security indexes that are traded on CFTC-
regulated trading platforms and security-based swaps on security 
indexes that are traded on SEC-regulated trading platforms.\749\ These 
rules and interpretation are discussed below.
---------------------------------------------------------------------------

    \747\ Id.
    \748\ See infra part III.G.4.
    \749\ See infra part III.G.5.
---------------------------------------------------------------------------

3. Narrow-Based Security Index Criteria for Index Credit Default Swaps
(a) In General
    The Commissions provided an interpretation in the Proposing Release 
regarding the narrow-based security index criteria for index CDS and 
are restating it without modification.\750\ While the Commissions 
understand that the underlying reference for most cleared CDS is a 
single entity or an index of entities rather than a single security or 
an index of securities, the underlying reference for CDS also could be 
a single security or an index of securities.\751\ A CDS where the 
underlying reference is a single entity (i.e., a single-name CDS), a 
single obligation of a single entity (e.g., a CDS on a specific bond, 
loan, or asset-backed security, or any tranche or series of any bond, 
loan, or asset-backed security), or an index CDS where the underlying 
reference is a narrow-based security index or the issuers of securities 
in a narrow-based security index is a security-based swap. An index CDS 
where the underlying reference is not a narrow-based security index or 
the issuers of securities in a narrow-based security index (i.e., a 
broad-based index) is a swap.\752\
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    \750\ See Proposing Release at 29847-48.
    \751\ See, e.g., Markit, ``Markit CDX'' (describing the Markit 
CDX indexes and the number of ``names'' included in each index), 
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page; Markit, ``Markit iTraxx Indices,'' 
(stating that the ``Markit iTraxx indices are comprised of the most 
liquid names in the European and Asian markets'') (emphasis added), 
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/itraxx/itraxx.page . Examples of indexes based on 
securities include the Markit ABX.HE and CMBX indexes. See Markit, 
``Markit ABX.HE,'' (describing the Markit ABX.HE index as ``a 
synthetic tradeable index referencing a basket of 20 subprime 
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx.page; 
and Markit, ``Markit CMBX,'' (describing the Markit CMBX index as 
``a synthetic tradeable index referencing a basket of 25 commercial 
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/cmbx/cmbx.page.
    \752\ Similarly, an option to enter into a single-name CDS or a 
CDS referencing a narrow-based security index as described above 
would be a security-based swap, while an option to enter into a CDS 
on a broad-based security index or the issuers of securities in a 
broad-based security index would be a swap. Index CDS where the 
underlying reference is a broad-based security index would be SBSAs. 
The SEC has enforcement authority with respect to swaps that are 
SBSAs, as discussed further in section V., infra.
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    The statutory definition of the term ``narrow-based security 
index,'' as explained above, was designed with the U.S. equity markets 
in mind.\753\ Thus, the statutory definition is not necessarily 
appropriate for determining whether an index underlying an index CDS is 
broad or narrow-based. Nor is the guidance that the Commissions have 
previously issued with respect to the narrow-based security index 
definition discussed above necessarily appropriate, because that 
guidance was designed to address and was uniquely tailored to the 
characteristics of volatility indexes and debt security indexes in the 
context of futures. Accordingly, the Commissions are clarifying that 
the guidance that the Commissions have previously issued with respect 
to the narrow-based security index definition discussed above does not 
apply to index CDS. Instead, the Commissions are adopting rules as 
discussed below that include separate criteria for determining whether 
an index underlying an index CDS is a narrow-based security index.
---------------------------------------------------------------------------

    \753\ See July 2006 Debt Index Rules.
---------------------------------------------------------------------------

    The Commissions are further defining the term ``security-based 
swap,'' and the use of the term ``narrow-based security index'' within 
that definition, to modify the criteria applied in the context of index 
CDS in assessing whether the index is a narrow-based security index. 
The third prong of the security-based swap definition includes a Title 
VII instrument based on the occurrence of an event relating to 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.'' \754\ The first 
prong of the security-based swap definition includes a Title VII 
instrument that is based on a narrow-based security-index.\755\ Because 
the third prong of the security-based swap definition relates to 
issuers of securities, while the first prong of such definition relates 
to securities, the Commissions are further defining both the term 
``narrow-based security index'' and the term ``issuers of securities in 
a narrow-based security index'' in the context of the security-based 
swap definition as applied to index CDS. The Commissions believe it is 
important to further define both terms in order to assure consistent 
analysis of index CDS.\756\ While the wording of the two definitions as 
adopted differs slightly, the Commissions expect that they will yield 
the same substantive results in distinguishing narrow-based and broad-
based index CDS.\757\
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    \754\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15 
U.S.C. 78c(a)(68)(A)(ii)(III).
    \755\ Section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(A)(ii)(I).
    \756\ Because they apply only with respect to index CDS, the 
definitions of ``issuers of securities in a narrow-based security 
index'' and ``narrow-based security index'' as adopted do not apply 
with respect to other types of event contracts, whether analyzed 
under the first or third prong.
    \757\ For example, if the reference entities included in one 
index are the same as the issuers of securities included in another 
index, application of the two definitions should result in both 
indexes being either broad-based or narrow-based.
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(b) Rules Regarding the Definitions of ``Issuers of Securities in a 
Narrow-Based Security Index'' and ``Narrow-Based Security Index'' for 
Index Credit Default Swaps
    The Commissions proposed rules to further define the terms 
``issuers of securities in a narrow-based security index'' and 
``narrow-based security index'' in order to provide appropriate 
criteria for determining whether an index composed of issuers of 
securities referenced by an index CDS and an index composed of 
securities referenced by an index CDS are narrow-based security 
indexes.\758\ The Commissions are adopting rules 1.3(zzz) and 1.3(aaaa) 
under the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act as 
proposed with certain modifications.\759\
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    \758\ See Proposing Release at 29848.
    \759\ The discussion throughout this section refers to 
``reference entities'' and ``issuers'' in discussing the final 
rules. The term ``reference entity'' is defined in paragraph (c)(3) 
of rule 1.3(zzz) under the CEA and rule 3a68-1a under the Exchange 
Act and the term ``issuer'' is defined in paragraph (c)(3) of rule 
1.3(aaaa) under the CEA and rule 3a68-1b under the Exchange Act. The 
final rules provide that the term ``reference entity'' includes: (i) 
An issuer of securities; (ii) an issuer of securities that is an 
issuing entity of asset-backed securities is a reference entity or 
issuer, as applicable; and (iii) an issuer of securities that is a 
borrower with respect to any loan identified in an index of 
borrowers or loans is a reference entity. The final rules provide 
that the term ``issuer'' includes: (i) An issuer of securities; and 
(ii) an issuer of securities that is an issuing entity of asset-
backed securities is a reference entity or issuer, as applicable. 
See paragraph (c)(3) of rules 1.3(zzz) and 1.3(aaaa) under the CEA 
and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------

    In formulating the criteria in the final rules, and consistent with 
the guidance and rules the Commissions have

[[Page 48274]]

previously issued and adopted regarding narrow-based security indexes 
in the context of security futures, the Commissions believe that there 
should be public information available about a predominant percentage 
of the reference entities included in the index, or, in the case of an 
index CDS on an index of securities, about the issuers of the 
securities or the securities underlying the index, in order to reduce 
the likelihood that non-narrow-based indexes referenced in index CDS or 
the component securities or issuers of securities in that index would 
be readily susceptible to manipulation, as well as to help prevent the 
misuse of material non-public information through the use of CDS based 
on such indexes.
    To satisfy these objectives, the Commissions are adopting rules 
that are based on the criteria developed for debt indexes discussed 
above \760\ but that tailor these criteria to address index CDS.\761\ 
These criteria are included solely for the purpose of defining the 
terms ``narrow-based security index'' and ``issuers of securities in a 
narrow-based security index'' in the first and third prongs of the 
security-based swap definition with respect to index CDS and will not 
affect any other interpretation or use of the term ``narrow-based 
security index'' or any other provision of the Dodd-Frank Act, the CEA, 
or the Exchange Act.
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    \760\ See discussion of July 2006 Debt Index Rules.
    \761\ The Commissions note that the language of the rules is 
intended, in general, to be consistent with the criteria developed 
for debt indexes discussed above. Certain changes from the criteria 
developed for debt indexes are necessary to address differences 
between futures on debt indexes and index CDS. Certain other changes 
are necessary because the rules for debt indexes define under what 
conditions an index is not a narrow-based security index, whereas 
the rules for index CDS define what is a narrow-based security 
index. For example, an index is not a narrow-based security index 
under the rule for debt indexes if it is not a narrow-based security 
index under either subparagraph (a)(1) or paragraph (a)(2) of the 
rule. See July 2006 Debt Index Rules. Under the rules for index CDS, 
however, an index is a narrow-based security index if it meets the 
requirements of both of the counterpart paragraphs in the rules 
regarding index CDS (paragraphs (1)(i) and (1)(ii) of rules 1.3(zzz) 
and 1.3(aaaa) under the CEA and paragraph (a)(1) and paragraph 
(a)(2) of rules 3a68-1a and 3a68-1b under the Exchange Act), even 
though the criteria in the debt index rules and the rules for index 
CDS include generally the same criteria and structure.
---------------------------------------------------------------------------

    Further, in response to commenters,\762\ the Commissions are 
clarifying that if an index CDS is based on an index of loans that are 
not securities,\763\ an event relating to a loan in the index, such as 
a default on a loan, is an event ``relating to'' the borrower.\764\ To 
the extent that the borrower is an issuer of securities, the index CDS 
based on such index of loans will be analyzed under the third prong of 
the security-based swap definition in the same manner as any other 
index CDS.
---------------------------------------------------------------------------

    \762\ See infra note 768 and accompanying text.
    \763\ If the loans underlying the index of loans are securities, 
the index CDS would be analyzed in the same manner as any other 
index CDS based on an index of securities.
    \764\ An index CDS referencing loans also may be based on events 
relating to the borrower, such as bankruptcy, and to defaults on any 
obligation of the borrower.
---------------------------------------------------------------------------

Comments
    The Commissions received two general comments requesting that the 
proposed rules further defining the terms ``issuers of securities in a 
narrow-based security index'' and ``narrow-based security index'' be 
simplified.\765\ One commenter believed that the rules were exceedingly 
complicated.\766\ Another commenter thought that the criteria should 
allow transactions to be readily and transparently classifiable as a 
swap or security-based swap.\767\ The commenters did not provide 
analysis supporting their comments or recommend language changes.
---------------------------------------------------------------------------

    \765\ See ISDA Letter and MarketAxess Letter.
    \766\ See MarketAxess Letter. This commenter stated that ``The 
Proposed Rules layout an exceedingly complex process for determining 
whether an index CDS is broad-based or narrow-based.'' Id.
    \767\ See ISDA Letter.
---------------------------------------------------------------------------

    The Commissions are adopting the rules regarding index CDS 
essentially as proposed with certain modifications to address 
commenters' concerns. While the final rules contain a number of 
elements that are similar or identical to elements contained in the 
statutory narrow-based security index definition, in order to enable 
the narrow-based security index definition to apply appropriately to 
index CDS, the final rules contain some alternative tests to those set 
forth in the statutory definition.
    The Commissions also recognize the diversity of Title VII 
instruments. While the final rules for index CDS are based on the July 
2006 Debt Index Rules, the substantive differences between the final 
rules in the index CDS and the equity or debt security contexts are 
intended to reflect the particular characteristics of the CDS 
marketplace, in which, for example, index components may be entities 
(issuers of securities) as well as specific equity and debt securities.
    The Commissions also received three comments requesting 
clarification regarding the applicability of the index CDS rules to CDS 
based on indexes of loans.\768\ One commenter noted that the 
Commissions did not address in the Proposing Release the question of 
whether an index composed exclusively of loans should be treated as a 
narrow-based security index.\769\ This commenter noted that because the 
first and third prongs of the statutory security-based swap definition 
do not explicitly reference loans, the statutory definition does not 
expressly categorize Title VII instruments based on more than one loan, 
or contingent on events that occur with respect to more than one loan 
borrower, unless such borrowers are also ``issuers of securities.'' 
\770\ Based on this commenter's view of the statutory definition, this 
commenter requested that the Commissions clarify the treatment of 
indexes composed exclusively of loans.\771\ Another commenter provided 
similar comments and also requested clarification regarding the 
treatment of CDS based on indexes of loans.\772\ A third commenter 
stated its view that the third prong of the statutory security-based 
swap definition implies that Title VII instruments on a basket of loans 
are security-based swaps if the lenders would satisfy the criteria for 
issuers of a ``narrow-based security index'' and encouraged the 
Commissions to clarify this issue.\773\ The Commissions agree with 
commenters that an index CDS based on an index of loans that are not 
securities is analyzed under the third prong of the statutory security-
based swap definition and, therefore, are clarifying the treatment of 
these Title VII instruments above.\774\
---------------------------------------------------------------------------

    \768\ See Allen & Overy Letter; July LSTA Letter; and SIFMA 
Letter.
    \769\ See Allen & Overy Letter.
    \770\ Id.
    \771\ Id.
    \772\ See July LSTA Letter. This commenter noted that prong 
(III) of the statutory security-based swap definition does not 
clearly reference borrowers of loans or indexes of borrowers. 
However, this commenter noted that because most borrowers that are 
named as reference entities in loan CDS transactions are corporate 
entities that issue equity interests to one or more shareholders 
(although they may not issue public securities or become subject to 
public reporting requirements), this commenter believes that prong 
(III) can be interpreted to include swaps that reference a single 
borrower or borrowers of loans in an index. Id.
    \773\ See SIFMA Letter.
    \774\ The Commissions also are providing guidance with respect 
to TRS based on two or more loans that are not securities. See supra 
part III.C.
---------------------------------------------------------------------------

(i) Number and Concentration Percentages of Reference Entities or 
Securities
    The Commissions believe that the first three criteria of the debt 
security index test (which are based on the statutory narrow-based 
security index definition) discussed above (i.e., the number and 
concentration weighting requirements) are appropriate to apply to index 
CDS,

[[Page 48275]]

whether CDS on indexes of securities or indexes of issuers of 
securities.\775\ Accordingly, the Commissions are adopting the first 
three criteria of rule 1.3(zzz) under the CEA and rule 3a68-1a under 
the Exchange Act as proposed with certain modifications in response to 
commenters' concerns.\776\ These rules contain the same number and 
concentration criteria as proposed, but modify the method of 
calculating affiliation among issuers and reference entities in 
response to commenters.\777\ Further, in response to commenters,\778\ 
the Commissions are providing an additional interpretation with respect 
to the application of these criteria to two particular types of CDS, 
commonly known as ``nth-to-default CDS'' and ``tranched CDS.''
---------------------------------------------------------------------------

    \775\ See infra notes 792 and 793 and accompanying text.
    \776\ See paragraphs (a)(1)(i)-(iii) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rules 3a68-1a and 3a68-1b under the 
Exchange Act.
    \777\ See infra note 804 and accompanying text.
    \778\ See infra notes 795 and 796 and accompanying text.
---------------------------------------------------------------------------

    The first three criteria provide that, for purposes of determining 
whether an index CDS is a security-based swap under section 
3(a)(68)(A)(ii)(III) of the Exchange Act,\779\ the term ``issuers of 
securities in a narrow-based security index'' includes issuers of 
securities identified in an index (including an index referencing loan 
borrowers) in which:
---------------------------------------------------------------------------

    \779\ 15 U.S.C. 78c(a)(68)(A)(ii)(III).
---------------------------------------------------------------------------

     Number: There are nine or fewer non-affiliated issuers of 
securities that are reference entities included in the index, provided 
that an issuer of securities shall not be deemed a reference entity 
included in the index unless (i) a credit event with respect to such 
reference entity would result in a payment by the credit protection 
seller to the credit protection buyer under the index CDS based on the 
related notional amount allocated to such reference entity; or (ii) the 
fact of such credit event or the calculation in accordance with clause 
(i) above of the amount owed with respect to such credit event is taken 
into account in determining whether to make any future payments under 
the index CDS with respect to any future credit events;
     Single Component Concentration: The effective notional 
amount allocated to any reference entity included in the index 
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective 
notional amount allocated to any five non-affiliated reference entities 
included in the index comprises more than 60 percent of the index's 
weighting.\780\
---------------------------------------------------------------------------

    \780\ These rules refer to the ``effective notional amount'' 
allocated to reference entities or securities in order to address 
potential situations in which the means of calculating payout across 
the reference entities or securities is not uniform. Thus, if one or 
more payouts is leveraged or enhanced by the structure of the 
transaction (i.e., 2x recovery rate), that amount would be the 
``effective notional amount'' for purposes of the 30 percent and 60 
percent tests in paragraphs (1)(i)(B) and (1)(i)(C) of rules 
1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) and (a)(1)(iii) of 
rules 3a68-1a and 3a68-1b. Similarly, if the aggregate notional 
amount under a CDS is not uniformly allocated to each reference 
entity or security, then the portion of the notional amount 
allocated to each reference entity or security (which may be by 
reference to the product of the aggregate notional amount and an 
applicable percentage) would be the ``effective notional amount.''
---------------------------------------------------------------------------

    Similarly, the Commissions are adopting as proposed the first three 
criteria of rule 1.3(aaaa) under the CEA and rule 3a68-1b under the 
Exchange Act. These three criteria provide that, for purposes of 
determining whether an index CDS is a security-based swap under section 
3(a)(68)(A)(ii)(I) of the Exchange Act,\781\ the term ``narrow-based 
security index'' includes an index in which essentially the same 
criteria apply, substituting securities for issuers. Under these 
criteria, the term ``narrow-based security index'' would mean an index 
in which:
---------------------------------------------------------------------------

    \781\ 15 U.S.C. 78c(a)(68)(A)(ii)(I).
---------------------------------------------------------------------------

     Number: There are nine or fewer securities, or securities 
that are issued by nine or fewer non-affiliated issuers, included in 
the index, provided that a security shall not be deemed a component of 
the index unless (i) a credit event with respect to the issuer of such 
security or a credit event with respect to such security would result 
in a payment by the credit protection seller to the credit protection 
buyer under the index CDS based on the related notional amount 
allocated to such security, or (ii) the fact of such credit event or 
the calculation in accordance with clause (i) above of the amount owed 
with respect to such credit event is taken into account in determining 
whether to make any future payments under the index CDS with respect to 
any future credit events;
     Single Component Concentration: The effective notional 
amount allocated to the securities of any issuer included in the index 
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective 
notional amount allocated to the securities of any five non-affiliated 
issuers included in the index comprises more than 60 percent of the 
index's weighting.
    Thus, the applicability of the final rules depends on conditions 
relating to the number of non-affiliated reference entities or issuers 
of securities, or securities issued by non-affiliated issuers, as 
applicable, included in an index and the weighting of notional amounts 
allocated to the reference entities or securities included in the 
index, as applicable. These first three criteria of the final rules 
evaluate the number and concentration of the reference entities or 
securities included in the index, as applicable, and ensure that an 
index with a small number of reference entities, issuers, or securities 
or concentrated in only a few reference entities, issuers, or 
securities is narrow-based, and thus where such index is the underlying 
reference of an index CDS, the index CDS is a security-based swap. 
Further, as more fully described below,\782\ the final rules provide 
that a reference entity or issuer of securities included in an index 
and any of that reference entity's or issuer's affiliated entities (as 
defined in the final rules) that also are included in the index are 
aggregated for purposes of determining whether the number and 
concentration criteria are met.
---------------------------------------------------------------------------

    \782\ See infra part III.G.3(b)(ii), for a discussion of the 
affiliation definition applicable to calculating the number and 
concentration criteria. As noted above, the Commissions are 
modifying the method of calculating affiliation for purposes of 
these criteria.
---------------------------------------------------------------------------

    Specifically, the final rules provide that an index meeting any one 
of certain identified conditions would be a narrow-based security 
index. The first condition in paragraph (1)(i)(A) of rule 1.3(zzz) 
under the CEA and paragraph (a)(1)(i) of rule 3a68-1a under the 
Exchange Act is that there are nine or fewer non-affiliated issuers of 
securities that are reference entities in the index. An issuer of 
securities counts toward this total only if a credit event with respect 
to such entity would result in a payment by the credit protection 
seller to the credit protection buyer under the index CDS based on the 
notional amount allocated to such entity, or if the fact of such a 
credit event or the calculation of the payment with respect to such 
credit event is taken into account when determining whether to make any 
future payments under the index CDS with respect to any future credit 
events.
    Similarly, the first condition in paragraph (1)(i)(A) of rule 
1.3(aaaa) under the CEA and paragraph (a)(1)(i) of rule 3a68-1b under 
the Exchange Act provides that a security counts toward the total 
number of securities in the index only if a credit event with respect 
to such security, or the issuer of such security, would result in a 
payment by the credit protection seller to the credit

[[Page 48276]]

protection buyer under the index CDS based on the notional amount 
allocated to such security, or if the fact of such a credit event or 
the calculation of the payment with respect to such credit event is 
taken into account when determining whether to make any future payments 
under the index CDS with respect to any future credit events.
    These provisions are intended to ensure that an index concentrated 
in a few reference entities or securities, or a few reference entities 
that are affiliated (as defined in the final rules) or a few securities 
issued by issuers that are affiliated, are within the narrow-based 
security index definition.\783\ These provisions also are intended to 
ensure that an entity is not counted as a reference entity included in 
the index, and a security is not counted as a security included in the 
index, unless a credit event with respect to the entity, issuer, or 
security affects payout under a CDS on the index.\784\
---------------------------------------------------------------------------

    \783\ This requirement is generally consistent with the 
definition of ``narrow-based security index'' in section 1a(35)(A) 
of the CEA, 7 U.S.C. 1a(35)(A), and section 3(a)(55)(B) of the 
Exchange Act, 15 U.S.C. 78c(a)(55)(B), and the July 2006 Debt Index 
Rules.
    \784\ Id.
---------------------------------------------------------------------------

    Further, as this condition is in the alternative (i.e., either 
there must be a credit event resulting in a payment under the index CDS 
or a credit event is considered in determining future CDS payments), 
the tests encompass all index CDS. For example, and in response to a 
commenter,\785\ the test would cover an nth-to-default CDS,\786\ in 
which default with respect to a specified component of an index (such 
as the first default or fifth default) triggers the CDS payment, even 
if the CDS payment is not made with respect to such particular credit 
event. As another example, and in response to another commenter,\787\ 
the test applies to a tranched CDS \788\ if the payments are made on 
only a tranche, or portion, of the potential aggregate notional amount 
of the CDS (often expressed as a percentage range of the total notional 
amount of the CDS) because the CDS payment takes into account a credit 
event with respect to an index component, even if the credit event 
itself does not result in such a payment.
---------------------------------------------------------------------------

    \785\ See infra note 795 and accompanying text.
    \786\ An ``nth-to-default CDS'' is a CDS in which the payout is 
linked to one in a series of defaults (such as first-, second- or 
third-to-default), with the contract terminating at that point. See 
SIFMA Letter.
    \787\ See infra note 796 and accompanying text.
    \788\ A ``tranched CDS'' is a CDS in which the counterparties 
agree to buy and sell credit protection on only a portion of the 
potential losses that could occur on an underlying portfolio of 
reference entities. The portion is typically denoted as a specified 
percentage range of aggregate losses (e.g., 2 percent to 5 percent, 
meaning the credit protection seller would not make payments until 
aggregate losses exceed 2 percent of the notional of the 
transaction, and would no longer be obligated to make payments after 
aggregate losses reach 5 percent). See SIFMA Letter.
---------------------------------------------------------------------------

    The second condition, in paragraphs (1)(i)(B) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and paragraphs (a)(1)(ii) of rules 3a68-1a and 
3a68-1b under the Exchange Act, is that the effective notional amount 
allocated to any reference entity or security of any issuer included in 
the index comprises more than 30 percent of the index's weighting.
    The third condition, in paragraphs (1)(i)(C) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and paragraphs (a)(1)(iii) of rules 3a68-1a and 
3a68-1b under the Exchange Act, is that the effective notional amount 
allocated to any five non-affiliated reference entities, or to the 
securities of any five non-affiliated issuers, included in the index 
comprises more than 60 percent of the index's weighting.
    Given that Congress determined that these concentration percentages 
are appropriate to characterize an index as a narrow-based security 
index, and the Commissions have determined they are appropriate for 
debt security indexes in the security futures context,\789\ the 
Commissions believe that these concentration percentages are 
appropriate to apply to the notional amount allocated to reference 
entities and securities in order to apply similar standards to indexes 
that are the underlying references of index CDS. Moreover, with respect 
to both the number and concentration criteria, the markets have had 
experience with these criteria with respect to futures on equity 
indexes, volatility indexes, and debt security indexes.\790\
---------------------------------------------------------------------------

    \789\ See July 2006 Debt Index Rules.
    \790\ As noted above, the Commissions are modifying the method 
of calculating affiliation for purposes of the number and 
concentration criteria. See infra part III.G.3(b)(ii).
---------------------------------------------------------------------------

Comments
    One commenter expressed its view that the Commissions should 
increase the percentage test in the largest five component 
concentration.\791\ The Commissions are adopting the number and 
concentration criteria as proposed. The statutory definition of the 
term ``security-based swap'' references the definition of the term 
``narrow-based security index'' contained in the Exchange Act and the 
CEA,\792\ which includes the same number and concentration percentages 
as the Commissions are adopting in this release. The Commissions are 
not modifying the statutory definition to change the percentages. The 
statutory definition included the concentration percentages, which the 
Commissions understand are intended to assure that a security index 
could not be used as a surrogate for the underlying securities in order 
to avoid application of the Federal securities laws. The Commissions 
also previously determined to retain these statutory percentages in 
connection with rules relating to debt security indexes in the security 
futures context.\793\ The Commissions believe that these percentages 
are similarly appropriate to apply to indexes on which index CDS are 
based. Moreover, with respect to the number and concentration criteria, 
as these are in the statutory definition of the term ``narrow-based 
security index'' applicable to security futures, market participants 
have experience in analyzing indexes, including equity, volatility and 
debt security indexes, to determine compliance with these criteria. As 
discussed below,\794\ though, the Commissions are modifying the 
affiliation definition used in analyzing the number and concentration 
criteria for an index.
---------------------------------------------------------------------------

    \791\ See ISDA Letter. According to this commenter, the 
``operational complexity'' of the number and concentration criteria 
will increase costs and compliance risks. Id.
    \792\ See 15 U.S.C. 78c(a)(55)(B) and 7 U.S.C. 1a(35).
    \793\ See July 2006 Debt Index Rules.
    \794\ See infra part III.G.3(b)(ii).
---------------------------------------------------------------------------

    Two commenters requested clarification regarding nth-to-default 
CDS, stating their view that such CDS should be treated as security-
based swaps to reflect their single-entity triggers.\795\ Two 
commenters requested clarification regarding tranched index CDS, 
including whether the CDS would be classified based on the underlying 
index.\796\ As discussed above, the Commissions are providing an 
interpretation on the applicability of the first three criteria of the 
rules to nth-to-default CDS and tranched CDS. As noted above, the 
Commissions believe the rules encompass all index CDS, regardless of 
the type or payment

[[Page 48277]]

structure, such as whether there is a single-entity payment based on 
credit events of other index components or whether the payment is based 
on a specific entity.
---------------------------------------------------------------------------

    \795\ See ISDA Letter and SIFMA Letter. One of these commenters 
noted that such an approach also made sense for nth-to-default CDS 
because they are typically based on baskets of less than 10 
securities. See ISDA Letter.
    \796\ See Markit Letter and SIFMA Letter. One of these 
commenters stated that classifying tranches underlying index CDS 
according to attachment or detachment points is not appropriate 
because it is impossible to know for certain at inception of the CDS 
the number of credit events that will ultimately affect actual 
payments, which typically depend on the severity of loss associated 
with each credit event. See SIFMA Letter.
---------------------------------------------------------------------------

(ii) Affiliation of Reference Entities and Issuers of Securities With 
Respect to Number and Concentration Criteria
    The Commissions are adopting the affiliation definition that 
applies when calculating the number and concentration criteria with 
certain modifications from the proposal to address commenters' 
concerns.\797\ The final rules provide that the terms ``reference 
entity included in the index'' and ``issuer of the security included in 
the index'' include a single reference entity or issuer of securities 
included in an index, respectively, or a group of affiliated reference 
entities or issuers included in an index, respectively.\798\ For 
purposes of the rules, affiliated reference entities or issuers of 
securities included in an index or securities included in an index 
issued by affiliated issuers will be counted together for determining 
whether the number and concentration criteria are met. However, with 
respect to asset-backed securities, the final rules provide that each 
reference entity or issuer of securities included in an index that is 
an issuing entity of an asset-backed security is considered a separate 
reference entity or issuer, as applicable, and will not be considered 
affiliated with other reference entities or issuers of securities 
included in the index.
---------------------------------------------------------------------------

    \797\ See infra note 804 and accompanying text.
    \798\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------

    The final rules provide that a reference entity or issuer of 
securities included in an index is affiliated with another reference 
entity or issuer of securities included in the index if it controls, is 
controlled by, or is under common control with, that other reference 
entity or issuer.\799\ The final rules define control, solely for 
purposes of this affiliation definition, to mean ownership of more than 
50 percent of a reference entity's or issuer's equity or the ability to 
direct the voting of more than 50 percent of a reference entity's or 
issuer's voting equity.\800\ The affiliation definition in the final 
rules differs from the definition included in the proposal, which 
provided for a control threshold of 20 percent ownership.\801\ This 
change is based on the Commissions' consideration of comments 
received.\802\ By using a more than 50 percent (i.e., majority 
ownership) test rather than a 20 percent ownership test for the control 
threshold, there is a greater likelihood that there will be an 
alignment of economic interests of the affiliated entities that is 
sufficient to aggregate reference entities or issuers of securities 
included in an index for purposes of the number and concentration 
criteria.\803\
---------------------------------------------------------------------------

    \799\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.
    \800\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.
    \801\ See Proposing Release at 29849.
    \802\ See infra note 804 and accompanying text. The Commissions 
note that another alternative would have been to include a 
requirement that the entities satisfy the 20 percent control 
threshold and also be consolidated with each other in financial 
statements. The Commissions did not include a requirement that the 
entities be consolidated with each other in financial statements 
because they do not believe that the scope of the affiliation 
definition should be exposed to the risk of future changes in 
accounting standards. Further, the use of a majority ownership 
control threshold (more than 50 percent) is generally consistent 
with consolidation under generally accepted accounting principles. 
See FASB ASC section 810-10-25, Consolidation--Overall--Recognition 
(stating that consolidation is appropriate if a reporting entity has 
a controlling financial interest in another entity and a specific 
scope exception does not apply).
    \803\ In such a case, as noted by commenters, the affiliated 
entities are viewed as part of group for which aggregation of these 
entities is appropriate. See infra note 806 and accompanying text.
---------------------------------------------------------------------------

    As the affiliation definition is applied to the number criterion, 
affiliated reference entities or issuers of securities included in an 
index will be viewed as a single reference entity or issuer of 
securities to determine whether there are nine or fewer non-affiliated 
reference entities included in the index or securities that are issued 
by nine or fewer non-affiliated issuers. Similarly, as the affiliation 
definition is applied to the concentration criteria, the notional 
amounts allocated to affiliated reference entities included in an index 
or the securities issued by a group of affiliated issuers of securities 
included in an index must be aggregated to determine the level of 
concentration of the components of the index for purposes of the 30-
percent and 60-percent concentration criteria.
Comments
    Three commenters requested that the Commissions revise the 
affiliation definition that applies when calculating the number and 
concentration criteria to increase the control threshold from 20 
percent ownership to majority ownership.\804\ These commenters noted 
that majority ownership is consistent with current market practice, 
including the definition of affiliate included in the 2003 ISDA Credit 
Derivatives Definitions.\805\ One commenter also stated its belief that 
affiliated entities should only be aggregated where the reference 
entities' credit risks are substantially similar and credit decisions 
are made by the same group of individuals.\806\ This commenter stated 
its view that 20 percent ownership is too low and that majority 
ownership is necessary for credit risk and credit decisions to be 
aligned enough as to warrant collapsing two issuers into one for 
purposes of the number and concentration criteria.\807\
---------------------------------------------------------------------------

    \804\ See ISDA Letter (requesting a threshold of at least 50 
percent); Markit Letter (requesting a threshold of at least 50 
percent); and SIFMA Letter (requesting a threshold of majority 
ownership, or 51 percent). One commenter also requested that the 
Commissions clarify the application of the affiliation definition. 
See Markit Letter. The Commissions have provided above and in infra 
part III.G.3(b)(ii), several examples illustrating the application 
of the affiliation definition in response to this commenter.
    \805\ Id.
    \806\ See SIFMA Letter. The ISDA Letter provides a similar 
rationale that ``the control threshold was too low and potentially 
disruptive when viewed against entities that the swap markets now 
trade as separate entities. In the CDS market, for example, entities 
that share ownership ties of substantially more than 20 percent 
trade quite independently. These entities may have completely 
disparate characteristics for the purpose of an index grouping of 
one sort or another.'' See ISDA Letter.
    \807\ See SIFMA Letter.
---------------------------------------------------------------------------

    As stated above, the Commissions are modifying the affiliation 
definition that applies when calculating the number and concentration 
criteria in response to commenters to use an affiliation test based on 
majority ownership. Based on commenters' letters, the Commissions 
understand that the current standard CDS documentation and the current 
approach used by certain index providers for index CDS with respect to 
the inclusion of affiliated entities in the same index use majority 
ownership rather than 20 percent ownership to determine affiliation. 
The Commissions are persuaded by commenters that, in the case of index 
CDS only it is more appropriate to use majority ownership because 
majority-owned entities are more likely to have their economic 
interests aligned and be viewed by the market as part of a group. The 
Commissions believe that revising the affiliation definition in this 
manner for purposes of calculating the number and concentration 
criteria responds to commenters' concerns that the percentage control 
threshold may inadvertently include entities that are not viewed as 
part of a group. Thus, as revised, the affiliation definition will 
include only those reference entities or issuers included in an index 
that satisfy the more than 50 percent (i.e., majority ownership) 
control threshold. The

[[Page 48278]]

Commissions believe that determining affiliation in this manner for 
purposes of calculating the number and concentration criteria responds 
to the commenters' concerns.
    The Commissions also believe that the modified affiliation 
definition addresses commenters' concerns noted above \808\ that the 
rules further defining the terms ``issuers of securities in a narrow-
based security index'' and ``narrow-based security index'' should be 
simplified. The modified affiliation definition enables market 
participants to make an affiliation determination for purposes of 
calculating the number and concentration criteria by measuring the more 
than 50 percent (i.e., majority ownership) control threshold.
---------------------------------------------------------------------------

    \808\ See supra note 765 and accompanying text.
---------------------------------------------------------------------------

(iii) Public Information Availability Regarding Reference Entities and 
Securities
    In addition to the number and concentration criteria, the debt 
security index test also includes, as discussed above, a public 
information availability test. The public information availability test 
is intended as the substitute for the average daily trading volume 
(``ADTV'') provision in the statutory narrow-based security index 
definition. An ADTV test is designed to take into account the trading 
of individual stocks and, because Exchange Act registration of the 
security being traded is a listing standard for equity securities, the 
issuer of the security being traded must be subject to the reporting 
requirements under the Exchange Act. Based on the provisions of the 
statutory ADTV test, the Commissions have determined that the ADTV test 
is not useful for purposes of determining the status of the index on 
which the index CDS is based because index CDS most commonly reference 
entities, which do not ``trade,'' or debt instruments, which commonly 
are not listed, and, therefore, do not have a significant trading 
volume. However, the underlying rationale of such provision, that there 
is sufficient trading in the securities and therefore public 
information and market following of the issuer of the securities, 
applies to index CDS.
    In general, if an index is not narrow-based under the number and 
concentration criteria, it will be narrow-based if one of the reference 
entities or securities included in the index fails to meet at least one 
of the criteria in the public information availability test. This test 
was designed to reduce the likelihood that broad-based debt security 
indexes or the component securities or issuers of securities in that 
index would be readily susceptible to manipulation. The fourth 
condition in the index CDS rules sets out a similar public information 
availability test that is intended solely for purposes of determining 
whether an index underlying a CDS is narrow-based.\809\ The Commissions 
are adopting the public information availability test essentially as 
proposed with certain modifications to address commenters' concerns, 
including modifications to the definition of affiliation for purposes 
of satisfying certain criteria of the public information availability 
test.\810\
---------------------------------------------------------------------------

    \809\ See Proposing Release at 29850.
    \810\ See infra notes 845, 847, 849 and 867 and accompanying 
text.
---------------------------------------------------------------------------

    The Commissions are adopting final rules under which an index CDS 
will be considered narrow-based (except as discussed below) if a 
reference entity or security included in the index does not meet any of 
the following criteria: \811\
---------------------------------------------------------------------------

    \811\ See paragraphs (a)(1)(iv)(A)-(G) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
---------------------------------------------------------------------------

     The reference entity or the issuer of the security 
included in the index is required to file reports pursuant to the 
Exchange Act or the regulations thereunder;
     The reference entity or the issuer of the security 
included in the index is eligible to rely on the exemption provided in 
rule 12g3-2(b) under the Exchange Act; \812\
---------------------------------------------------------------------------

    \812\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------

     The reference entity or the issuer of the security 
included in the index has a worldwide market value of its outstanding 
common equity held by non-affiliates of $700 million or more; \813\
---------------------------------------------------------------------------

    \813\ See July 2006 Debt Index Rules (noting that issuers having 
worldwide equity market capitalization of $700 million or more are 
likely to have public information available about them).
---------------------------------------------------------------------------

     The reference entity or the issuer of the security 
included in the index (other than a reference entity or an issuer of 
the security included in the index that is an issuing entity of an 
asset-backed security as defined in section 3(a)(77) of the Exchange 
Act \814\) has outstanding notes, bonds, debentures, loans, or 
evidences of indebtedness (other than revolving credit facilities) 
having a total remaining principal amount of at least $1 billion; \815\
---------------------------------------------------------------------------

    \814\ 15 U.S.C. 78c(a)(77).
    \815\ See July 2006 Debt Index Rules (noting that issuers having 
at least $1 billion in outstanding debt are likely to have public 
information available about them).
---------------------------------------------------------------------------

     The reference entity included in the index is an issuer of 
an exempted security, or the security included in the index is an 
exempted security, each as defined in section 3(a)(12) of the Exchange 
Act \816\ and the rules promulgated thereunder (except a municipal 
security);
---------------------------------------------------------------------------

    \816\ 15 U.S.C. 78c(a)12.
---------------------------------------------------------------------------

     The reference entity or the issuer of the security 
included in the index is a government of a foreign country or a 
political subdivision of a foreign country; or
     If the reference entity or the issuer of the security 
included in the index is an issuing entity of asset-backed securities 
as defined in section 3(a)(77) of the Exchange Act,\817\ such asset-
backed security was issued in a transaction registered under the 
Securities Act and has publicly available distribution reports.
---------------------------------------------------------------------------

    \817\ 15 U.S.C. 78c(a)(77).
---------------------------------------------------------------------------

    However, so long as the effective notional amounts allocated to 
reference entities or securities included in the index that satisfy the 
public information availability test comprise at least 80 percent of 
the index's weighting, failure by a reference entity or security 
included in the index to satisfy the public information availability 
test will be disregarded if the effective notional amounts allocated to 
that reference entity or security comprise less than five percent of 
the index's weighting.\818\ In this situation, the public information 
availability test for purposes of the index would be satisfied.
---------------------------------------------------------------------------

    \818\ See paragraph (b) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------

    The determination as to whether an index CDS is narrow-based is 
conditioned on the likelihood that information about a predominant 
percentage of the reference entities or securities included in the 
index is publicly available.\819\ For example, a reference entity or an 
issuer of securities

[[Page 48279]]

included in the index that is required to file reports pursuant to the 
Exchange Act or the regulations thereunder makes regular and public 
disclosure through those filings. Moreover, a reference entity or an 
issuer of securities included in the index that does not file reports 
with the SEC but that is eligible to rely on the exemption in rule 
12g3-2(b) under the Exchange Act (i.e., foreign private issuers) is 
required to make certain types of financial information publicly 
available in English on its Web site or through an electronic 
information delivery system generally available to the public in its 
primary trading markets.\820\
---------------------------------------------------------------------------

    \819\ Most of the thresholds in the public information 
availability test are similar to those the Commissions adopted in 
their joint rules regarding the application of the definition of the 
term ``narrow-based security index'' to debt security indexes and 
security futures on debt securities. See July 2006 Debt Index Rules. 
The July 2006 Debt Index Rules also included an additional 
requirement regarding the minimum principal amount outstanding for 
each security in the index. The Commissions have not included this 
requirement in rule 1.3(zzz) under the CEA and rule 3a68-1a under 
the Exchange Act. That requirement was intended as a substitute 
criterion for trading volume because the trading volume of debt 
securities with a principal amount outstanding above that minimum 
amount was found to be generally larger than debt securities with a 
principal amount outstanding below that minimum amount. See July 
2006 Debt Index Release. There is no similar criterion that would be 
applicable in the context of index CDS. The numerical thresholds 
also are similar to those the SEC adopted in other contexts, 
including in the existing definitions of ``well-known seasoned 
issuer'' and ``large accelerated filer.'' See rule 405 under the 
Securities Act, 17 CFR 230.405, and rule 12b-2 under the Exchange 
Act, 17 CFR 240.12b-2.
    \820\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------

    The Commissions believe that other reference entities or issuers of 
securities included in the index that do not file reports with the SEC, 
but that have worldwide equity market capitalization of $700 million or 
more, have at least $1 billion in outstanding debt obligations (other 
than in the case of issuing entities of asset-backed securities), issue 
exempted securities (other than municipal securities), or are foreign 
sovereign entities either are required to or are otherwise sufficiently 
likely, solely for purposes of the ``narrow-based security-index'' and 
``issuers of securities in a narrow-based security index'' definitions, 
to have public information available about them.\821\
---------------------------------------------------------------------------

    \821\ It is important to note that the public information 
availability test is designed solely for purposes of distinguishing 
between index CDS that are swaps and index CDS that are security-
based swaps. The proposed criteria are not intended to provide any 
assurance that there is any particular level of information actually 
available regarding a particular reference entity or issuer of 
securities. Meeting one or more of the criteria for the limited 
purpose here--defining the terms ``narrow-based security index'' and 
``issuers of securities in a narrow-based security index'' in the 
first and third prongs of the security-based swap definition with 
respect to index CDS--would not substitute for or satisfy any other 
requirement for public disclosure of information or public 
availability of information for purposes of the Federal securities 
laws.
---------------------------------------------------------------------------

    In response to commenters,\822\ the Commissions are modifying the 
outstanding debt threshold criterion in the public information 
availability test to include any indebtedness, including loans, so long 
as such indebtedness is not a revolving credit facility. The 
Commissions believe that expanding the definition of indebtedness to 
include loans (other than revolving credit) for purposes of the debt 
threshold determination is consistent with the view that entities that 
have significant outstanding indebtedness likely will have public 
information available about them.\823\
---------------------------------------------------------------------------

    \822\ See infra note 845 and accompanying text.
    \823\ See July 2006 Debt Index Release.
---------------------------------------------------------------------------

    As more fully described below,\824\ for purposes of satisfying one 
of these issuer eligibility criteria, the final rules provide that a 
reference entity or an issuer of securities included in an index may 
rely upon the status of an affiliated entity as an Exchange Act 
reporting company or foreign private issuer or may aggregate the 
worldwide equity market capitalization or outstanding indebtedness of 
an affiliated entity, regardless of whether such affiliated entity 
itself or its securities are included in the index.
---------------------------------------------------------------------------

    \824\ See infra part III.G.3(b)(iv), for a discussion regarding 
the affiliation definition applicable to the public information 
availability test. As noted above, the Commissions are modifying the 
method of calculating affiliation for purposes of this test.
---------------------------------------------------------------------------

    In the case of indexes including asset-backed securities, or 
reference entities that are issuing entities of asset-backed 
securities, information about the reference entity or issuing entity of 
the asset-backed security will not alone be sufficient and, 
consequently, the rules provide that the public information 
availability test will be satisfied only if certain information also is 
available about the asset-backed securities. An issuing entity (whether 
or not a reference entity) of asset-backed securities will meet the 
public information availability test if such asset-backed securities 
were issued in a transaction for which the asset-backed securities 
issued (which includes all tranches) \825\ were registered under the 
Securities Act and distribution reports about such asset-backed 
securities are publicly available. In response to commenters,\826\ the 
Commissions note that distribution reports, which sometimes are 
referred to as servicer reports, delivered to the trustee or security 
holders, as the case may be, are filed with the SEC on Form 10-D. In 
addition, because of the lack of public information regarding many 
asset-backed securities, despite the size of the outstanding amount of 
securities,\827\ the rules do not permit such reference entities and 
issuers to satisfy the public information availability test by having 
at least $1 billion in outstanding indebtedness. Characterizing an 
index with reference entities or securities for which public 
information is not likely to be available as narrow-based, and thus 
index CDS where the underlying references or securities are such 
indexes as security-based swaps, should help to ensure that the index 
cannot be used to circumvent the Federal securities laws, including 
those relating to Securities Act compliance and the antifraud, 
antimanipulation and insider trading prohibitions with respect to the 
index components or the securities of the reference entities.
---------------------------------------------------------------------------

    \825\ Under this part of the public information availability 
test, all offerings of the asset-backed securities will have to be 
covered by a registration statement under the Securities Act, 
including all tranches, so that public information would exist for 
any tranche included in an index. However, as noted below, CDS that 
are offered to ECPs only may rely on alternatives to satisfy the 
public information test for asset-backed securities.
    \826\ See infra note 849 and accompanying text.
    \827\ See generally Asset-Backed Securities, 75 FR 23328 (May 3, 
2010).
---------------------------------------------------------------------------

    As noted above, if an index is not narrow-based under the number 
and concentration criteria, it will be narrow-based if one of the 
reference entities or securities included in the index fails to meet at 
least one of the criteria in the public information availability test. 
However, even if one or more of the reference entities or securities 
included in the index fail the public information availability test, 
the final rules provide that the index will not be considered ``issuers 
of securities in a narrow-based security index'' or a ``narrow-based 
security index,'' so long as the applicable reference entity or 
security that fails the test represents less than five percent of the 
index's weighting, and so long as reference entities or securities 
comprising at least 80 percent of the index's weighting satisfy the 
public information availability test.
    An index that includes a very small proportion of reference 
entities or securities that do not satisfy the public information 
availability test will be treated as a broad-based security index if 
the other elements of the definition, including the five percent and 80 
percent thresholds, are satisfied prior to execution, but no later than 
when the parties offer to enter into the index CDS.\828\ The five-
percent weighting threshold is designed to provide that reference 
entities or securities not satisfying the public information 
availability test comprise only a very small portion of the index, and 
the 80-percent weighting threshold is designed to provide that a 
predominant percentage of the reference entities or securities in the 
index satisfy the public information availability test. As a result, 
these thresholds provide market participants with flexibility in 
constructing an index. The Commissions believe that these thresholds 
are appropriate and that providing such flexibility is not likely to 
increase the likelihood that an index that satisfies these provisions 
or the component securities or issuers of securities in that index 
would be readily susceptible to manipulation or that there would be 
misuse of material non-public information about the component

[[Page 48280]]

securities or issuers of securities in that index through the use of 
CDS based on such indexes.
---------------------------------------------------------------------------

    \828\ See supra note 625 and accompanying text.
---------------------------------------------------------------------------

    The final rules also provide that, for index CDS entered into 
solely between ECPs, there are alternative means to satisfy the public 
information availability test. Under the final rules, solely for index 
CDS entered into between ECPs, an index will be considered narrow-based 
if a reference entity or security included in the index does not meet 
(i) any of the criteria enumerated above or (ii) any of the following 
criteria: \829\
---------------------------------------------------------------------------

    \829\ See paragraph (a)(1)(iv)(H) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
---------------------------------------------------------------------------

     The reference entity or the issuer of the security 
included in the index (other than a reference entity or issuer included 
in the index that is an issuing entity of an asset-backed security) 
makes available to the public or otherwise makes available to such ECP 
information about such reference entity or issuer pursuant to rule 
144A(d)(4) under the Securities Act; \830\
---------------------------------------------------------------------------

    \830\ 17 CFR 230.144A(d)(4).
---------------------------------------------------------------------------

     Financial information about the reference entity or the 
issuer of the security included in the index (other than a reference 
entity or issuer included in the index that is an issuing entity of an 
asset-backed security) is otherwise publicly available; or
     In the case of an asset-backed security included in the 
index, or a reference entity included in the index that is an issuing 
entity of an asset-backed security, information of the type and level 
included in public distribution reports for similar asset-backed 
securities is publicly available about both the reference entity or 
issuing entity and the asset-backed security.
    As more fully described below, for purposes of satisfying either 
the rule 144A information criterion or the financial information 
otherwise publicly available criterion, the final rules provide that a 
reference entity or an issuer of securities included in an index may 
look to an affiliated entity to determine whether it satisfies one of 
these criterion, regardless of whether such affiliated entity itself or 
its securities are included in the index.\831\
---------------------------------------------------------------------------

    \831\ See infra part III.G.3(b)(iv), for a discussion regarding 
the affiliation definition applicable to the public information 
availability test applicable to index CDS entered into solely 
between ECPs. As noted above, the Commissions are modifying the 
method of calculating affiliation for purposes of this test.
---------------------------------------------------------------------------

    In response to commenters,\832\ the Commissions are revising the 
rule 144A information criterion of the public information availability 
test applicable to index CDS entered into solely between ECPs to 
clarify that the rule 144A information must either be made publicly 
available or otherwise made available to the ECP. In addition, the 
Commissions are clarifying that financial information about the 
reference entity or the issuer of the security may otherwise be 
publicly available through an issuer's Web site, through public filings 
with other regulators or exchanges, or through other electronic means. 
This method of satisfying the public information availability test does 
not specify the precise method by which financial information must be 
available.
---------------------------------------------------------------------------

    \832\ See infra note 847 and accompanying text.
---------------------------------------------------------------------------

    As with other index CDS, with respect to index CDS entered into 
solely with ECPs, if the percentage of the effective notional amounts 
allocated to reference entities or securities satisfying this expanded 
public information availability test comprise at least 80 percent of 
the index's weighting, then a reference entity or security included in 
the index that fails to satisfy the alternative public information test 
criteria will be disregarded so long as the effective notional amount 
allocated to that reference entity or security comprises less than five 
percent of the index's weighting.
Comments
    The Commissions received a number of general and specific comments 
regarding the public information availability test.
    A number of commenters believed that the public information 
availability test should not be included in the final rules for various 
reasons, including the potential disparate treatment between products 
based on indexes due to changes in index components,\833\ the impact of 
the migration of indexes from narrow-based to broad-based and vice-
versa,\834\ and assertions that the test was not needed due to the 
types of participants engaged in swap and security-based swap 
transactions.\835\ One commenter suggested replacing the public 
information availability test with a volume trading test.\836\
---------------------------------------------------------------------------

    \833\ See SIFMA Letter. This commenter expressed its concern 
that transactions on the same or similar indexes may result in 
differing regulatory treatment due to changes in index components as 
a result of component adjustments or as the availability of 
information relating to a component issuer changes over time. Id.
    \834\ See Markit Letter. According to this commenter, 
determining whether an index of loans or borrowers meets the public 
information availability test would be more difficult and more 
costly than making the same determination for an index of 
securities, which ``are generally subject to national or exchange-
based reporting and disclosure regimes'' and could create regulatory 
uncertainty. Id. This commenter also expressed its belief that the 
public information availability test would cause indexes to switch 
between a narrow-based and broad-based classification, which could 
result in unnecessary cost, confusion, and market disruption. Id.
    \835\ See ISDA Letter. This commenter expressed its belief that 
the public information availability test is not needed given the 
largely institutional nature of the existing over-the-counter 
market. Id. See also July LSTA Letter.
    \836\ See Markit Letter. This commenter expressed its belief 
that a volume-based classification process would be preferable to 
the public information availability test for several reasons. First, 
the statutory definition of ``narrow-based security index'' includes 
a volume-based factor. Second, a volume-based factor could be 
applied easily and transparently because the outstanding notional 
volume of CDS referencing each index constituent is captured by the 
Trade Information Warehouse. Third, an index classification based on 
outstanding notional amount as opposed to the public information 
availability test would result in less indices migrating from broad- 
to narrow-based classifications, and vice versa. This commenter also 
expressed its belief that a volume-based test would ensure that 
broad-based indices are not readily susceptible to manipulation 
because indexes based on constituents with high volumes are likely 
to have significant public information available. Id.
---------------------------------------------------------------------------

    The Commissions are adopting the public information availability 
test as proposed with certain modifications described above. As 
discussed above, the public information availability test is intended 
as the substitute for the ADTV provision in the statutory narrow-based 
security index definition, which the Dodd-Frank Act included as the 
method for determining whether index CDS are swaps or security-based 
swaps. Based on the reasons discussed above, the Commissions have 
retained the public information availability test as the underlying 
rationale of such provision, that there is sufficient trading in the 
securities and therefore public information and market following of the 
issuer of the securities, applies to index CDS. Accordingly, the 
Commissions believe that there should be public information available 
about a predominant percentage of the reference entities or issuers of 
securities underlying the index in order to prevent circumvention of 
other provisions of the Federal securities laws through the use of CDS 
based on such indexes, to reduce the likelihood that the index, the 
component securities, or the named issuers of securities in the index 
could be readily susceptible to manipulation, and to prevent the misuse 
of material non-public information about such an index, the component 
securities, or the reference entities.
    The Commissions understand that the characterization of an index 
underlying a CDS as broad-based or narrow-based may change because of 
changes to the index, such as addition or removal of components, or 
changes regarding the

[[Page 48281]]

specific components of the index, such as a decrease in the amount of 
outstanding common equity for a component. However, these types of 
changes are contemplated by the statutory narrow-based security index 
definition, which the Dodd-Frank Act used to establish whether index 
CDS are swaps or security-based swaps.\837\ Moreover, the Commissions 
have provided that the determination of whether a Title VII instrument 
is a swap, security-based swap or mixed swap is made prior to 
execution, but no later than when the parties offer to enter into the 
Title VII instrument,\838\ and does not change if a security index 
underlying such instrument subsequently migrates from broad to narrow 
(or vice versa) during its life. Accordingly, even if the public 
information availability test would cause indexes underlying index CDS 
to migrate as suggested by a commenter, that will not affect the 
classification of outstanding index CDS entered into prior to such 
migration. However, if an amendment or change is made to such 
outstanding index CDS that would cause it to be a new purchase or sale 
of such index CDS, that could affect the classification of such 
outstanding index CDS. Further, as is true for other products using the 
narrow-based security index definition, the Commissions also believe 
that the effects of changes to an index underlying a CDS traded on an 
organized platform are addressed through the tolerance period and grace 
period rules the Commissions are adopting, which rules are based on 
tolerance period and grace period rules for security futures to which 
the statutory narrow-based security index definition applies.\839\
---------------------------------------------------------------------------

    \837\ The index migration issue exists for all products in which 
the ``narrow-based security index'' definition is used. Thus, as is 
true for security futures, the migration issue exists for debt 
security indexes and the statutory definition of the term ``narrow-
based security index,'' under which an index's characterization may 
be affected by a change to the index itself or to the components of 
the index.
    \838\ See supra note 625 and accompanying text.
    \839\ See infra part III.G.6.
---------------------------------------------------------------------------

    The Commissions are not adopting a volume-based test based on the 
trading of the CDS or the trading of the index, either as a replacement 
for the public information availability test or as an alternative means 
of satisfying it, as one commenter suggested.\840\ The Commissions 
believe that using a volume-based test based on the trading of the CDS 
or the trading of the index would not work in the index CDS context 
because the character of the index CDS would have to be determined 
before any trading volume could exist and, therefore, the index CDS 
would fail a volume-based test. The Commissions also believe that a 
volume-based test based either on the CDS components of the index or 
the index itself would not be an appropriate substitute for or an 
alternative to a public information availability test with respect to 
the referenced entity, issuer of securities, or underlying security 
because such a volume-based test would not provide transparency on such 
underlying entities, issuers of securities or securities.\841\
---------------------------------------------------------------------------

    \840\ See supra note 836 and accompanying text.
    \841\ In the context of equity securities indexes to which the 
ADTV test applies, there likely is information regarding the 
underlying entities, issuers of securities or securities because, as 
noted above, Exchange Act registration of the security being traded 
is a listing standard for equity securities and, therefore, the 
issuer of the security being traded must be subject to the reporting 
requirements under the Exchange Act. However, in the context of 
index CDS, there are no comparable listing standards that would be 
applicable to provide transparency on the underlying entities, 
issuers of securities or securities.
---------------------------------------------------------------------------

    The Commissions believe that the public information availability 
test in the index CDS rules allows more flexibility with respect to the 
types of components included in indexes underlying index CDS. For many 
indexes, such as bespoke indexes, trading volume for CDS on individual 
components may not be significant even though the index component would 
otherwise have no trouble satisfying one of the criteria of the public 
information availability test. The public information availability test 
in the index CDS rules also is very similar to the test in the rules 
for debt security indexes, which, as noted above, apply in the context 
of Title VII instruments, thus providing a consistent set of rules 
under which index compilers and market participants can analyze the 
characterization of CDS.
    One commenter also had concerns regarding specific types of indexes 
and specific types of index components, including the applicability of 
the public information availability test to indexes of loans or 
borrowers.\842\ As discussed above, however, the Commissions believe 
that index CDS based on indexes of loans or borrowers should be 
analyzed under the third prong of the statutory security-based swap 
definition in the same manner as any other index CDS. Although this 
commenter noted such indexes may include a higher proportion of 
``private'' borrowers (those borrowers who are not public reporting 
companies or that do not register offerings of their securities) and 
thus may themselves not satisfy any of the criteria for the public 
information availability test,\843\ the Commissions believe that the 
information tests of the rule as modified will address these concerns. 
The modified rule will add loans to the categories of instruments to be 
aggregated for purposes of the outstanding indebtedness criterion and, 
as discussed below, will aggregate outstanding indebtedness of 
affiliates.\844\ As a result of these modifications, the Commissions 
believe that the indexes the commenter was concerned about may be more 
likely to satisfy the public information availability test.
---------------------------------------------------------------------------

    \842\ See July LSTA Letter.
    \843\ Id.
    \844\ As noted above, the Commissions are modifying the method 
of calculating affiliation for purposes of certain criteria of the 
public information availability test. See infra part III.G.3(b)(iv).
---------------------------------------------------------------------------

    One commenter agreed with including an outstanding debt threshold 
as a criterion in the public information availability test, but 
requested that the Commissions change this criterion to include loans 
that are not within the definition of security, as well as affiliate 
debt guaranteed by the issuer of securities or reference entity, and to 
reduce the required outstanding debt threshold from $1 billion to $100 
million.\845\ As discussed above, the Commissions are revising the 
rules to expand the types of debt that are counted toward the $1 
billion debt threshold to include any indebtedness, including loans, so 
long as such indebtedness is not a revolving credit facility. The 
Commissions have made no other changes to the $1 billion debt 
threshold.
---------------------------------------------------------------------------

    \845\ See Markit Letter. This commenter suggested that the debt 
threshold should be reduced to $100 million because debt issuances 
in some debt markets, such as the high yield markets, tend to be 
relatively small. This commenter also suggested that the debt 
threshold should include debt guaranteed by the issuer of the 
securities or reference entity because in many cases the issuer of 
the securities or reference entity is merely guaranteeing debt of 
its affiliates and not issuing the debt. Finally, this commenter 
requested clarification as to whether the debt threshold included 
loans and leveraged loans.
---------------------------------------------------------------------------

    The Commissions believe that the fact that an entity has guaranteed 
the obligations of another entity will not affect the likelihood that 
public information is available about either the borrower on the 
guaranteed obligation or on the guarantor entity. However, the 
Commissions note that they are providing an additional interpretation 
on the affiliation definition of the index CDS rules, including 
modifying the method of calculating affiliation, that should address 
this commenter's concerns regarding guaranteed affiliate

[[Page 48282]]

debt.\846\ The Commissions also believe that the $1 billion debt 
threshold, which is the same amount as the outstanding debt threshold 
in the rules for debt security indexes, is set at the appropriate level 
to achieve the objective that such entities are likely to have public 
information available about them.
---------------------------------------------------------------------------

    \846\ See infra part III.G.3(b)(iv).
---------------------------------------------------------------------------

    One commenter suggested that the proposed rule 144A information 
criterion of the public information availability test applicable to 
index CDS entered into solely between ECPs should be satisfied if the 
issuer made the rule 144A information available upon request to the 
public or to the ECP in question, rather than being required to provide 
the information.\847\ In response to this commenter, the Commissions 
are revising the rule 144A information criterion of the public 
information availability test applicable to index CDS entered into 
solely between ECPs to clarify that the rule 144A information must be 
made publicly available or otherwise made available to the ECP.
---------------------------------------------------------------------------

    \847\ See SIFMA Letter.
---------------------------------------------------------------------------

    The Commissions received one comment regarding the criteria of the 
public information availability test that relate specifically to asset-
backed securities.\848\ The commenter was concerned that the test for 
asset-backed securities underlying an index may be difficult to apply 
because all asset-backed securities underlying an index are not always 
registered under the Securities Act.\849\ This commenter also was 
concerned that the term ``distribution reports'' may not be the same as 
monthly service reports, which this commenter indicated are available 
through the deal trustee and/or the SEC Web site.\850\ This commenter 
also believed that it was unclear whether these monthly service reports 
would qualify as ``distribution reports'' for purposes of the public 
information availability test and whether information regarding Agency 
MBS pools, which are available on Agency Web sites, would be sufficient 
to satisfy the public information availability test.\851\ In addition, 
this commenter requested that the Commissions clarify that not all 
tranches of a transaction need to be registered under the Securities 
Act to satisfy the publicly available distribution report 
requirement.\852\
---------------------------------------------------------------------------

    \848\ See Markit Letter.
    \849\ Id.
    \850\ Id.
    \851\ Id.
    \852\ Id.
---------------------------------------------------------------------------

    The Commissions are adopting as proposed the provisions of the 
public information availability test applicable to indexes based on 
asset-backed securities. The Commissions note that there are two 
possible ways to satisfy the public information availability test for 
index CDS based on asset-backed securities or asset-backed issuers. For 
index CDS available to non-ECPs, all asset-backed securities in the 
index or of the issuer in the index must have been sold in registered 
offerings under the Securities Act and have publicly available 
distribution reports. The Commissions are clarifying that monthly 
service reports filed with the SEC will satisfy the requirement for 
publicly available distribution reports.\853\ However, for index CDS 
being sold only to ECPs, the public information availability test with 
respect to the index components is satisfied, regardless of whether the 
asset-backed securities have been sold in registered offerings under 
the Securities Act, if information of the type and level included in 
public distribution reports for similar asset-backed securities is 
publicly available about both the issuing entity and such asset-backed 
securities. The Commissions believe that requiring such information 
about the asset-backed securities and the assets in the pools 
underlying such asset-backed securities is consistent with existing 
disclosure requirements for asset-backed securities and existing 
practices of ABS issuers.
---------------------------------------------------------------------------

    \853\ Distribution reports, which sometimes are referred to as 
servicer reports, delivered to the trustee or security holders, as 
the case may be, are filed with the SEC on Form 10-D.
---------------------------------------------------------------------------

(iv) Affiliation of Reference Entities and Issuers of Securities With 
Respect to Certain Criteria of the Public Information Availability Test
    The Commissions are adopting the affiliation definition that 
applies to certain criteria of the public information availability test 
with certain modifications from the proposals to address commenters' 
concerns.\854\ The Commissions are making modifications to this 
affiliation definition that are the same as the modifications the 
Commissions are making to the affiliation definition that applies when 
calculating the number and concentration criteria.\855\
---------------------------------------------------------------------------

    \854\ See infra note 867 and accompanying text.
    \855\ See supra part III.G.3(b)(ii).
---------------------------------------------------------------------------

    This affiliation definition applies for purposes of determining 
whether a reference entity or issuer of securities included in an index 
satisfies one of the following four criteria of the public information 
availability test: (i) The reference entity or issuer of the security 
included in the index is required to file reports pursuant to the 
Exchange Act or the regulations thereunder; \856\ (ii) the reference 
entity or issuer of the security included in the index is eligible to 
rely on the exemption provided in rule 12g3-2(b) under the Exchange Act 
for foreign private issuers; \857\ (iii) the reference entity or issuer 
of the security included in the index has a worldwide market value of 
its outstanding common equity held by non-affiliates of $700 million or 
more; \858\ and (iv) the reference entity or issuer of the security 
included in the index has outstanding notes, bonds, debentures, loans, 
or evidences of indebtedness (other than revolving credit facilities) 
having a total remaining principal amount of at least $1 billion.\859\ 
This affiliation definition also applies for purposes of determining 
whether a reference entity or issuer of securities included in an index 
satisfies one of the following two criteria of the alternative public 
information availability test applicable to index CDS entered into 
solely between ECPs: (i) The reference entity or issuer of the security 
included in the index makes available rule 144A information; \860\ and 
(ii) financial information about the reference entity or issuer of the 
security included in the index is otherwise publicly available.\861\
---------------------------------------------------------------------------

    \856\ See paragraph (a)(1)(iv)(A) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
    \857\ See paragraph (a)(1)(iv)(B) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
    \858\ See paragraph (a)(1)(iv)(C) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
    \859\ See paragraph (a)(1)(iv)(D) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
    \860\ See paragraph (a)(1)(iv)(H)(1) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
    \861\ See paragraph (a)(1)(iv)(H)(2) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the 
Exchange Act.
---------------------------------------------------------------------------

    The final rules provide that the terms ``reference entity included 
in the index'' and ``issuer of the security included in the index'' 
include a single reference entity or issuer of securities included in 
an index, respectively, or a group of affiliated entities.\862\ For 
purposes of the rules, a reference entity or issuer of securities 
included in an index may rely upon an affiliated entity to satisfy 
certain criteria of the public information availability test. However, 
with respect to asset-backed securities, the final rules provide that 
each reference entity or issuer of securities included in an index

[[Page 48283]]

that is an issuing entity of an asset-backed security is considered a 
separate reference entity or issuer, as applicable, and will not be 
considered affiliated with any other entities.
---------------------------------------------------------------------------

    \862\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------

    The final rules provide that a reference entity or issuer of 
securities included in an index is affiliated with another entity if it 
controls, is controlled by, or is under common control with, that other 
entity.\863\ The final rules define control, solely for purposes of 
this affiliation definition, to mean ownership of more than 50 percent 
of a reference entity's or issuer's equity or the ability to direct the 
voting of more than 50 percent of a reference entity's or issuer's 
voting equity.\864\ This revision is the same as the modification the 
Commissions are making to the affiliation definition that applies when 
calculating the number and concentration criteria, which is discussed 
above.\865\
---------------------------------------------------------------------------

    \863\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
    \864\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under 
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
    \865\ See supra part III.G.3(b)(ii).
---------------------------------------------------------------------------

    As the Commissions noted above, this change is based on the 
Commissions' consideration of comments received. By using a more than 
50 percent (i.e., majority ownership) test rather than a 20 percent 
ownership test for the control threshold, there is a greater likelihood 
that there will be information available about the reference entity or 
issuer of securities included in the index because the market likely 
will view the affiliated entity and the reference entity or issuer of 
securities included in the index as a single company or economic 
entity.\866\ Accordingly, to the extent information regarding the 
affiliated entity is publicly available, there may be information 
regarding the reference entity or issuer of securities included in the 
index that also is publicly available. This modified control threshold 
will permit such reference entity or issuer of securities to rely upon 
an affiliated entity to satisfy one of the criteria of the public 
information availability test. Further, unlike the affiliation 
definition that applies when calculating the number and concentration 
criteria, the affiliation definition that applies to certain criteria 
of the public information availability test does not require that the 
affiliated entity or its securities be included in the index.
---------------------------------------------------------------------------

    \866\ The more than 50 percent (i.e., majority ownership) test 
is generally consistent with consolidation under U.S. generally 
accepted accounting principles. See FASB ASC section 810-10-25, 
Consolidation--Overall--Recognition (stating that consolidation is 
appropriate if a reporting entity has a controlling financial 
interest in another entity and a specific scope exception does not 
apply). Accordingly, using a more than 50 percent (i.e., majority 
ownership) test will make it more likely that the reference entity 
or issuer of securities included in the index and the affiliated 
entity will be consolidated with each other in financial statements. 
Consolidated financial statements present the financial position and 
results of operations for a parent (controlling entity) and one or 
more subsidiaries (controlled entities) as if the individual 
entities actually were a single company or economic entity.
---------------------------------------------------------------------------

    As the affiliation definition applies to the Exchange Act reporting 
company and foreign private issuer criteria of the public information 
availability test, a reference entity or an issuer of securities 
included in an index that itself is not required to file reports 
pursuant to the Exchange Act or the regulations thereunder or is not 
eligible to rely on the exemption provided in rule 12g3-2(b) under the 
Exchange Act for foreign private issuers may rely upon the status of an 
affiliated entity as an Exchange Act reporting company or foreign 
private issuer, regardless of whether that affiliated entity itself or 
its securities are included in the index, to satisfy one of these 
criteria. For example, a majority-owned subsidiary included in an index 
may rely upon the status of its parent, which may or may not be 
included in the index, to satisfy the issuer eligibility criteria if 
the parent is required to file reports under the Exchange Act or is a 
foreign private issuer.
    Similarly, as the affiliation definition applies to the worldwide 
equity market capitalization and outstanding indebtedness criteria of 
the public information availability test, a reference entity or an 
issuer of securities included in an index that itself does not have a 
worldwide market value of its outstanding common equity held by non-
affiliates of $700 million or more or outstanding notes, bonds, 
debentures, loans, or evidences of indebtedness (other than revolving 
credit facilities) having a total remaining principal amount of at 
least $1 billion, may aggregate the worldwide equity market 
capitalization or outstanding indebtedness of an affiliated entity, 
regardless of whether that affiliated entity itself or its securities 
are included in the index, to satisfy one of these criteria. For 
example, a majority-owned subsidiary included in an index may aggregate 
the worldwide equity market capitalization or outstanding indebtedness 
of its parent and/or other affiliated entities, such as other majority-
owned subsidiaries of the parent, to satisfy one of these criteria.
    Finally, as the affiliation definition applies to the rule 144A 
information and financial information otherwise publicly available 
criteria of the alternative public information availability test 
applicable to index CDS entered into solely between ECPs, a reference 
entity or an issuer of securities included in an index that itself does 
not make available rule 144A information or does not have financial 
information otherwise publicly available may rely upon an affiliated 
entity, regardless of whether that affiliated entity itself or its 
securities are included in the index, to satisfy one of these criteria.
Comments
    One commenter requested that the Commissions revise the affiliation 
definition that applies for purposes of the public information 
availability test to increase the threshold from 20 percent ownership 
to majority ownership.\867\ This commenter noted that majority 
ownership is consistent with current market practice, including the 
definition of affiliate included in the 2003 ISDA Credit Derivatives 
Definitions.\868\ This commenter also noted that the current approach 
with respect to the inclusion of affiliated entities in the same index 
uses majority ownership rather than 20 percent ownership to determine 
affiliation.\869\ This commenter also requested that the Commissions 
clarify the application of the affiliation definition to the public 
information availability test.\870\ Further, this commenter requested 
that the worldwide equity market capitalization criterion should 
include all affiliated entities because the reference entity included 
in the index may not be the member of a corporate group that issues 
public equity.\871\ Finally, this commenter was concerned that the 
outstanding indebtedness criterion would not include affiliate debt 
guaranteed by the reference entity or issuer of securities included in 
the index.\872\ Further, as noted above,\873\ another commenter was 
concerned that index CDS may include a higher proportion of ``private'' 
borrowers (those borrowers that are not public reporting companies or 
that do not register offerings of their securities) and thus may 
themselves not satisfy each of the

[[Page 48284]]

criteria for the public information availability test.\874\
---------------------------------------------------------------------------

    \867\ See Markit Letter (requesting a threshold of at least 50 
percent).
    \868\ Id.
    \869\ Id.
    \870\ Id.
    \871\ Id. This commenter provided Kinder Morgan Kansas Inc. 
(CDS) and Kinder Morgan Inc. (equity) as an example of where the 
reference entity and issuer of equity among a corporate group are 
not the same. Id.
    \872\ Id.
    \873\ See supra note 842 and accompanying text.
    \874\ See July LSTA Letter.
---------------------------------------------------------------------------

    The Commissions note the commenters' concerns. The Commissions are 
modifying the method of determining affiliation that applies for 
purposes of satisfying certain criteria of the public information 
availability test. The final rules provide that a reference entity or 
issuer of securities included in an index may rely upon an affiliated 
entity (meeting the more than 50 percent control threshold) to satisfy 
one of the criterion of the public information availability test. This 
modification is similar to the one the Commissions are making to the 
affiliation definition that applies for purposes of calculating the 
number and concentration criteria. As noted above, based on commenters' 
letters, the Commissions understand that the current standard CDS 
documentation and the current approach with respect to the inclusion of 
affiliated entities in the same index use majority ownership rather 
than 20 percent ownership to determine affiliation. The Commissions 
agree with commenters that in the case of index CDS only it is more 
appropriate to use a more than 50 percent (i.e., majority ownership) 
test rather than a 20 percent ownership test. The Commissions believe 
that because reference entities or issuers of securities included in an 
index may rely on an affiliated entity to help satisfy the public 
information availability test a threshold of majority ownership rather 
than 20 percent ownership will increase the likelihood that there is 
information available about the reference entity or issuer of 
securities included in the index. The Commissions believe that 
determining affiliation in this manner for purposes of the public 
availability of information test responds to the commenter's concerns.
    Further, the Commissions are providing several illustrative 
examples of the way in which the affiliation definition works in the 
context of the public availability of information criteria to address 
the commenter's concerns regarding the application of the affiliation 
definition in that context. The Commissions also note that the final 
rules respond to the commenter's concerns regarding the applicability 
of the affiliation definition to the worldwide equity market 
capitalization criterion by providing that the worldwide market 
capitalization of an affiliate can be counted in determining whether 
the reference entity or issuer of securities included in the index 
meets the worldwide equity market capitalization criterion. Moreover, 
the Commissions note that the final rules respond to the commenter's 
concerns regarding affiliate debt by providing that indebtedness of an 
affiliate can be counted in determining whether the reference entity or 
issuer of securities included in the index meets the outstanding 
indebtedness criterion. Finally, the Commissions note that the 
affiliation definition as modified responds to the commenter's concerns 
regarding ``private'' borrowers because the modified affiliation 
definition will allow a reference entity or issuer of securities 
included in an index to consider the indebtedness, the outstanding 
equity, and the reporting status of an affiliate in determining whether 
the public information availability test is satisfied.
    As noted above, the Commissions also believe that the modified 
affiliation definition responds to commenters' concerns noted above 
that the rules further defining the terms ``issuers of securities in a 
narrow-based security index'' and ``narrow-based security index'' 
should be simplified. The modified affiliation definition enables 
market participants to make an affiliation determination for purposes 
of the public information availability test criteria by measuring the 
more than 50 percent (i.e., majority ownership) control threshold.
(v) Application of the Public Information Availability Requirements to 
Indexes Compiled by a Third-Party Index Provider
    The Commissions requested comment in the Proposing Release as to 
whether the public information availability test should apply to an 
index compiled by an index provider that is not a party to an index CDS 
(``third-party index provider'') that makes publicly available general 
information about the construction of the index, index rules, identity 
of components, and predetermined adjustments, and which index is 
referenced by an index CDS that is offered on or subject to the rules 
of a DCM or SEF, or by direct access in the U.S. from an FBOT that is 
registered with the CFTC.\875\ Two commenters stated that the presence 
of a third-party index provider would assure that sufficient 
information is available regarding the index CDS itself.\876\ Neither 
commenter provided any analysis to explain how or whether a third-party 
index provider would be able to provide information about the 
underlying securities or issuers of securities in the index. The 
Commissions are not revising the rules to exclude from the public 
information availability test any index compiled by a third-party index 
provider.
---------------------------------------------------------------------------

    \875\ See Proposing Release at 29851-52.
    \876\ See ISDA Letter and SIFMA Letter.
---------------------------------------------------------------------------

(vi) Treatment of Indexes Including Reference Entities That Are Issuers 
of Exempted Securities or Including Exempted Securities
    The Commissions are adopting the rules regarding the treatment of 
indexes that include exempted securities or reference entities that are 
issuers of exempted securities as proposed without modification.\877\ 
The Commissions believe such treatment is consistent with the objective 
and intent of the statutory definition of the term ``security-based 
swap,'' as well as the approach taken in the context of security 
futures.\878\ Accordingly, paragraph (1)(ii) of rules 1.3(zzz) and 
1.3(aaaa) under the CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-
1b under the Exchange Act provide that, in the case of an index that 
includes exempted securities, or reference entities that are issuers of 
exempted securities, in each case as defined as of the date of 
enactment of the Futures Trading Act of 1982 (other than municipal 
securities), such securities or reference entities are excluded from 
the index when determining whether the securities or reference entities 
in the index constitute a ``narrow-based security index'' or ``issuers 
of securities in a narrow-based security index'' under the rules.
---------------------------------------------------------------------------

    \877\ See rules 1.3(zzz)(1)(i) and 1.3(aaaa)(1)(i) under the CEA 
and rules 3a68-1a(a)(2) and 3a68-1b(a)(2) under the Exchange Act; 
and July 2006 Debt Index Rules. The Commissions did not receive any 
comments on the proposed rules regarding the treatment of indexes 
that include exempted securities or reference entities that are 
issuers of exempted securities.
    \878\ See section 3(a)(68)(C) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(C) (providing that ``[t]he term `security-based swap' 
does not include any agreement, contract, or transaction that meets 
the definition of a security-based swap only because such agreement, 
contract, or transaction references, is based upon, or settles 
through the transfer, delivery, or receipt of an exempted security 
under paragraph (12) [of the Exchange Act], as in effect on the date 
of enactment of the Futures Trading Act of 1982 (other than any 
municipal security as defined in paragraph (29) [of the Exchange 
Act] as in effect on the date of enactment of the Futures Trading 
Act of 1982), unless such agreement, contract, or transaction is of 
the character of, or is commonly known in the trade as, a put, call, 
or other option'').
---------------------------------------------------------------------------

    Under paragraph (1)(ii) of rules 1.3(zzz) and 1.3(aaaa) under the 
CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-1b) under the 
Exchange Act, an index composed solely of securities that are, or 
reference entities that are issuers of, exempted securities (other than 
municipal securities) will not be a

[[Page 48285]]

``narrow-based security index'' or an index composed of ``issuers of 
securities in a narrow-based security index.'' In the case of an index 
where some, but not all, of the securities or reference entities are 
exempted securities (other than municipal securities) or issuers of 
exempted securities (other than municipal securities), the index will 
be a ``narrow-based security index'' or an index composed of ``issuers 
of securities in a narrow-based security index'' only if the index is 
narrow-based when the securities that are, or reference entities that 
are issuers of, exempted securities (other than municipal securities) 
are disregarded. The Commissions believe this approach should result in 
consistent treatment for indexes regardless of whether they include 
securities that are, or issuers of securities that are, exempted 
securities (other than municipal securities) while helping to ensure 
that exempted securities (other than municipal securities) and issuers 
of exempted securities (other than municipal securities) are not 
included in an index merely to make the index either broad-based or 
narrow-based under the rules.
4. Security Indexes
    The Dodd-Frank Act defines the term ``index'' as ``an index or 
group of securities, including any interest therein or based on the 
value thereof.'' \879\ The Commissions provided an interpretation in 
the Proposing Release regarding how to determine when a portfolio of 
securities is a narrow-based or broad-based security index, and the 
circumstances in which changes to the composition of a security index 
(including a portfolio of securities) \880\ underlying a Title VII 
instrument would affect the characterization of such Title VII 
instrument.\881\ The Commissions are restating the interpretation set 
forth in the Proposing Release with one clarification in response to a 
commenter.\882\ Specifically, the Commissions are clarifying what is 
meant by ``predetermined'' for purposes of whether criteria or a self-
executing formula for adjusting the security index underlying a Title 
VII instrument qualify under the interpretation. The Commissions find 
that this interpretation is an appropriate way to address how to 
determine when a portfolio of securities is a narrow-based or broad-
based security index, and the circumstances in which changes to the 
composition of a security index (including a portfolio of securities) 
underlying a Title VII instrument would affect the characterization of 
such Title VII instrument, and is designed to reduce costs associated 
with making such a determination.\883\
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    \879\ See section 3(a)(68)(E) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(E).
    \880\ The Commissions noted in the Proposing Release that a 
``portfolio'' of securities could be a group of securities and 
therefore an ``index'' for purposes of the Dodd-Frank Act. See 
Proposing Release at 29854. To the extent that changes are made to 
the securities underlying the Title VII instrument and each such 
change is individually confirmed, then those substituted securities 
are not part of a security index as defined in the Dodd-Frank Act, 
and therefore a Title VII instrument on each of those substituted 
securities is a security-based swap.
    \881\ Solely for purposes of the discussion in this section, the 
terms ``security index'' and ``security portfolio'' are intended to 
include either securities or the issuers of securities.
    \882\ See infra note 891 and accompanying text.
    \883\ See supra part I, under ``Overall Economic 
Considerations''.
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    A security index in most cases is designed to reflect the 
performance of a market or sector by reference to representative 
securities or interests in securities. There are several well-known 
security indexes established and maintained by recognized index 
providers currently in the market.\884\ However, instead of using these 
established indexes, market participants may enter into a Title VII 
instrument where the underlying reference of the Title VII instrument 
is a portfolio of securities selected by the counterparties or created 
by a third-party index provider at the behest of one or both 
counterparties. In some cases, the Title VII instrument may give one or 
both of the counterparties, either directly or indirectly (e.g., 
through an investment adviser or through the third-party index 
provider), discretionary authority to change the composition of the 
security portfolio, including, for example, by adding or removing 
securities in the security portfolio on an ``at-will'' basis during the 
term of the Title VII instrument.\885\ Where the counterparties, either 
directly or indirectly (e.g., through an investment adviser or through 
the third-party index provider), have this discretionary authority to 
change the composition or weighting of securities in a security 
portfolio, that security portfolio will be treated as a narrow-based 
security index, and therefore a Title VII instrument on that security 
portfolio is a security-based swap.\886\
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    \884\ One example is the S&P 500[supreg] Index, an index that 
gauges the large cap U.S. equities market.
    \885\ Alternatively, counterparties may enter into Title VII 
instruments where a third-party investment manager selects an 
initial portfolio of securities and has discretionary authority to 
change the composition of the security portfolio in accordance with 
guidelines agreed upon with the counterparties. Under the final 
guidance the Commissions are issuing today, such security portfolios 
are treated as narrow-based security indexes, and Title VII 
instruments on those security portfolios are security-based swaps.
    \886\ The Commissions understand that a security portfolio could 
be labeled as such or could just be an aggregate of individual Title 
VII instruments documented, for example, under a master agreement or 
by amending an annex of securities attached to a master trade 
confirmation. If the security portfolio were created by aggregating 
individual Title VII instruments, each Title VII instrument must be 
evaluated in accordance with the guidance to determine whether it is 
a swap or a security-based swap. For the avoidance of doubt, if the 
counterparties to a Title VII instrument exchanged payments under 
that Title VII instrument based on a security index that was itself 
created by aggregating individual security-based swaps, such Title 
VII instrument would be a security-based swap. See supra part III.D.
---------------------------------------------------------------------------

    However, not all changes that occur to the composition or weighting 
of a security index underlying a Title VII instrument will always 
result in that security index being treated as a narrow-based security 
index. Many security indexes are constructed and maintained by an index 
provider pursuant to a published methodology.\887\ For instance, the 
various Standard & Poor's security indexes are reconstituted and 
rebalanced as needed and on a periodic basis pursuant to published 
index criteria.\888\ Such indexes underlying a Title VII instrument 
would be broad-based or narrow-based depending on the composition and 
weighting of the underlying security index.
---------------------------------------------------------------------------

    \887\ See, e.g., NASDAQ, ``NASDAQ-100 Index'' (``The NASDAQ-100 
Index is calculated under a modified capitalization-weighted 
methodology. The methodology generally is expected to retain the 
economic attributes of capitalization-weighting while providing 
enhanced diversification. To accomplish this, NASDAQ will review the 
composition of the NASDAQ-100 Index on a quarterly basis and adjust 
the weightings of Index components using a proprietary algorithm, if 
certain pre-established weight distribution requirements are not 
met.''), available at http://dynamic.nasdaq.com/dynamic/nasdaq100_activity.stm.
    \888\ Information regarding security indexes and their related 
methodologies may be widely available to the general public or 
restricted to licensees in the case of proprietary or ``private 
label'' security indexes. Both public and private label security 
indexes frequently are subject to intellectual property protection.
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    In addition, counterparties to a Title VII instrument frequently 
agree to use as the underlying reference of a Title VII instrument a 
security index based on predetermined criteria where the security index 
composition or weighting may change as a result of the occurrence of 
certain events specified in the Title VII instrument at execution, such 
as ``succession events.'' Counterparties to a Title VII instrument also 
may use a predetermined self-executing formula to make other changes to 
the composition or weighting of a security index underlying a Title VII 
instrument. In either of these situations, the composition of a 
security index may

[[Page 48286]]

change pursuant to predetermined criteria or predetermined self-
executing formulas without the Title VII instrument counterparties, 
their agents, or third-party index providers having any direct or 
indirect discretionary authority to change the security index.
    In general, and by contrast to Title VII instruments in which the 
counterparties, either directly or indirectly (e.g., through an 
investment adviser or through the third-party index provider), have the 
discretion to change the composition or weighting of the referenced 
security index, where there is an underlying security index for which 
there are predetermined criteria or a predetermined self-executing 
formula for adjusting the security index that are not subject to change 
or modification through the life of the Title VII instrument and that 
are set forth in the Title VII instrument at execution (regardless of 
who establishes the criteria or formula), a Title VII instrument on 
such underlying security index is based on a broad-based or narrow-
based security index, depending on the composition and weighting of the 
underlying security index. Subject to the interpretation discussed 
below regarding security indexes that may shift from being a narrow-
based security index or broad-based security index during the life of 
an existing Title VII instrument, the characterization of a Title VII 
instrument based on a security index as either a swap or a security-
based swap will depend on the characterization of the security index 
using the above interpretation.\889\
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    \889\ See supra note 886, regarding the aggregation of separate 
trades.
---------------------------------------------------------------------------

    The Commissions are clarifying in response to a commenter that, for 
purposes of this interpretation, criteria or a self-executing formula 
regarding composition of a security index underlying a Title VII 
instrument shall be considered ``predetermined'' if it is bilaterally 
agreed upon pre-trade by the parties to a transaction.\890\ In order to 
qualify under this interpretation, however, the Commissions reiterate 
that the ``predetermined'' criteria or self-executing formula, as 
described above, must not be subject to change or modification through 
the life of the Title VII instrument and must be set forth in the Title 
VII instrument at execution (regardless of who establishes the criteria 
or formula).
---------------------------------------------------------------------------

    \890\ See infra note 891 and accompanying text.
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Comments
    The Commissions requested comment on a number of issues regarding 
the interpretation contained in this section as it was proposed, 
including whether the terms ``predetermined criteria'' and 
``predetermined self-executing formula'' are clear, and whether 
additional interpretations should be provided with respect to these 
terms. The Commissions received one comment on the interpretation 
provided in the Proposing Release, in which the commenter requested 
clarification that criteria affecting the composition of an index, when 
such criteria are agreed bilaterally, pre-trade, by the counterparties 
to a bespoke index trade, are ``predetermined'' for purposes of 
determining whether the index is treated as narrow-based or broad-
based.\891\
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    \891\ See ISDA Letter. While this commenter agrees with the 
guidance that the predetermined changes described in this section 
should not alter the character of an index (or the classification of 
a Title VII instrument based thereon), this commenter disagrees that 
the ability to make discretionary changes should cause an otherwise 
broad-based security index to be a narrow-based security index. This 
commenter requested that the Commissions classify transactions ``at 
inception and upon actual change in respect of any classification-
related characteristic, be that change the product of a 
renegotiation or a unilateral exercise of discretion.'' Id. The 
Commissions note that if material terms of a Title VII instrument 
are amended or modified during its life based on an exercise of 
discretion and not through predetermined criteria or a predetermined 
self-executing formula, the Commissions view the amended or modified 
Title VII instrument as a new Title VII instrument. See infra part 
III.G.5.
---------------------------------------------------------------------------

    The Commissions are restating the interpretation set forth in the 
Proposing Release with one clarification in response to the commenter's 
concerns. As discussed above, the Commissions are providing that not 
all changes that occur to the composition or weighting of a security 
index underlying a Title VII instrument will result in that security 
index being treated as a narrow-based security index. Foremost among 
these examples is a security index that is constructed and maintained 
by an index provider pursuant to a published methodology.\892\ Changes 
to such an index pursuant to such a methodology are not the type of 
discretionary changes that will render an otherwise broad-based 
security index a narrow-based security index. The Commissions believe 
this clarification addresses the commenter's concerns.
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    \892\ Indeed, the Commissions specifically mentioned in this 
regard, and have included in the final guidance above, the various 
Standard & Poor's security indexes--some of which may be described 
as ``common equity indices'' as alluded to in ISDA's comment--that 
are reconstituted and rebalanced as needed and on a periodic basis 
pursuant to published index criteria.
---------------------------------------------------------------------------

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
    The determination of whether a Title VII instrument is a swap, a 
security-based swap, or both (i.e., a mixed swap), is made prior to 
execution, but no later than when the parties offer to enter into the 
Title VII instrument.\893\ If the security index underlying a Title VII 
instrument migrates from being broad-based to being narrow-based, or 
vice versa, during the life of a Title VII instrument, the 
characterization of that Title VII instrument will not change from its 
initial characterization regardless of whether the Title VII instrument 
was entered into bilaterally or was executed through a trade on or 
subject to the rules of a DCM, SEF, FBOT, security-based SEF, or NSE. 
For example, if two counterparties enter into a swap based on a broad-
based security index, and three months into the life of the swap the 
security index underlying that Title VII instrument migrates from being 
broad-based to being narrow-based, the Title VII instrument will remain 
a swap for the duration of its life and will not be recharacterized as 
a security-based swap.
---------------------------------------------------------------------------

    \893\ See supra note 625 and accompanying text.
---------------------------------------------------------------------------

    If the material terms of a Title VII instrument are amended or 
modified during its life based on an exercise of discretion and not 
through predetermined criteria or a predetermined self-executing 
formula, the Commissions view the amended or modified Title VII 
instrument as a new Title VII instrument.\894\ As a result, the 
characteristics of the underlying security index must be reassessed at 
the time of such an amendment or modification to determine whether the 
security index has migrated from broad-based to narrow-based, or vice 
versa. If the security index has migrated, then the characterization of 
the amended or

[[Page 48287]]

modified Title VII instrument will be determined by evaluating the 
underlying security index at the time the Title VII instrument is 
amended or modified. Similarly, if a security index has migrated from 
broad-based to narrow-based, or vice versa, any new Title VII 
instrument based on that security index will be characterized pursuant 
to an evaluation of the underlying security index at the execution of 
that new Title VII instrument.
---------------------------------------------------------------------------

    \894\ For example, if, on its effective date, a Title VII 
instrument tracks the performance of an index of 12 securities but 
is amended during its term to track the performance of only 8 of 
those 12 securities, the Commissions would view the amended or 
modified Title VII instrument as a new Title VII instrument. Because 
it is a new Title VII instrument, any regulatory requirements 
regarding new Title VII instruments apply. Conversely, if, on its 
effective date, a Title VII instrument tracks the performance of an 
index of 12 securities but is amended during its term to reflect the 
replacement of a departing ``key person'' of a hedge fund that is a 
counterparty to the Title VII instrument with a new ``key person,'' 
the Commissions would not view the amended or modified Title VII 
instrument as a new Title VII instrument because the amendment or 
modification is not to a material term of the Title VII instrument.
---------------------------------------------------------------------------

    The Commissions provided an interpretation in the Proposing Release 
regarding circumstances in which the character of a security index on 
which a Title VII instrument is based changes according to 
predetermined criteria or a predetermined self-executing formula set 
forth in the Title VII instrument (or in a related or other agreement 
entered into by the counterparties or a third-party index provider to 
the Title VII instrument) at execution. The Commissions are restating 
this interpretation with one clarification in response to a 
commenter.\895\
---------------------------------------------------------------------------

    \895\ See infra note 898 and accompanying text.
---------------------------------------------------------------------------

    Where at the time of execution such criteria or such formula would 
cause the underlying broad-based security index to become or assume the 
characteristics of a narrow-based security index or vice versa during 
the duration of the instrument,\896\ then the Title VII instrument 
based on such security index is a mixed swap during the entire life of 
the Title VII instrument.\897\ Although at certain points during the 
life of the Title VII instrument, the underlying security index would 
be broad-based and at other points the underlying security index would 
be narrow-based, regulating such a Title VII instrument as a mixed swap 
from the execution of the Title VII instrument and throughout its life 
reflects the appropriate characterization of a Title VII instrument 
based on a security index that migrates pursuant to predetermined 
criteria or a predetermined self-executing formula.
---------------------------------------------------------------------------

    \896\ Thus, for example, if a predetermined self-executing 
formula agreed to by the counterparties of a Title VII instrument at 
or prior to the execution of the Title VII instrument provided that 
the security index underlying the Title VII instrument would 
decrease from 20 to 5 securities after six months, such that the 
security index would become narrow-based as a result of the reduced 
number of securities, then the Title VII instrument is a mixed swap 
at its execution. The characterization of the Title VII instrument 
as a mixed swap will not change during the life of the Title VII 
instrument.
    \897\ As discussed in section III.G.4., supra, to the extent a 
Title VII instrument permits ``at-will'' substitution of an 
underlying security index, however, as opposed to the use of 
predetermined criteria or a predetermined self-executing formula, 
the Title VII instrument is a security-based swap at its execution 
and throughout its life regardless of whether the underlying 
security index was narrow-based at the execution of the Title VII 
instrument.
---------------------------------------------------------------------------

    The Commissions are clarifying what is meant by whether the pre-
determined criteria or pre-determined self-executing formula ``would 
cause'' the underlying broad-based security index to become or assume 
the characteristics of a narrow-based security index, or vice versa, as 
noted above in the interpretation. The Commissions believe that, unless 
the criteria or formula were intentionally designed to change the index 
from narrow to broad, or vice versa, Title VII instruments based on 
indexes that may, but will not necessarily, change from broad to narrow 
(or vice versa) under such criteria or formula should be considered 
swaps or security-based swaps, as appropriate, at execution and for the 
term thereof, and not mixed swaps. In such circumstances, it is not the 
case that the criteria or formula ``would cause'' the change within the 
meaning of the Commission's interpretation.
    The Commissions believe that this interpretation regarding the use 
of predetermined criteria or a predetermined self-executing formula 
will prevent potential gaming of the Commissions' interpretation 
regarding security indexes, and prevent potential regulatory arbitrage 
based on the migration of a security index from broad-based to narrow-
based, or vice versa. In particular, predetermined criteria and 
predetermined self-executing formulas can be constructed in ways that 
take into account the characteristics of a narrow-based security index 
and prevent a narrow-based security index from becoming broad-based, 
and vice versa.
Comments
    The Commissions received two comments on the proposed 
interpretation in this section regarding the classification of Title 
VII Instruments based on security indexes that change from narrow-based 
to broad-based, or vice versa, under predetermined criteria or a 
predetermined self-executing formula, as mixed swaps. One commenter 
requested that the Commissions clarify that a Title VII instrument 
based on a security index that may, but will not necessarily, change 
from narrow-based to broad-based, or vice versa, under predetermined 
criteria or a predetermined self-executing formula should be 
characterized at execution as a swap or security-based swap, as 
applicable, and not as a mixed swap.\898\ This commenter believed that 
the Commissions' interpretation should capture as mixed swaps only 
those Title VII instruments on indexes that will change with certainty, 
and not those that might change given specific market 
circumstances.\899\ Moreover, this commenter believed that the 
Commissions' statement that a Title VII instrument on a security index 
governed by a pre-determined self-executing formula that ``would 
cause'' a change from broad to narrow, or narrow to broad, means that 
the change in character must be a certainty for the instrument to be 
classified as a mixed swap.\900\ The Commissions have clarified their 
interpretation in response to this commenter's concerns as discussed 
above.
---------------------------------------------------------------------------

    \898\ See SIFMA Letter.
    \899\ Id.
    \900\ Id.
---------------------------------------------------------------------------

    Another commenter disagreed with the Commissions' proposed 
interpretation that transactions on indexes under predetermined 
criteria or a predetermined self-executing formula that would change 
from broad to narrow, or narrow to broad, should be classified as mixed 
swaps at inception.\901\ This commenter does not believe that 
regulatory arbitrage is such a significant concern in this context that 
would justify the challenges to market participants if these 
transactions were treated as mixed swaps subject to the dual regulatory 
authority of the Commissions.\902\
---------------------------------------------------------------------------

    \901\ See ISDA Letter.
    \902\ Id.
---------------------------------------------------------------------------

    The Commissions believe that regulatory arbitrage is a sufficient 
concern to justify mixed swap status and dual regulatory oversight for 
Title VII instruments where the index would change from broad to 
narrow, or narrow to broad, under the pre-determined criteria or 
predetermined self-executing formula. Counterparties that are concerned 
about regulatory burdens associated with mixed swap status can redesign 
their formula to avoid the result, or enter into another swap or 
security-based swap that is structured to achieve the same economic 
result without mixed swap status.
(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
    As was recognized in the Proposing Release, security indexes 
underlying Title VII instruments that are traded on DCMs, SEFs, FBOTs, 
security-based SEFs, or NSEs raise particular issues if an underlying 
security index migrates

[[Page 48288]]

from broad-based to narrow-based, or vice versa.\903\ The Commissions 
are adopting as proposed their interpretation clarifying that the 
characterization of an exchange-traded Title VII instrument based on a 
security index at its execution will not change through the life of the 
Title VII instrument, regardless of whether the underlying security 
index migrates from broad-based to narrow-based, or vice versa. 
Accordingly, a market participant who enters into a swap on a broad-
based security index traded on or subject to the rules of a DCM, SEF or 
FBOT that migrates from broad-based to narrow-based may hold that 
position until the swap's expiration without any change in regulatory 
responsibilities, requirements, or obligations; similarly, a market 
participant who enters into a security-based swap on a narrow-based 
security index traded on a security-based SEF or NSE that migrates from 
narrow-based to broad-based may hold that position until the security-
based swap's expiration without any change in regulatory 
responsibilities, requirements, or obligations.
---------------------------------------------------------------------------

    \903\ See Proposing Release at 29856.
---------------------------------------------------------------------------

    In addition, the Commissions are adopting, as proposed, final rules 
providing for tolerance and grace periods for Title VII instruments on 
security indexes that are traded on DCMs, SEFs, FBOTs, security-based 
SEFs and NSEs.\904\ As was noted in the Proposing Release,\905\ in the 
absence of any action by the Commissions, if a market participant wants 
to offset a swap or enter into a new swap on a DCM, SEF or FBOT where 
the underlying security index has migrated from broad-based to narrow-
based, or to offset a security-based swap or enter into a new security-
based swap on a security-based SEF or NSE where the underlying security 
index has migrated from narrow-based to broad-based, the participant 
would be prohibited from doing so. That is because swaps may trade only 
on DCMs, SEFs, and FBOTs, and security-based swaps may trade only on 
registered NSEs and security-based SEFs.\906\ The rules being adopted 
by the Commissions address how to treat Title VII instruments traded on 
trading platforms where the underlying security index migrates from 
broad-based to narrow-based or narrow-based to broad-based, so that 
market participants will know where such Title VII instruments may be 
traded and can avoid potential disruption of their ability to offset or 
enter into new Title VII instruments on trading platforms when such 
migration occurs.\907\
---------------------------------------------------------------------------

    \904\ See paragraphs (2), (3) and (4) of rule 1.3(yyy) under the 
CEA and paragraphs (b), (c) and (d) of rule 3a68-3 under the 
Exchange Act.
    \905\ See Proposing Release at 29857.
    \906\ If a swap were based on a security index that migrated 
from broad-based to narrow-based, a DCM, SEF, or FBOT could no 
longer offer the Title VII instrument because it is now a security-
based swap. Similarly, if a security-based swap were based on a 
security index that migrated from narrow-based to broad-based, a 
security-based SEF or NSE could no longer offer the Title VII 
instrument because it is now a swap.
    \907\ The rules apply only to the particular Title VII 
instrument that is traded on or subject to the rules of a DCM, SEF, 
FBOT, security-based SEF, or NSE. As the Commissions noted in the 
Proposing Release, to the extent that a particular Title VII 
instrument is not traded on such a trading platform (even if another 
Title VII instrument of the same class or type is traded on such a 
trading platform), the rules do not apply to that particular Title 
VII instrument. See Proposing Release at 29857 n. 259.
---------------------------------------------------------------------------

    As was noted in the Proposing Release,\908\ Congress and the 
Commissions addressed a similar issue in the context of security 
futures, where the security index on which a future is based may 
migrate from broad-based to narrow-based or vice versa. Congress 
provided in the definition of the term ``narrow-based security index'' 
in both the CEA and the Exchange Act \909\ for a tolerance period 
ensuring that, under certain conditions, a futures contract on a broad-
based security index traded on a DCM may continue to trade, even when 
the index temporarily assumes characteristics that would render it a 
narrow-based security index under the statutory definition.\910\ In 
general, an index is subject to this tolerance period, and therefore is 
not a narrow-based security index, if: (i) A futures contract on the 
index traded on a DCM for at least 30 days as a futures contract on a 
broad-based security index before the index assumed the characteristics 
of a narrow-based security index; and (ii) the index does not retain 
the characteristics of a narrow-based security index for more than 45 
business days over 3 consecutive calendar months. Pursuant to these 
statutory provisions, if the index becomes narrow-based for more than 
45 business days over 3 consecutive calendar months, the index is 
excluded from the definition of the term ``narrow-based security 
index'' for the following 3 calendar months as a grace period.
---------------------------------------------------------------------------

    \908\ See Proposing Release at 29857.
    \909\ CEA section 1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii); 
section 3(a)(55)(C)(iii) of the Exchange Act, 15 U.S.C. 
78c(a)(55)(C)(iii).
    \910\ By joint rules, the Commissions have provided that 
``[w]hen a contract of sale for future delivery on a security index 
is traded on or subject to the rules of a foreign board of trade, 
such index shall not be a narrow-based security index if it would 
not be a narrow-based security index if a futures contract on such 
index were traded on a designated contract market * * * .'' See rule 
41.13 under the CEA, 17 CFR 41.13, and rule 3a55-3 under the 
Exchange Act, 17 CFR 240.3a55-3. Accordingly, the statutory 
tolerance period applicable to futures on security indexes traded on 
DCMs applies to futures traded on FBOTs as well.
---------------------------------------------------------------------------

    The Commissions believe that a similar tolerance period should 
apply to swaps traded on DCMs, SEFs, and FBOTs and security-based swaps 
traded on security-based SEFs and NSEs. Accordingly, the Commissions 
are adopting the rules, as proposed, providing for tolerance periods 
for swaps that are traded on DCMs, SEFs, or FBOTs \911\ and for 
security-based swaps traded on security-based SEFs and NSEs.\912\
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    \911\ See paragraph (2) of rule 1.3(yyy) under the CEA and 
paragraph (b) of rule 3a68-3 under the Exchange Act.
    \912\ See paragraph (3) of rule 1.3(yyy) under the CEA and 
paragraph (c) of rule 3a68-3 under the Exchange Act.
---------------------------------------------------------------------------

    The final rules provide that to be subject to the tolerance period, 
a security index underlying a swap executed on or subject to the rules 
of a DCM, SEF, or FBOT must not have been a narrow-based security index 
\913\ during the first 30 days of trading.\914\ If the index becomes 
narrow-based during the first 30 days of trading, the index must not 
have been a narrow-based security index during every trading day of the 
6 full calendar months preceding a date no earlier than 30 days prior 
to the commencement of trading of a swap on such index.\915\ If either 
of these alternatives is met, the index will not be a narrow-based 
security index if it has been a narrow-based security index for no more 
than 45 business days over 3 consecutive calendar months.\916\ These 
provisions apply solely for purposes of swaps traded on or subject to 
the rules of a DCM, SEF, or FBOT.
---------------------------------------------------------------------------

    \913\ For purposes of these rules, the term ``narrow-based 
security index'' shall also mean ``issuers of securities in a 
narrow-based security index.'' See supra part III.G.3(b), 
(discussing the rules defining ``issuers of securities in a narrow-
based security index'').
    \914\ This provision is consistent with the provisions of the 
CEA and the Exchange Act applicable to futures contracts on security 
indexes. CEA section 1a(35)(B)(iii)(I), 7 U.S.C. 1a(35)(B)(iii)(I); 
section 3(a)(55)(C)(iii)(I) of the Exchange Act, 15 U.S.C. 
78c(a)(55)(C)(iii)(I).
    \915\ This alternative test is the same as the alternative test 
applicable to futures contracts in CEA rule 41.12, 17 CFR 41.12, and 
rule 3a55-2 under the Exchange Act, 17 CFR 240.3a55-2.
    \916\ These provisions are consistent with the parallel 
provisions in the CEA and Exchange Act applicable to futures 
contracts on security indexes traded on DCMs. See CEA section 
1a(35)(B)(iii)(II), 7 U.S.C. 1a(35)(B)(iii)(II), and section 
3(a)(55)(C)(iii)(II) of the Exchange Act, 15 U.S.C. 
78c(a)(55)(C)(iii)(II).
---------------------------------------------------------------------------

    Similarly, the rules provide a tolerance period for security-based 
swaps traded on security-based SEFs or NSEs. To be subject to the 
tolerance period, a security index underlying a security-based swap 
executed on a security-based SEF or NSE must have

[[Page 48289]]

been a narrow-based security index during the first 30 days of trading. 
If the index becomes broad-based during the first 30 days of trading, 
paragraph (3)(i)(B) of rule 1.3(yyy) under the CEA and paragraph 
(c)(1)(ii) of rule 3a68-3 under the Exchange Act provide that the index 
must have been a non-narrow-based (i.e., a broad-based) security index 
during every trading day of the 6 full calendar months preceding a date 
no earlier than 30 days prior to the commencement of trading of a 
security-based swap on such index. If either of these alternatives is 
met, the index will be a narrow-based security index if it has been a 
security index that is not narrow-based for no more than 45 business 
days over 3 consecutive calendar months.\917\ These provisions apply 
solely for purposes of security-based swaps traded on security-based 
SEFs or NSEs.
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    \917\ These provisions are consistent with the parallel 
provisions in the CEA and the Exchange Act applicable to futures 
contracts on security indexes traded on DCMs. See CEA section 
1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii); section 3(a)(55)(C)(iii) of 
the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(iii).
---------------------------------------------------------------------------

    In addition, the Commissions are adopting rules as proposed that, 
once the tolerance period under the rules has ended, there will be a 
grace period during which a Title VII instrument based on a security 
index that has migrated from broad-based to narrow-based, or vice 
versa, will be able to trade on the platform on which Title VII 
instruments based on such security index were trading before the 
security index migrated and can also, during such period, be 
cleared.\918\ The final rules provide for an additional three-month 
grace period applicable to a security index that becomes narrow-based 
for more than 45 business days over three consecutive calendar months, 
solely with respect to swaps that are traded on or subject to the rules 
of DCMs, SEFs, or FBOTs. During the grace period, such an index will 
not be considered a narrow-based security index. The rules apply the 
same grace period to a security-based swap on a security index that 
becomes broad-based for more than 45 business days over 3 consecutive 
calendar months, solely with respect to security-based swaps that are 
traded on a security-based SEF or NSE. During the grace period, such an 
index will not be considered a broad-based security index.\919\ As a 
result, this rule provides sufficient time for a Title VII instrument 
based on a migrated security index to satisfy listing and clearing 
requirements applicable to swaps or security-based swaps, as 
appropriate.
---------------------------------------------------------------------------

    \918\ See paragraph (4) of rule 1.3(yyy) under the CEA and 
paragraph (d) of rule 3a68-3 under the Exchange Act.
    \919\ These provisions are consistent with the parallel 
provisions in the CEA and the Exchange Act applicable to futures 
contracts on security indexes traded on DCMs. See CEA section 
1a(35)(D), 7 U.S.C. 1a(35)(D); section 3(a)(55)(E) of the Exchange 
Act, 15 U.S.C. 78c(a)(55)(E).
---------------------------------------------------------------------------

    As was noted in the Proposing Release,\920\ there will be no 
overlap between the tolerance and the grace periods under the rules and 
no ``re-triggering'' of the tolerance period. For example, if a 
security index becomes narrow-based for more than 45 business days over 
3 consecutive calendar months, solely with respect to swaps that are 
traded on or subject to the rules of DCMs, SEFs, or FBOTs, but as a 
result of the rules is not considered a narrow-based security index 
during the grace period, the tolerance period provisions will not 
apply, even if the security-index migrated temporarily during the grace 
period. After the grace period has ended, a security index will need to 
satisfy anew the requirements under the rules regarding the tolerance 
period in order to trigger a new tolerance period.
---------------------------------------------------------------------------

    \920\ See Proposing Release at 29858.
---------------------------------------------------------------------------

    The rules will not result in the re-characterization of any 
outstanding Title VII instruments. In addition, the tolerance and grace 
periods as adopted will apply only to Title VII instruments that are 
traded on or subject to the rules of DCMs, SEFs, FBOTs, security-based 
SEFs, and NSEs.
Comments
    The Commissions received one comment on the proposed rules 
described in this section.\921\ This commenter stated its view that 
extending the ``grace period'' from three months to six months would 
ease any disruption or dislocation associated with the delisting 
process with respect to an index that has migrated from broad to 
narrow, or narrow to broad, and that has failed the tolerance 
period.\922\ This commenter also stated its view that where an index 
CDS migrates, for entities operating both a SEF and a security-based 
SEF, such entities should be permitted to move the index from one 
platform to the other simply by providing a notice to the SEC and 
CFTC.\923\
---------------------------------------------------------------------------

    \921\ See MarketAxess Letter.
    \922\ Id.
    \923\ Id.
---------------------------------------------------------------------------

    As discussed above, the Commissions are adopting the proposed rules 
without modification. The Commissions note that the three-month grace 
period applicable to security futures was mandated by Congress in that 
context,\924\ and the commenter has provided no data or evidence for 
its request that the Commissions diverge from that grace period and 
provide for a longer grace period with respect to swaps and security-
based swaps. The Commissions believe that the three-month grace period 
is similarly appropriate to apply in the context of a Title VII 
instrument based on an index that has migrated to provide sufficient 
time to execute off-setting positions. With respect to the commenter's 
other suggestion that entities operating both a SEF and a security-
based SEF should be able to move the index from one platform to another 
where an index CDS migrates simply by filing a notice with the SEC and 
CFTC, the Commissions do not believe that this proposal is within the 
scope of this rulemaking.
---------------------------------------------------------------------------

    \924\ See July 2006 Debt Index Rules. The Commissions are not 
aware of any disruptions caused by the three-month grace period in 
the context of security futures.
---------------------------------------------------------------------------

H. Method of Settlement of Index CDS

    The method that the parties have chosen or use to settle an index 
CDS following the occurrence of a credit event under such index CDS 
also can affect whether such index CDS would be a swap, a security-
based swap, or both (i.e., a mixed swap). The Commissions provided an 
interpretation in the Proposing Release regarding the method of 
settlement of index CDS and are restating the interpretation without 
modification. The Commissions find that this interpretation is an 
appropriate way to address index CDS with different settlement methods 
and is designed to reduce the cost associated with determining whether 
such an index CDS is a swap or a security-based swap.\925\
---------------------------------------------------------------------------

    \925\ See supra part I, under ``Overall Economic 
Considerations''.
---------------------------------------------------------------------------

    If an index CDS that is not based on a narrow-based security index 
under the Commissions' rules includes a mandatory physical settlement 
provision that would require the delivery of, and therefore the 
purchase and sale of, a non-exempted security \926\

[[Page 48290]]

or a loan in the event of a credit event, such an index CDS is a mixed 
swap.\927\ Conversely, if an index CDS that is not based on a narrow-
based security index under the Commissions' rules includes a mandatory 
cash settlement \928\ provision, such index CDS is a swap, and not a 
security-based swap or a mixed swap, even if the cash settlement were 
based on the value of a non-exempted security or a loan.
---------------------------------------------------------------------------

    \926\ The Commissions note that section 3(a)(68)(C) of the 
Exchange Act, 15 U.S.C. 78c(a)(68)(C), provides that ``[t]he term 
``security-based swap'' does not include any agreement, contract, or 
transaction that meets the definition of a security-based swap only 
because such agreement, contract, or transaction references, is 
based upon, or settles through the transfer, delivery, or receipt of 
an exempted security under paragraph (12) [of the Exchange Act], as 
in effect on the date of enactment of the Futures Trading Act of 
1982 (other than any municipal security as defined in paragraph (29) 
[of the Exchange Act] as in effect on the date of enactment of the 
Futures Trading Act of 1982), unless such agreement, contract, or 
transaction is of the character of, or is commonly known in the 
trade as, a put, call, or other option.''
    \927\ The SEC also notes that there must either be an effective 
registration statement covering the transaction or an exemption 
under the Securities Act would need to be available for such 
physical delivery of securities and compliance issues under the 
Exchange Act would also need to be considered.
    \928\ The Commissions are aware that the 2003 Definitions 
include ``Cash Settlement'' as a defined term and that such 
``Settlement Method'' (also a defined term in the 2003 Definitions) 
works differently than auction settlement pursuant to the ``Big Bang 
Protocol'' or ``Auction Supplement'' (each as defined below). The 
Commissions' use of the term ``cash settlement'' in this section 
includes ``Cash Settlement,'' as defined in the 2003 Definitions, 
and auction settlement, as described in the ``Big Bang Protocol'' or 
``Auction Supplement.'' See infra note 929 and accompanying text.
---------------------------------------------------------------------------

    An index CDS that is not based on a narrow-based security index 
under the Commissions' rules and that provides for cash settlement in 
accordance with the 2009 ISDA Credit Derivatives Determinations 
Committees and Auction Settlement Supplement to the 2003 Definitions 
(the ``Auction Supplement'') or with the 2009 ISDA Credit Derivatives 
Determinations Committees and Auction Settlement CDS Protocol (``Big 
Bang Protocol'') \929\ is a swap, and will not be considered a 
security-based swap or a mixed swap solely because the determination of 
the cash price to be paid is established through a securities or loan 
auction.\930\ In 2009, auction settlement, rather than physical 
settlement, became the default method of settlement for, among other 
types of CDS, index CDS on corporate issuers of securities.\931\ The 
amount of the cash settlement is determined through an auction 
triggered by the occurrence of a credit event.\932\ The Auction 
Supplement ``hard wired'' the mechanics of credit event auctions into 
the 2003 Definitions.\933\ The Commissions understand that the credit 
event auction process that is part of the ISDA terms works as follows.
---------------------------------------------------------------------------

    \929\ See ISDA, ``2009 ISDA Credit Derivatives Determinations 
Committees and Auction Settlement CDS Protocol,'' available at 
http://www.isda.org/bigbangprot/docs/Big-Bang-Protocol.pdf.
    \930\ The possibility that such index CDS may, in fact, be 
physically settled if an auction is not held or if the auction fails 
would not affect the characterization of the index CDS.
    \931\ The Commissions understand that the Big Bang Protocol is 
followed for index CDS involving corporate debt obligations but is 
not followed for index CDS based on asset-backed securities, loan-
only CDS, and certain other types of CDS contracts. To the extent 
that such other index CDS contain auction procedures similar to the 
auction procedures for corporate debt to establish the cash price to 
be paid, the Commissions also would not consider such other index 
CDS that are not based on narrow-based security indexes under the 
Commissions' rules to be mixed swaps.
    \932\ The Commissions understand that other conditions may need 
to be satisfied as well for an auction to be held.
    \933\ See supra note 48.
---------------------------------------------------------------------------

    Following the occurrence of a credit event under a CDS, a 
determinations committee (``DC'') established by ISDA, following a 
request by any party to a credit derivatives transaction that is 
subject to the Big Bang Protocol or Auction Supplement, will determine, 
among other matters: (i) Whether and when a credit event occurred; (ii) 
whether or not to hold an auction to enable market participants to 
settle those of their credit derivatives transactions covered by the 
auction; (iii) the list of deliverable obligations of the relevant 
reference entity; and (iv) the necessary auction specific terms. The 
credit event auction takes place in two parts. In the first part of the 
auction, dealers submit physical settlement requests, which are 
requests to buy or sell any of the deliverable obligations (based on 
the dealer's needs and those of its counterparties), and an initial 
market midpoint price is created based on dealers' initial bids and 
offers. Following the establishment of the initial market midpoint, the 
physical settlement requests are then calculated to determine the 
amount of open interest.
    The aggregate amount of open interest is the basis for the second 
part of the auction. In the second part of the auction, dealers and 
investors can determine whether to submit limit orders and the levels 
of such limit orders. The limit orders, which are irrevocable, have a 
firm price in addition to size and whether it is a buy or sell order. 
The auction is conducted as a ``dutch'' auction, in which the open buy 
interests and open sell interests are matched.\934\ The final price of 
the auction is the last limit order used to match against the open 
interest. The final price in the auction is the cash price used for 
purposes of calculating the settlement payments in respect of the 
orders to buy and sell the deliverable obligations and it is also used 
to determine the cash settlement payment under the CDS.
---------------------------------------------------------------------------

    \934\ The second part of the credit event auction process 
involves offers and sales of securities that must be made in 
compliance with the provisions of the Securities Act and the 
Exchange Act. First, the submission of a physical settlement request 
constitutes an offer by the counterparty to either buy or sell any 
one of the deliverable obligations in the auction. Second, the 
submission of the irrevocable limit orders by dealers or investors 
are sales or purchases by such persons at the time of submission of 
the irrevocable limit order. Through the auction mechanism, where 
the open interest (which represents physical settlement requests) is 
matched with limit orders, buyers and sellers are matched. Finally, 
following the auction and determination of the final price, the 
counterparty who has submitted the physical delivery request decides 
which of the deliverable obligations will be delivered to satisfy 
the limit order in exchange for the final price. The sale of the 
securities in the auction occurs at the time the limit order is 
submitted, even though the identification of the specific 
deliverable obligation does not occur until the auction is 
completed.
---------------------------------------------------------------------------

Comments
    One commenter believed that a mandatory physical settlement 
provision in an index CDS based on a broad-based security index should 
not transform a swap into a mixed swap because (i) the SEC would retain 
jurisdiction over a transfer of securities as part of such settlement 
and (ii) application of the interpretation would be difficult since 
many instruments contemplate physical settlement but have a cash 
settlement option, or vice versa.\935\
---------------------------------------------------------------------------

    \935\ See ISDA Letter.
---------------------------------------------------------------------------

    As discussed above, the Commissions are restating the 
interpretation regarding mandatory physical settlement as provided in 
the Proposing Release. The Commissions' interpretation assures that the 
Federal securities laws apply to the offer and sale of the underlying 
securities at the time the index CDS is sold.\936\ The Commissions note 
the commenter's concerns but believe that as a result of the 
Commissions' understanding of the auction settlement process for index 
CDS, which is the primary method by which index CDS are settled and 
which addresses circumstances in which securities may be tendered in 
the auction process separate from the CDS settlement payment, it is not 
clear that there is in fact any significant number of circumstances in 
which such index CDS may be optionally physically settled. The 
Commissions note that this commenter did not elaborate on the

[[Page 48291]]

circumstances in which the auction process would not apply.
---------------------------------------------------------------------------

    \936\ With respect to the applicability of the Federal 
securities laws, the Commissions are concerned about the use of 
index CDS to effect distributions of securities without compliance 
with the requirements of the Securities Act. The Commissions 
recognize that with respect to transactions in security-based swaps 
by an issuer of an underlying security, an affiliate of the issuer, 
or an underwriter the offer and sale of the underlying security (in 
this case the security to be delivered) occur at the time that the 
security-based swap is offered and sold, not at the time of 
settlement. Further, the Commissions note the restrictions on offers 
and sales of security-based swaps to non-ECPs without compliance 
with the registration requirements of the Securities Act. See 
section 5(e) of the Securities Act, 15 U.S.C. 77e(d).
---------------------------------------------------------------------------

I. Security-Based Swaps as Securities Under the Exchange Act and 
Securities Act

    Pursuant to the Dodd-Frank Act, a security-based swap is defined as 
a ``security'' under the Exchange Act\937\ and Securities Act.\938\ As 
a result, security-based swaps are subject to the Exchange Act and the 
Securities Act and the rules and regulations promulgated 
thereunder.\939\
---------------------------------------------------------------------------

    \937\ See section 761(a)(2) of the Dodd-Frank Act (inserting the 
term ``security-based swap'' into the definition of ``security'' in 
section 3a(10) of the Exchange Act, 15 U.S.C. 78c(a)(10)).
    \938\ See section 768(a)(1) of the Dodd-Frank Act (inserting the 
term ``security-based swap'' into the definition of ``security'' in 
section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1)).
    \939\ Sections 761(a)(3) and (4) of the Dodd-Frank Act amend 
sections 3(a)(13) and (14) of the Exchange Act, 15 U.S.C. 78c(a)(13) 
and (14), and section 768(a)(3) of the Dodd-Frank Act adds section 
2(a)(18) to the Securities Act, 15 U.S.C. 77b(a)(18), to provide 
that the terms ``purchase'' and ``sale'' of a security-based swap 
shall mean the ``the execution, termination (prior to its scheduled 
maturity date), assignment, exchange, or similar transfer or 
conveyance of, or extinguishing of rights or obligations under, a 
security-based swap, as the context may require.''
---------------------------------------------------------------------------

    The SEC did not provide interpretations in the Proposing Release on 
the application of the Exchange Act and the Securities Act, and the 
rules and regulations thereunder, to security-based swaps. However, the 
SEC solicited comment on whether additional interpretations may be 
necessary regarding the application of certain provisions of the 
Exchange Act and the Securities Act, and the rules and regulations 
promulgated thereunder, to security-based swaps. The SEC did not 
receive any comments with respect to this issue in the context of this 
rulemaking and is not providing any interpretations in this release.

IV. Mixed Swaps

A. Scope of the Category of Mixed Swap

    The category of mixed swap is described, in both the definition of 
the term ``security-based swap'' in the Exchange Act and the definition 
of the term ``swap'' in the CEA, as a security-based swap that is also 
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 an event described in subparagraph 
(A)(ii)(III) [of section 3(a)(68) of the Exchange Act]).\940\
---------------------------------------------------------------------------

    \940\ Section 3(a)(68)(D) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(D); section 1a(47)(D) of the CEA, 7 U.S.C. 1a(47)(D).
---------------------------------------------------------------------------

    A mixed swap, therefore, is both a security-based swap and a 
swap.\941\ As stated in the Proposing Release, the Commissions believe 
that the scope of mixed swaps is, and is intended to be, narrow.\942\ 
Title VII establishes robust and largely parallel regulatory regimes 
for both swaps and security-based swaps and directs the Commissions to 
jointly prescribe such regulations regarding mixed swaps as may be 
necessary to carry out the purposes of the Dodd-Frank Act.\943\ More 
generally, the Commissions believe the category of mixed swap was 
designed so that there would be no gaps in the regulation of swaps and 
security-based swaps. Therefore, in light of the statutory scheme 
created by the Dodd-Frank Act for swaps and security-based swaps, the 
Commissions believe the category of mixed swap covers only a small 
subset of Title VII instruments.
---------------------------------------------------------------------------

    \941\ Id. The exclusion from the definition of the term ``swap'' 
for security-based swaps does not include security-based swaps that 
are mixed swaps. See section 1a(47)(B)(x) of the CEA, 7 U.S.C. 
1a(47)(B)(x).
    \942\ See Proposing Release at 29860.
    \943\ See section 712(a)(8) of the Dodd-Frank Act.
---------------------------------------------------------------------------

    For example, a Title VII instrument in which the underlying 
references are the value of an oil corporation stock and the price of 
oil would be a mixed swap. Similarly, a Title VII instrument in which 
the underlying reference is a portfolio of both securities (assuming 
the portfolio is not an index or, if it is an index, that the index is 
narrow-based) and commodities would be a mixed swap. Mixed swaps also 
would include certain Title VII instruments called ``best of'' or ``out 
performance'' swaps that require a payment based on the higher of the 
performance of a security and a commodity (other than a security). As 
discussed elsewhere in this release, the Commissions also believe that 
certain Title VII instruments may be mixed swaps if they meet specified 
conditions.
    The Commissions also believe that the use of certain market 
standard agreements in the documentation of Title VII instruments 
should not in and of itself transform a Title VII instrument into a 
mixed swap. For example, many instruments are documented by 
incorporating by reference market standard agreements. Such agreements 
typically set out the basis of establishing a trading relationship with 
another party but are not, taken separately, a swap or security-based 
swap. These agreements also include termination and default events 
relating to one or both of the counterparties; such counterparties may 
or may not be entities that issue securities.\944\ The Commissions 
believe that the term ``any agreement * * * based on * * * the 
occurrence of an event relating to a single issuer of a security,'' as 
provided in the definition of the term ``security-based swap,'' was not 
intended to include such termination and default events relating to 
counterparties included in standard agreements that are incorporated by 
reference into a Title VII instrument.\945\ Therefore, an instrument 
would not be simultaneously a swap and a security-based swap (and thus 
not a mixed swap) simply by virtue of having incorporated by reference 
a standard agreement, including default and termination events relating 
to counterparties to the Title VII instrument.
---------------------------------------------------------------------------

    \944\ Those standard events include inter alia bankruptcy, 
breach of agreement, cross default to other indebtedness, and 
misrepresentations.
    \945\ See section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15 
U.S.C. 78c(a)(68)(A)(ii)(III).
---------------------------------------------------------------------------

Comments
    While the Commissions did not receive any comments on the 
interpretation regarding the scope of the category of mixed swaps, one 
commenter recommended that the Commissions require that market 
participants disaggregate mixed swaps and enter into separate 
simultaneous transactions so that they cannot employ mixed swaps to 
obscure the underlying substance of transactions.\946\ The Commissions 
are not adopting any rules or interpretations to require disaggregation 
of mixed swaps into their separate components, as the Dodd-Frank Act 
specifically contemplated that there would be mixed swaps comprised of 
both swaps and security-based swaps.
---------------------------------------------------------------------------

    \946\ See Better Markets Letter.
---------------------------------------------------------------------------

B. Regulation of Mixed Swaps

1. Introduction
    The Commissions are adopting as proposed paragraph (a) of rule 1.9 
under the CEA and rule 3a68-4 under the Exchange Act to define a 
``mixed swap'' in the same manner as the term is defined in both the 
CEA and the Exchange Act. The Commissions also are adopting as proposed 
two rules to address the regulation of mixed swaps. First, paragraph 
(b) of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act 
will provide a regulatory framework with which parties to bilateral 
uncleared mixed swaps (i.e.,

[[Page 48292]]

mixed swaps that are neither executed on or subject to the rules of a 
DCM, NSE, SEF, security-based SEF, or FBOT nor cleared through a DCO or 
clearing agency), as to which at least one of the parties is dually 
registered with both Commissions, will need to comply. Second, 
paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the 
Exchange Act establishes a process for persons to request that the 
Commissions issue a joint order permitting such persons (and any other 
person or persons that subsequently lists, trades, or clears that class 
of mixed swap)\947\ to comply, as to parallel provisions\948\ only, 
with specified parallel provisions of either the CEA or the Exchange 
Act, and related rules and regulations (collectively ``specified 
parallel provisions''), instead of being required to comply with 
parallel provisions of both the CEA and the Exchange Act.
---------------------------------------------------------------------------

    \947\ All references to Title VII instruments in parts IV and VI 
shall include a class of such Title VII instruments as well. For 
example, a ``class'' of Title VII instrument would include 
instruments that are of similar character and provide substantially 
similar rights and privileges.
    \948\ As stated in paragraph (c) of proposed rule 1.9 under the 
CEA and rule 3a68-4 under the Exchange Act, ``parallel provisions'' 
means comparable provisions of the CEA and the Exchange Act that 
were added or amended by Title VII with respect to security-based 
swaps and swaps, and the rules and regulations thereunder.
---------------------------------------------------------------------------

2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-Registered 
Dealers or Major Participants
    Swap dealers and major swap participants will be comprehensively 
regulated by the CFTC, and security-based swap dealers and major 
security-based swap participants will be comprehensively regulated by 
the SEC.\949\ The Commissions recognize that there may be differences 
in the requirements applicable to swap dealers and security-based swap 
dealers, or major swap participants and major security-based swap 
participants, such that dually-registered market participants may be 
subject to potentially conflicting or duplicative regulatory 
requirements when they engage in mixed swap transactions. In order to 
assist market participants in addressing such potentially conflicting 
or duplicative requirements, the Commissions are adopting, as proposed 
with one modification explained below, rules that will permit dually-
registered swap dealers and security-based swap dealers and dually-
registered major swap participants and major security-based swap 
participants to comply with an alternative regulatory regime when they 
enter into certain mixed swaps under specified circumstances. The 
Commissions received no comments on the proposed rules.
---------------------------------------------------------------------------

    \949\ Section 712(a)(7)(A) of the Dodd-Frank Act requires the 
Commissions to treat functionally or economically similar entities 
in a similar manner.
---------------------------------------------------------------------------

    Accordingly, as adopted, paragraph (b) of rule 1.9 under the CEA 
and rule 3a68-4 under the Exchange Act provide that a bilateral 
uncleared mixed swap,\950\ where at least one party is dually-
registered with the CFTC as a swap dealer or major swap participant and 
with the SEC as a security-based swap dealer or major security-based 
swap participant, will be subject to all applicable provisions of the 
Federal securities laws (and SEC rules and regulations promulgated 
thereunder). The rules as adopted also provide that such mixed swaps 
will be subject to only the following provisions of the CEA (and CFTC 
rules and regulations promulgated thereunder):
---------------------------------------------------------------------------

    \950\ Under paragraph (b) of rule 1.9 under the CEA and rule 
3a68-4 under the Exchange Act, a ``bilateral uncleared mixed swap'' 
will be a mixed swap that: (i) Is neither executed on nor subject to 
the rules of a DCM, NSE, SEF, security-based SEF, or FBOT; and (ii) 
will not be submitted to a DCO or registered or exempt clearing 
agency to be cleared. To the extent that a mixed swap is subject to 
the mandatory clearing requirement (see section 2(h)(1)(A) of the 
CEA, 7 U.S.C. 2(h)(1)(A), and section 3C(a)(1) of the Exchange Act) 
(and where a counterparty is not eligible to rely on the end-user 
exclusion from the mandatory clearing requirement (see section 
2(h)(7) of the CEA, 7 U.S.C. 2(h)(7), and section 3C(g) of the 
Exchange Act)), this alternative regulatory treatment will not be 
available.
---------------------------------------------------------------------------

     Examinations and information sharing: CEA sections 4s(f) 
and 8; \951\
---------------------------------------------------------------------------

    \951\ 7 U.S.C. 6s(f) and 12, respectively.
---------------------------------------------------------------------------

     Enforcement: CEA sections 2(a)(1)(B), 4(b), 4b, 4c, 
4s(h)(1)(A), 4s(h)(4)(A), 6(c), 6(d), 6c, 6d, 9, 13(a), 13(b) and 23; 
\952\
---------------------------------------------------------------------------

    \952\ 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 6s(h)(1)(A), 
6s(h)(4)(A), 9 and 15, 13b, 13a-1, 13a-2, 13, 13c(a), 13c(b), and 
26, respectively.
---------------------------------------------------------------------------

     Reporting to an SDR: CEA section 4r; \953\
---------------------------------------------------------------------------

    \953\ 7 U.S.C. 6r.
---------------------------------------------------------------------------

     Real-time reporting: CEA section 2(a)(13); \954\
---------------------------------------------------------------------------

    \954\ 7 U.S.C. 2(a)(13).
---------------------------------------------------------------------------

     Capital: CEA section 4s(e); \955\ and
---------------------------------------------------------------------------

    \955\ 7 U.S.C. 6s(e).
---------------------------------------------------------------------------

     Position Limits: CEA section 4a.\956\
---------------------------------------------------------------------------

    \956\ 7 U.S.C. 6a.
---------------------------------------------------------------------------

    The Commissions are modifying proposed rule 1.9(b)(3)(i) under the 
CEA and Rule 3a68-4(b)(3)(i) to include additional ``enforcement'' 
authority. Specifically, as adopted, the rules provide that such swaps 
will be subject to the anti-fraud, anti-manipulation, and other 
provisions of the business conduct standards in CEA sections 
4s(h)(1)(A) and 4s(h)(4)(A) and the rules promulgated thereunder for 
mixed swaps.\957\ Rule 23.410 under the CEA,\958\ adopted under CEA 
section 4s(h)(1)(A), applies to swap dealers and major swap 
participants and prohibits fraud, manipulation, and other abusive 
practices and also imposes requirements regarding the confidential 
treatment of counterparty information, which will apply to mixed 
swaps.\959\
---------------------------------------------------------------------------

    \957\ 7 U.S.C. 6s(h)(1)(A) and 6s(h)(4)(A).
    \958\ 17 CFR 23.410.
    \959\ Business Conduct Standards for Swap Dealers and Major Swap 
Participants With Counterparties, 77 FR 9734, 9751-9755 (Feb. 17, 
2012). The Commissions note that, while the introductory text of 
rule 1.9(b)(3)(i)(A) through (F) under the CEA and rule 3a68-
4(b)(3)(i)(A) through (F) under the Exchange Act characterizes the 
cited CEA sections (e.g., ``enforcement,'' ``capital,'' etc.), such 
characterization is meant as guidance only. For example, final rule 
1.9(b)(3)(i)(B) uses the word ``enforcement'' to characterize 
certain of the cited CEA sections and the rules and regulations 
promulgated thereunder that prohibit fraud, manipulation, or abusive 
practices. Other cited provisions, such as the Whistleblower 
protections under CEA section 23, or the related rules and 
regulations, such as requirements to keep counterparty information 
confidential under rule 23.410(c) under the CEA, 17 CFR 23.410(c), 
are similarly enforcement provisions in that they protect market 
participants from fraudulent or other abusive practices.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commissions believe that 
paragraph (b) of rule 1.9 under the CEA and rule 3a68-4 under the 
Exchange Act will address potentially conflicting or duplicative 
regulatory requirements for dually-registered dealers and major 
participants that are subject to regulation by both the CFTC and the 
SEC, while requiring dual registrants to comply with the regulatory 
requirements the Commissions believe are necessary to provide 
sufficient regulatory oversight for mixed swap transactions entered 
into by such dual registrants. The CFTC also believe that paragraph (b) 
of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act will 
provide clarity to dually-registered dealers and major participants, 
who are subject to regulation by both the CFTC and the SEC, as to the 
requirements of each Commission that will apply to their bilateral 
uncleared mixed swaps.
3. Regulatory Treatment for Other Mixed Swaps
    Because mixed swaps are both security-based swaps and swaps,\960\ 
absent a joint rule or order by the Commissions permitting an 
alternative regulatory approach, persons who desire or intend to list, 
trade, or clear a mixed swap (or class thereof) will be required to 
comply with all the statutory provisions in the CEA and the Exchange 
Act (including all the rules and regulations thereunder) that were 
added or amended by Title VII with respect to swaps or security-based 
swaps.\961\ Such

[[Page 48293]]

dual regulation may not be appropriate in every instance and may result 
in potentially conflicting or duplicative regulatory requirements. 
However, before the Commissions can determine the appropriate 
regulatory treatment for mixed swaps (other than the treatment 
discussed above), the Commissions will need to understand better the 
nature of the mixed swaps that parties want to trade. As a result, the 
Commissions proposed paragraph (c) of rule 1.9 under the CEA and rule 
3a68-4 under the Exchange Act to establish a process pursuant to which 
any person who desires or intends to list, trade, or clear a mixed swap 
(or class thereof) that is not subject to the provisions of paragraph 
(b) of the rules (i.e., bilateral uncleared mixed swaps entered into by 
at least one dual registrant) may request the Commissions to publicly 
issue a joint order permitting such person (and any other person or 
persons that subsequently lists, trades, or clears that class of mixed 
swap) to comply, as to parallel provisions only, with the specified 
parallel provisions, instead of being required to comply with parallel 
provisions of both the CEA and the Exchange Act.\962\ The Commissions 
received no comments on the proposed rules and are adopting the rules 
as proposed.
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    \960\ See supra note 10.
    \961\ Because security-based swaps are also securities, 
compliance with the Federal securities laws and rules and 
regulations thereunder (in addition to the provisions of the Dodd-
Frank Act and the rules and regulations thereunder) will also be 
required. To the extent one of the Commissions has exemptive 
authority with respect to other provisions of the CEA or the Federal 
securities laws and the rules and regulations thereunder, persons 
may submit separate exemptive requests or rulemaking petitions 
regarding those provisions to the relevant Commission.
    \962\ Other than with respect to the specified parallel 
provisions with which such persons may be permitted to comply 
instead of complying with parallel provisions of both the CEA and 
the Exchange Act, any other provision of either the CEA or the 
Federal securities laws that applies to swaps or security-based 
swaps will continue to apply.
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    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 
under the Exchange Act further provide that a person submitting such a 
request to the Commissions must provide the Commissions with:
    (i) All material information regarding the terms of the specified, 
or specified class of, mixed swap;
    (ii) the economic characteristics and purpose of the specified, or 
specified class of, mixed swap;
    (iii) the specified parallel provisions, and the reasons the person 
believes such specified parallel provisions would be appropriate for 
the mixed swap (or class thereof);
    (iv) an analysis of (1) the nature and purposes of the parallel 
provisions that are the subject of the request; (2) the comparability 
of such parallel provisions; and (3) the extent of any conflicts or 
differences between such parallel provisions; and
    (v) such other information as may be requested by either of the 
Commissions.
    This provision is intended to provide the Commissions with 
sufficient information regarding the mixed swap (or class thereof) and 
the proposed regulatory approach to make an informed determination 
regarding the appropriate regulatory treatment of the mixed swap (or 
class thereof).
    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 
under the Exchange Act also will allow a person to withdraw a request 
regarding the regulation of a mixed swap at any time prior to the 
issuance of a joint order by the Commissions. This provision is 
intended to permit persons to withdraw requests that they no longer 
need. This, in turn, will save the Commissions time and staff 
resources.
    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 
under the Exchange Act further provide that in response to a request 
pursuant to the rules, the Commissions may jointly issue an order, 
after public notice and opportunity for comment, permitting the 
requesting person (and any other person or persons that subsequently 
lists, trades, or clears that class of mixed swap) to comply, as to 
parallel provisions only, with the specified parallel provisions (or 
another subset of the parallel provisions that are the subject of the 
request, as the Commissions determine is appropriate), instead of being 
required to comply with parallel provisions of both the CEA and the 
Exchange Act. In determining the contents of such a joint order, the 
Commissions can consider, among other things:
    (i) The nature and purposes of the parallel provisions that are the 
subject of the request;
    (ii) the comparability of such parallel provisions; and
    (iii) the extent of any conflicts or differences between such 
parallel provisions.
    Finally, as adopted, paragraph (c) of rule 1.9 under the CEA and 
rule 3a68-4 under the Exchange Act require the Commissions, if they 
determine to issue a joint order pursuant to these rules, to do so 
within 120 days of receipt of a complete request (with such 120-day 
period being tolled during the pendency of a request for public comment 
on the proposed interpretation). If the Commissions do not issue a 
joint order within the prescribed time period, the rules require that 
each Commission publicly provide the reasons for not having done so. 
Paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the 
Exchange Act makes clear that nothing in the rules requires either 
Commission to issue a requested joint order regarding the regulation of 
a particular mixed swap (or class thereof).
    These provisions are intended to provide market participants with a 
prompt review of requests for a joint order regarding the regulation of 
a particular mixed swap (or class thereof). The rules also will provide 
transparency and accountability by requiring that at the end of the 
review period, the Commissions issue the requested order or publicly 
state the reasons for not doing so.

V. Security-Based Swap Agreements

A. Introduction

    SBSAs are swaps over which the CFTC has regulatory and enforcement 
authority but for which the SEC also has antifraud and certain other 
authority.\963\ The term ``security-based swap agreement'' is defined 
as a ``swap agreement'' (as defined in section 206A of the GLBA \964\) 
of which ``a material term is based on the price, yield, value, or 
volatility of any security or any group or index of securities, 
including any interest therein'' but does not include a security-based 
swap.\965\
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    \963\ See section 3(a)(78) of the Exchange Act, 15 U.S.C. 
78c(a)(78); CEA section 1a(47)(A)(v), 7 U.S.C. 1a(47)(A)(v). The 
Dodd-Frank Act provides that certain CFTC registrants, such as DCOs 
and SEFs, will keep records regarding SBSAs open to inspection and 
examination by the SEC upon request. See, e.g., sections 725(e) and 
733 of the Dodd-Frank Act. The Commissions are committed to working 
cooperatively together regarding their dual enforcement authority 
over SBSAs.
    \964\ 15 U.S.C. 78c note. The Dodd-Frank Act amended the 
definition of ``swap agreement'' in section 206A of the GLBA to 
eliminate the requirements that a swap agreement be between ECPs, as 
defined in section 1a(18)(C) of the CEA, 7 U.S.C. 1a(18)(C), and 
subject to individual negotiation. See section 762(b) of the Dodd-
Frank Act. Sections 762(c) and (d) of the Dodd-Frank Act also made 
conforming amendments to the Exchange Act and the Securities Act to 
reflect the changes to the regulation of ``swap agreements'' that 
are either ``security-based swaps'' or ``security-based swap 
agreements'' under the Dodd-Frank Act.
    \965\ See section 3(a)(78) of the Exchange Act, 15 U.S.C. 
78c(a)(78). The CFMA amended the Exchange Act and the Securities Act 
to exclude swap agreements from the definitions of security in those 
statutes but subjected ``security-based swap agreements,'' as 
defined in section 206B of the GLBA, 15 U.S.C. 78c note, to the 
antifraud, anti-manipulation, and anti-insider trading provisions of 
the Exchange Act and Securities Act. See CFMA, supra note 697, title 
III.
     The CEA does not contain a stand-alone definition of 
``security-based swap agreement,'' but includes the definition 
instead 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)), while the definition 
of SBSA in the CEA does not contain a similar exclusion. Instead, 
the exclusion for security-based swaps is placed in the general 
exclusions from the swap definition in the CEA (see CEA section 
1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)).

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[[Page 48294]]

B. Swaps That are Security-Based Swap Agreements

    Although the Commissions believe it is not possible to provide a 
bright line test to define an SBSA, the Commissions believe that it is 
possible to clarify that certain types of swaps clearly fall within the 
definition of SBSA. For example, as the Commissions noted in the 
Proposing Release, a swap based on an index of securities that is not a 
narrow-based security index (i.e., a broad-based security index) would 
fall within the definition of an SBSA under the Dodd-Frank Act.\966\ 
Similarly, an index CDS that is not based on a narrow-based security 
index or on the ``issuers of securities in a narrow-based security 
index,'' as defined in rule 1.3(zzz) under the CEA and rule 3a68-1a 
under the Exchange Act, would be an SBSA. In addition, a swap based on 
a U.S. Treasury security or on certain other exempted securities other 
than municipal securities would fall within the definition of an SBSA 
under the Dodd-Frank Act.\967\
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    \966\ See Proposing Release at 29863. Swaps based on indexes 
that are not narrow-based security indexes are not included within 
the definition of the term security-based swap under the Dodd-Frank 
Act. See section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C. 
78c(a)(68)(A)(ii)(I), and discussion supra part III.G. However, such 
swaps have a material term that is ``based on the price, yield, 
value, or volatility of any security or any group or index of 
securities, or any interest therein,'' and therefore such swaps fall 
within the SBSA definition.
    \967\ Swaps on U.S. Treasury securities that do not have any 
other underlying references involving securities are expressly 
excluded from the definition of the term ``security-based swap'' 
under the Dodd-Frank Act. See section 3(a)(68)(C) of the Exchange 
Act, 15 U.S.C. 78c(a)(68)(C) (providing that an agreement, contract, 
or transaction that would be a security-based swap solely because it 
references, is based on, or settles through the delivery of one or 
more U.S. Treasury securities (or certain other exempted securities) 
is excluded from the security-based swap definition). However, swaps 
on U.S. Treasury securities or on other exempted securities covered 
by subparagraph (C) of the security-based swap definition have a 
material term that is ``based on the price, yield, value, or 
volatility of any security or any group or index of securities, or 
any interest therein,'' and therefore fall within the SBSA 
definition.
---------------------------------------------------------------------------

    The Commissions received no comments on the examples provided in 
the Proposing Release regarding SBSAs. Accordingly, the Commissions are 
not further defining SBSA beyond restating the examples above.\968\
---------------------------------------------------------------------------

    \968\ The Commissions noted that certain transactions that were 
not ``security-based swap agreements'' under the CFMA are 
nevertheless included in the definition of security-based swap under 
the Dodd-Frank Act--including, for example, a CDS on a single loan. 
Accordingly, although such transactions were not subject to insider 
trading restrictions under the CFMA, under the Dodd-Frank Act they 
are subject to the Federal securities laws, including insider 
trading restrictions.
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C. Books and Records Requirements for Security-Based Swap Agreements

    The Commissions are adopting rule 1.7 under the CEA and rule 3a68-3 
under the Exchange Act, as proposed, to clarify that there will not be 
additional books and records requirements regarding SBSAs other than 
those that are required for swaps. The Dodd-Frank Act provides that the 
Commissions shall adopt rules regarding the books and records required 
to be kept for SBSAs.\969\ As discussed above, SBSAs are swaps over 
which the CFTC has regulatory authority, but for which the SEC has 
antifraud, anti-manipulation, and certain other authority. In the 
Proposing Release, the Commissions noted that the CFTC had proposed 
rules governing books and records for swaps, which would apply to swaps 
that also are SBSAs.\970\ The Commissions further stated their belief 
that those proposed rules would provide sufficient books and records 
regarding SBSAs, and that additional books and records requirements 
were not necessary for SBSAs.\971\ The Commissions received no comments 
on the proposed rules.
---------------------------------------------------------------------------

    \969\ Specifically, 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 SDRs under the CEA, including uniform rules 
that specify the data elements that shall be collected and 
maintained by each SDR. 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 major security-based 
swap participants.
    \970\ See Swap Data Recordkeeping and Reporting Requirements, 75 
FR 76573 (Dec. 8, 2010) (proposed rules regarding swap data 
recordkeeping and reporting requirements for SDRs, DCOs, DCMs, SEFs, 
swap dealers, major swap participants, and swap counterparties who 
are neither swap dealers nor major swap participants); See 
Reporting, Recordkeeping, and Daily Trading Records Requirements for 
Swap Dealers and Major Swap Participants, 75 FR 76666 (Dec. 9, 2010) 
(proposed rules regarding reporting and recordkeeping requirements 
and daily trading records requirements for swap dealers and major 
swap participants). These rules have been adopted by the CFTC. See 
Swap Data Recordkeeping and Reporting Requirements, 77 FR 2136 (Jan. 
13, 2012) (final rules regarding swap data recordkeeping and 
reporting requirements for SDRs, DCOs, DCMs, SEFs, swap dealers, 
major swap participants, and swap counterparties who are neither 
swap dealers or major swap participants); See Swap Dealer and Major 
Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures 
Commission Merchant and Introducing Broker Conflicts of Interest 
Rules; and Chief Compliance Officer Rules for Swap Dealers, Major 
Swap Participants, and Futures Commission Merchants, 77 FR 20128 
(Apr. 3, 2012) (final rules regarding reporting and recordkeeping 
requirements and daily trading records requirements for swap dealers 
and major swap participants).
    \971\ See Proposing Release at 29863.
---------------------------------------------------------------------------

    Accordingly, rule 1.7 under the CEA and rule 3a68-3 under the 
Exchange Act provide that persons registered as SDRs under the CEA and 
the rules and regulations thereunder are not required to (i) keep and 
maintain additional books and records regarding SBSAs other than the 
books and records regarding swaps that SDRs would be required to keep 
and maintain pursuant to the CEA and rules and regulations thereunder; 
and (ii) collect and maintain additional data regarding SBSAs other 
than the data regarding swaps that SDRs are required to collect and 
maintain pursuant to the CEA and rules and regulations thereunder. In 
addition, rule 1.7 under the CEA and rule 3a68-3 under the Exchange Act 
provide that persons registered as swap dealers or major swap 
participants under the CEA and the rules and regulations thereunder, or 
registered as security-based swap dealers or major security-based swap 
participants under the Exchange Act and the rules and regulations 
thereunder, are not required to keep and maintain additional books and 
records, including daily trading records, regarding SBSAs other than 
the books and records regarding swaps that those persons are required 
to keep and maintain pursuant to the CEA and the rules and regulations 
thereunder.\972\
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    \972\ Rule 1.7 under the CEA and Rule 3a69-3 under the Exchange 
Act provide that the term ``security-based swap agreement'' has the 
meaning set forth in CEA section 1a(47)(A)(v), 7 U.S.C. 
1a(47)(A)(v), and section 3(a)(78) of the Exchange Act, 15 U.S.C. 
78c(a)(78), respectively.
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VI. Process for Requesting Interpretations of the Characterization of a 
Title VII Instrument

    The Commissions recognize that there may be Title VII instruments 
(or classes of Title VII instruments) that may be difficult to 
categorize definitively as swaps or security-based swaps. Further, 
because mixed swaps are both swaps and security-based swaps, 
identifying a mixed swap may not always be straightforward.
    Section 712(d)(4) of the Dodd-Frank Act provides that any 
interpretation of, or guidance by, either the CFTC or SEC regarding a 
provision of Title VII shall be effective only if issued jointly by the 
Commissions (after consultation with the Board) on issues where Title 
VII requires the CFTC and SEC to issue joint regulations to implement 
the provision. The Commissions believe that any interpretation or 
guidance regarding whether a Title VII instrument is a

[[Page 48295]]

swap, a security-based swap, or both (i.e., a mixed swap), must be 
issued jointly pursuant to this requirement.
    The Commissions proposed rules in the Proposing Release to 
establish a process for interested persons to request a joint 
interpretation by the Commissions regarding whether a particular Title 
VII instrument (or class of Title VII instruments) is a swap, a 
security-based swap, or both (i.e., a mixed swap).\973\ The Commissions 
are adopting the rules as proposed.
---------------------------------------------------------------------------

    \973\ See Proposing Release at 29864-65.
---------------------------------------------------------------------------

    Section 718 of the Dodd-Frank Act establishes a process for 
determining the status of ``novel derivative products'' that may have 
elements of both securities and futures contracts. Section 718 of the 
Dodd-Frank Act provides a useful model for a joint Commission review 
process to appropriately categorize Title VII instruments. As a result, 
the final rules include various attributes of the process established 
in section 718 of the Dodd-Frank Act. In particular, to permit an 
appropriate review period that provides sufficient time to ensure 
Federal regulatory interests are satisfied that also does not unduly 
delay the introduction of new financial products, the adopted process, 
like the process established in section 718, includes a deadline for 
responding to a request for a joint interpretation.\974\
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    \974\ The Commissions note that section 718 of the Dodd-Frank 
Act is a separate process from the process the Commissions are 
adopting, and that any future interpretation involving the process 
under section 718 would not affect the process being adopted here, 
nor will any future interpretation involving the process adopted 
here affect the process under section 718.
---------------------------------------------------------------------------

    The Commissions are adopting rule 1.8 under the CEA and rule 3a68-2 
under the Exchange Act that establish a process for parties to request 
a joint interpretation regarding the characterization of a particular 
Title VII instrument (or class thereof). Specifically, the final rules 
provide that any person may submit a request to the Commissions to 
provide a public joint interpretation of whether a particular Title VII 
instrument is a swap, a security-based swap, or both (i.e., a mixed 
swap).\975\
---------------------------------------------------------------------------

    \975\ See paragraph (a) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------

    The final rules afford market participants with the opportunity to 
obtain greater certainty from the Commissions regarding the regulatory 
status of particular Title VII instruments under the Dodd-Frank Act. 
This provision should decrease the possibility that market participants 
inadvertently might fail to meet the regulatory requirements applicable 
to a particular Title VII instrument.
    The final rules provide that a person requesting an interpretation 
as to the characterization of a Title VII instrument as a swap, a 
security-based swap, or both (i.e., a mixed swap), must provide the 
Commissions with the person's determination of the characterization of 
the instrument and supporting analysis, along with certain other 
documentation.\976\ Specifically, the person must provide the 
Commissions with the following information:
---------------------------------------------------------------------------

    \976\ See paragraph (b) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------

     All material information regarding the terms of the Title 
VII instrument;
     A statement of the economic characteristics and purpose of 
the Title VII instrument;
     The requesting person's determination as to whether the 
Title VII instrument should be characterized as a swap, a security-
based swap, or both (i.e., a mixed swap), including the basis for such 
determination; and
     Such other information as may be requested by either 
Commission.
    This provision should provide the Commissions with sufficient 
information regarding the Title VII instrument at issue so that the 
Commissions can appropriately evaluate whether it is a swap, a 
security-based swap, or both (i.e., a mixed swap).\977\ By requiring 
that requesting persons furnish a determination regarding whether they 
believe the Title VII instrument is a swap, a security-based swap, or 
both (i.e., a mixed swap), including the basis for such determination, 
this provision also will assist the Commissions in more quickly 
identifying and addressing the relevant issues involved in arriving at 
a joint interpretation of the characterization of the instrument.
---------------------------------------------------------------------------

    \977\ The Commissions also may use this information to issue 
(within the timeframe for issuing a joint interpretation) a joint 
notice of proposed rulemaking to further define one or more of the 
terms ``swap,'' ``security-based swap,'' or ``mixed swap.'' See 
paragraph (f) of rule 1.8 under the CEA and rule 3a68-2 under the 
Exchange Act, which are discussed below.
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    The final rules provide that a person may withdraw a request at any 
time prior to the issuance of a joint interpretation or joint notice of 
proposed rulemaking by the Commissions.\978\ Notwithstanding any such 
withdrawal, the Commissions may provide an interpretation regarding the 
characterization of the Title VII instrument that was the subject of a 
withdrawn request.
---------------------------------------------------------------------------

    \978\ See paragraph (c) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------

    This provision will permit parties to withdraw requests for which 
the party no longer needs an interpretation. This, in turn, should save 
the Commissions time and staff resources. If the Commissions believe 
such an interpretation is necessary regardless of a particular request 
for interpretation, however, the Commissions may provide such a joint 
interpretation of their own accord.
    The final rules provide that if either Commission receives a 
proposal to list, trade, or clear an agreement, contract, or 
transaction (or class thereof) that raises questions as to the 
appropriate characterization of such agreement, contract, or 
transaction (or class thereof) as a swap, security-based swap, or both 
(i.e., a mixed swap), the receiving Commission promptly shall notify 
the other.\979\ This provision of the final rules further provides that 
either Commission, or their Chairmen jointly, may submit a request for 
a joint interpretation to the Commissions as to the characterization of 
the Title VII instrument where no external request has been received.
---------------------------------------------------------------------------

    \979\ See paragraph (d) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------

    This provision is intended to ensure that Title VII instruments do 
not fall into regulatory gaps and will help the Commissions to fulfill 
their responsibility to oversee the regulatory regime established by 
Title VII of the Dodd-Frank Act by making sure that Title VII 
instruments are appropriately characterized, and thus appropriately 
regulated. An agency, or their Chairmen jointly, submitting a request 
for an interpretation as to the characterization of a Title VII 
instrument under this paragraph will be required to submit the same 
information as, and could withdraw a request in the same manner as, a 
person submitting a request to the Commissions. The bases for these 
provisions are set forth above with respect to paragraphs (b) and (c) 
of the final rules.
    The final rules require that the Commissions, if they determine to 
issue a joint interpretation as to the characterization of a Title VII 
instrument, do so within 120 days of receipt of the complete external 
or agency submission (unless such 120-day period is tolled during the 
pendency of a request for public comment on the proposed 
interpretation).\980\ If the Commissions do not issue a joint 
interpretation within the prescribed time period, the final rules 
require that each Commission publicly provide the reasons for not 
having done so within

[[Page 48296]]

such prescribed time period. This provision of the final rules also 
incorporates the mandate of the Dodd-Frank Act that any joint 
interpretation by the Commissions be issued only after consultation 
with the Board of Governors of the Federal Reserve System.\981\ 
Finally, the rules make clear that nothing requires either Commission 
to issue a requested joint interpretation regarding the 
characterization of a particular instrument.
---------------------------------------------------------------------------

    \980\ See paragraph (e) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act. This 120-day period is based on the 
timeframe set forth in section 718(a)(3) of the Dodd-Frank Act.
    \981\ See section 712(d)(4) of the Dodd-Frank Act.
---------------------------------------------------------------------------

    These provisions are intended to assure market participants a 
prompt review of submissions requesting a joint interpretation of 
whether a Title VII instrument is a swap, a security-based swap, or 
both (i.e., a mixed swap). The final rules also provide transparency 
and accountability by requiring that at the end of the review period, 
the Commissions issue the requested interpretation or publicly state 
the reasons for not doing so.
    The final rules permit the Commissions, in lieu of issuing a 
requested interpretation, to issue (within the timeframe for issuing a 
joint interpretation) a joint notice of proposed rulemaking to further 
define one or more of the terms ``swap,'' ``security-based swap,'' or 
``mixed swap.'' \982\ Under the final rules, the 120-day period to 
provide a response will be tolled during the pendency of a request for 
public comment on any such proposed interpretation. Such a rulemaking, 
as required by Title VII, would be required to be done in consultation 
with the Board of Governors of the Federal Reserve System. This 
provision is intended to provide the Commissions with needed 
flexibility to address issues that may be of broader applicability than 
the particular Title VII instrument that is the subject of a request 
for a joint interpretation.
---------------------------------------------------------------------------

    \982\ See paragraph (f) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------

Comments
    Three commenters discussed the proposed process for requesting 
interpretations of the characterization of a Title VII instrument,\983\ 
and while supporting such joint interpretive process, suggested certain 
changes, including extending it to SBSAs,\984\ mandating that the 
Commissions issue a response to a request,\985\ and suggesting that the 
Commissions should seek expedited judicial review in the event the 
Commissions do not agree on the interpretation.\986\
---------------------------------------------------------------------------

    \983\ See Better Markets Letter; CME Letter; and SIFMA Letter.
    \984\ See Better Markets Letter.
    \985\ See CME Letter and SIFMA Letter. These commenters 
suggested that the Commissions should be required to issue a joint 
interpretation for all joint interpretive requests that are not 
withdrawn. Id.
    \986\ See CME Letter. This commenter suggested that the 
Commissions should seek expedited judicial review to determine the 
characterization of a Title VII instrument if the Commissions cannot 
agree on a joint interpretation. Id.
---------------------------------------------------------------------------

    The Commissions are adopting the final rules as proposed and are 
not including SBSAs in the process. The joint interpretive process is 
intended to decrease the possibility that market participants 
inadvertently might fail to meet regulatory requirements that are 
applicable to swaps, security-based swaps, or mixed swaps and, as such, 
provides a mechanism for market participants to request whether an 
instrument will be regulated by the CFTC, the SEC, or both. However, 
the Commissions do not believe it is appropriate to predetermine 
whether particular swaps also are SBSAs as SBSAs are already swaps over 
which the CFTC has regulatory and enforcement authority and as to which 
the SEC has antifraud and certain other related authorities.\987\ 
Predetermining whether particular swaps may be SBSAs under this process 
is not needed to provide certainty as to the applicable regulatory 
treatment of these instruments.
---------------------------------------------------------------------------

    \987\ See section 3(a)(78) of the Exchange Act, 15 U.S.C. 
78c(a)(78), and section 1a(47)(A)(v) of the CEA, 7 U.S.C. 
1a(47)(A)(v). The Dodd-Frank Act provides that certain CFTC 
registrants, such as DCOs and SEFs, will keep records regarding 
security-based swap agreements open to inspection and examination by 
the SEC upon request. See, e.g., sections 725(e) and 733 of the 
Dodd-Frank Act.
---------------------------------------------------------------------------

    The Commissions also are retaining in the final rules the framework 
for providing or not providing joint interpretations. As noted above, 
section 718 of the Dodd-Frank Act contains a framework for evaluating 
novel derivative products that may have elements of both securities and 
futures contracts (other than swaps, security-based swaps or mixed 
swaps). The Commissions believe that establishing a joint interpretive 
process for swaps, security-based swaps and mixed swaps that is modeled 
in part on this statutory framework should facilitate providing 
interpretations to market participants in a timely manner, if the 
Commissions determine to do so. Establishing a process by rule will 
provide market participants with an understandable method by which they 
can request an interpretation from the Commissions. As the Commissions 
have the authority, but not the obligation, under the Dodd-Frank Act to 
further define the terms ``swap,'' ``security-based swap,'' and ``mixed 
swap,'' the Commissions are retaining the flexibility in the 
interpretive process rules to decide whether or not to issue joint 
interpretations. The Commissions believe, however, that it is 
appropriate to advise market participants of the reasons why such 
interpretation is not being issued and the final rules retain the 
requirement that the Commissions publicly explain the reasons for not 
issuing a joint interpretation.
    Further, the Commissions are not revising the final rules to 
provide for expedited judicial review. The Dodd-Frank Act does not 
contain any provision that provides for expedited judicial review if 
the Commissions do not issue a joint interpretation with respect to a 
Title VII instrument. Although the Commissions note that section 718 of 
the Dodd-Frank Act contains a statutorily mandated expedited judicial 
review of one of the Commission's actions (if sought by the other 
Commission) regarding novel derivative products that may have elements 
of both securities and futures contracts, such statutory provision does 
not apply to Title VII instruments.\988\ Further, Title VII provides 
flexibility to the Commissions to determine the methods by which joint 
interpretations are provided. Title VII does not contain any required 
expedited judicial review of Commission actions, and the Commissions do 
not have the authority to require expedited judicial review under Title 
VII, with respect to a Title VII instrument. Accordingly, the 
Commissions do not believe that including such a provision is 
appropriate in the context of providing interpretations to market 
participants regarding the definitions of swap, security-based swap, or 
mixed swap.
---------------------------------------------------------------------------

    \988\ The Commissions note that judicial review provisions in 
section 718 relating to the status of novel derivative products only 
provide that either Commission (either the SEC or the CFTC) has the 
right to petition for review of a final order of the other 
Commission with respect to novel derivative products that may have 
elements of both securities and futures that affects jurisdictional 
issues. Nothing in section 718 requires that the Commissions issue 
exemptions or interpretations pursuant to such section or provides 
any person other than the Commissions the right to petition for 
Court review of a Commission order issued pursuant to section 718.
---------------------------------------------------------------------------

    Two commenters were concerned about the length of the review period 
and believed that the Commissions should shorten such time period.\989\ 
The

[[Page 48297]]

Commissions are not modifying the final rules from those proposed with 
respect to the length of the review period. The 120-day review period 
is based on a timeframe established by Congress with respect to 
determining the status of novel derivative products.\990\ The 
Commissions believe that this length of the review period also is 
appropriate for other derivative products such as swaps, security-based 
swaps, and mixed swaps. Further, the Commissions believe the 120-day 
review period is necessary to enable the Commissions to obtain the 
necessary information regarding a Title VII instrument, thoroughly 
analyze the instrument, and formulate any joint interpretation 
regarding the instrument. In a related comment, one commenter suggested 
that the Commissions allow a requesting party, while awaiting a joint 
interpretation, to make a good faith characterization of a particular 
Title VII instrument and engage in transactions based on such 
characterization.\991\ The Commissions believe that it is essential 
that the characterization of an instrument be established prior to any 
party engaging in the transactions so that the appropriate regulatory 
schemes apply. The Commissions do not believe that allowing market 
participants to make such a determination as to the status of a product 
is either appropriate or consistent with the statutory provisions 
providing for the Commissions to further define the terms ``swap,'' 
``security-based swap'' and ``mixed swap.'' Further, allowing market 
participants to determine the status of a product could give rise to 
regulatory arbitrage and inconsistent treatment of similar products.
---------------------------------------------------------------------------

    \989\ See CME Letter and Markit Letter. One of these commenters 
suggested that the Commissions should reduce the 120-day review 
period to 30 days because the value of receiving a joint 
interpretation would be negated if a market participant had to wait 
120 days. This commenter also suggested that foreign competitors 
will gain a competitive advantage to U.S. market participants 
because they will not need to wait for a joint interpretation before 
trading similar or identical products. See CME Letter. The 
Commissions note that to the extent foreign competitors are engaging 
in swap and security-based swap transactions subject to either 
Commission's jurisdiction, they will be subject to the same process 
for requesting interpretations of the characterization of Title VII 
instruments as U.S. market participants. The other commenter 
requested that the Commissions issue a joint interpretation for each 
``widely-utilized index,'' at the time of the index series' launch, 
within a two-week period rather than the proposed 120-day period for 
novel derivative products under section 718 of the Dodd-Frank Act. 
This commenter did not recognize that the joint interpretive process 
would be available in this case, and that it may be initiated by an 
index provider. See paragraph (a) of rule 1.8 under the CEA and rule 
3a68-2 under the Exchange Act (providing that ``[a]ny person'' may 
submit a request for a joint interpretation). See Markit Letter.
    \990\ See section 718(a)(3) of the Dodd-Frank Act.
    \991\ See SIFMA Letter. This commenter also suggested that while 
the requesting party, and all other market participants, would be 
bound by the joint interpretation when issued, they should not face 
retroactive re-characterization of a transaction executed during the 
review period and prior to the issuance of the joint interpretation. 
Id.
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    Finally, some commenters expressed concern about the public 
availability of information regarding the joint interpretive process 
and asked that the parties be able to seek confidential treatment of 
their submissions.\992\ The Commissions note that under existing rules 
of both Commissions, requesting parties may seek confidential treatment 
for joint interpretive requests from the SEC and the CFTC in accordance 
with the applicable existing rules relating to confidential treatment 
of information.\993\ The Commissions also note that even if 
confidential treatment has been requested, all joint interpretive 
requests, as well all joint interpretations and any decisions not to 
issue a joint interpretation (along with the explanation of the grounds 
for such decision), will be made publicly available at the conclusion 
of the review period.\994\
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    \992\ One commenter suggested that the Commissions should permit 
the parties seeking a joint interpretation to request confidential 
treatment from the Commissions during the course of the review 
period in order to protect proprietary information and deal 
structures. See SIFMA Letter. Another commenter suggested that the 
Commissions should make public all requests for joint 
interpretations, any guidance actually provided in response to such 
requests, and any decisions not to provide guidance in response to 
such requests (along with an explanation of the grounds for any such 
decision). See Better Markets Letter.
    \993\ See 17 CFR 200.81 and 17 CFR 140.98. The Commissions note 
that the joint interpretive process is intended to provide, among 
other things, notification to all market participants as to the 
regulatory classification of a particular Title VII instrument. In 
this regard, the Commissions do not believe it is appropriate to 
provide a joint interpretation only to the market participants 
requesting the interpretation, while delaying publication of the 
same joint interpretation to market participants generally. 
Therefore, CFTC staff will not exercise its discretion under 17 CFR 
140.98(b) to delay publication of a joint interpretation. SEC staff 
does not have discretion under 17 CFR 200.81(b) to delay publication 
of a joint interpretation.
    \994\ The CFTC's publication of any joint interpretative request 
and the joint interpretation itself will be subject to the 
restrictions of section 8 of the CEA. See 7 U.S.C. 12. Subject to 
limited exceptions, CEA section 8 generally restricts the CFTC from 
publishing ``data and information that would separately disclose the 
business transactions or market positions of any person and trade 
secrets or names of customers[hellip]'' Id. The CFTC and its staff 
have a long history of providing interpretive guidance with respect 
to the regulatory status of specific proposed transactions in 
compliance with CEA section 8. However, market participants making a 
joint interpretive request should be aware that the SEC is not 
subject to CEA section 8 and, therefore, is not subject to the 
restrictions of CEA section 8. The CFTC anticipates that most joint 
interpretive requests will not contain CEA Section 8 information. 
However, given that the SEC is not subject to the restrictions of 
CEA section 8, the CFTC intends to work with requesting parties to 
assure that joint interpretive requests do not include CEA section 8 
information. Nevertheless, given the foregoing, market participants 
should not submit CEA section 8 information in their joint 
interpretive requests.
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VII. Anti-Evasion

A. CFTC Anti-Evasion Rules

1. CFTC's Anti-Evasion Authority
(a) Statutory Basis for the Anti-Evasion Rules
    Pursuant to the authority in sections 721(c) and 725(g)(2) of the 
Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i),\995\ the CFTC is 
promulgating the anti-evasion rules as they were proposed and restating 
the accompanying interpretation with modifications in response to 
commenters. The CFTC also is providing an additional interpretation 
regarding rules 1.3(xxx)(6) and 1.6 under the CEA.
---------------------------------------------------------------------------

    \995\ 7 U.S.C. 1a(47)(E) and 2(i).
---------------------------------------------------------------------------

    Section 721(c) of the Dodd-Frank Act requires the CFTC to further 
define the terms ``swap,'' ``swap dealer,'' ``major swap participant,'' 
and ``eligible contract participant,'' in order ``[t]o include 
transactions and entities that have been structured to evade'' subtitle 
A of Title VII (or an amendment made by subtitle A of the CEA). 
Moreover, as the CFTC noted in the Proposing Release,\996\ several 
other provisions of Title VII reference the promulgation of anti-
evasion rules, including:
---------------------------------------------------------------------------

    \996\ Proposing Release at 29866.
---------------------------------------------------------------------------

     Subparagraph (E) of the definition of ``swap'' provides 
that foreign exchange swaps and foreign exchange forwards shall be 
considered swaps unless the Secretary of the Treasury makes a written 
determination that either foreign exchange swaps or foreign exchange 
forwards, or both, among other things, ``are not structured to evade 
the [Dodd-Frank Act] in violation of any rule promulgated by the [CFTC] 
pursuant to section 721(c) of that Act;'' \997\
---------------------------------------------------------------------------

    \997\ CEA section 1a(47)(E), 7 U.S.C. 1a(47)(E).
---------------------------------------------------------------------------

     Section 722(d) of the Dodd-Frank Act provides that the 
provisions of the CEA relating to swaps shall not apply to activities 
outside the United States unless those activities, among other things, 
``contravene such rules or regulations as the [CFTC] may prescribe or 
promulgate as are necessary or appropriate to prevent the evasion of 
any provision of [the CEA] that was enacted by the [Title VII];'' \998\ 
and
---------------------------------------------------------------------------

    \998\ CEA section 2(i), 7 U.S.C. 2(i). New CEA section 2(i), as 
added by section 722(d) of the Dodd-Frank Act, also provides that 
the provisions of Title VII relating to swaps shall not apply to 
activities outside the United States unless those activities ``have 
a direct and significant connection with activities in, or effect 
on, commerce of the United States.''
---------------------------------------------------------------------------

     Section 725(g) of the Dodd-Frank Act amends the Legal 
Certainty for Bank Products Act of 2000 to provide that,

[[Page 48298]]

although identified banking products generally are excluded from the 
CEA, that exclusion shall not apply to an identified banking product 
that is a product of a bank that is not under the regulatory 
jurisdiction of an appropriate Federal banking agency,\999\ meets the 
definition of the terms ``swap'' or ``security-based swap,'' and ``has 
been structured as an identified banking product for the purpose of 
evading the provisions of the [CEA], the [Securities Act], or the 
[Exchange Act].'' \1000\
---------------------------------------------------------------------------

    \999\ The term ``identified banking product'' is defined in 
section 402 of the Legal Certainty for Bank Products Act of 2000, 7 
U.S.C. 27. The term ``appropriate Federal banking agency'' is 
defined in CEA section 1a(2), 7 U.S.C. 1a(2), and section 3(a)(72) 
of the Exchange Act, 15 U.S.C. 78c(a)(72), which were added by 
sections 721(a) and 761(a) of the Dodd-Frank Act, respectively.
    \1000\ Section 741(b) of the Dodd-Frank Act amends section 6(e) 
of the CEA, 7 U.S.C. 9a, to provide that any DCO, swap dealer, or 
major swap participant ``that knowingly or recklessly evades or 
participates in or facilitates an evasion of the requirements of 
section 2(h) [of the CEA] shall be liable for a civil monetary 
penalty in twice the amount otherwise available for a violation of 
section 2(h) [of the CEA].'' This anti-evasion provision is not 
dependent upon the promulgation of a rule under section 721(c) of 
the Dodd Frank Act, and hence the proposed rule and interpretive 
guidance is not meant to apply to CEA section 6(e).
---------------------------------------------------------------------------

Comments
    One commenter asserted the CFTC has no statutory basis to 
promulgate the anti-evasion rules, as proposed.\1001\ Specifically, 
this commenter stated that neither CEA sections 2(h)(4)(A) nor 6(e) 
grant the CFTC authority to prescribe an anti-evasion rule and 
interpretation as described in the Proposing Release.\1002\ Moreover, 
this commenter argued that CEA section 2(i) limits the CFTC to 
prescribing anti-evasion rules related only to activities occurring 
outside of the United States.\1003\ The CFTC finds these comments 
misplaced because CEA sections 2(h)(4)(A) and 6(e) provide the CFTC 
with additional authority to prescribe anti-evasion rules for specific 
purposes above and beyond the authority provided by sections 721(c) and 
725(g) of the Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i), upon 
which the CFTC is relying in this rulemaking.\1004\ In addition, 
section 2(i) of the CEA provides that activities conducted outside the 
United States, including entering into agreements, contracts and 
transactions or structuring entities, which willfully evade or attempt 
to evade any provision of the CEA, shall be subject to the provisions 
of Subtitle A of Title VII of the Dodd-Frank Act; it does not limit the 
CFTC's other authorities cited above. Accordingly, nothing in CEA 
sections 2(h)(4)(A), 2(i) or 6(e) prevent the CFTC from prescribing 
rules 1.3(xxx)(6) and 1.6.
---------------------------------------------------------------------------

    \1001\ See IECA Letter.
    \1002\ Id.; 7 U.S.C. 2(h)(4)(A) and 9a.
    \1003\ See IECA Letter; 7 U.S.C. 2(i).
    \1004\ CEA section 2(h)(4)(A), 7 U.S.C. 2(h)(4)(A), provides: 
The Commission shall prescribe rules under this subsection (and 
issue interpretations of rules prescribed under this subsection) as 
determined by the Commission to be necessary to prevent evasions of 
the mandatory clearing requirements under this Act.
     CEA section 6(e), 7 U.S.C. 9a, in relevant part, provides: (4) 
Any designated clearing organization that knowingly or recklessly 
evades or participates in or facilitates an evasion of the 
requirements of section 2(h) shall be liable for a civil money 
penalty in twice the amount otherwise available for a violation of 
section 2(h). (5) Any swap dealer or major swap participant that 
knowingly or recklessly evades or participates in or facilitates an 
evasion of the requirements of section 2(h) shall be liable for a 
civil money penalty in twice the amount otherwise available for a 
violation of section 2(h).
---------------------------------------------------------------------------

    Two commenters supported the proposal's ``principles-based'' 
approach to anti-evasion,\1005\ while several others suggested 
modifications.\1006\ Two commenters believed that the Proposing Release 
is overly broad and that, if the CFTC does finalize anti-evasion rules, 
such rules should be narrower in scope.\1007\ Similarly, one other 
commenter asserted that the CFTC erred in the Proposing Release by 
placing too great an emphasis on the flexibility of the rules as 
opposed to providing clarity for market participants.\1008\ The CFTC 
continues to believe a ``principles-based'' approach to its anti-
evasion rules is appropriate. The CFTC is not adopting an alternative 
approach, whereby it provides a bright-line test of non-evasive 
conduct, because such an approach may provide potential wrongdoers with 
a roadmap for structuring evasive transactions. Notwithstanding this 
concern, as described below, the CFTC is providing an additional 
interpretation and examples of evasion in order to provide clarity to 
market participants.\1009\
---------------------------------------------------------------------------

    \1005\ See Barnard Letter and Better Markets Letter.
    \1006\ See CME Letter; ISDA Letter; and SIFMA Letter.
    \1007\ See ISDA Letter and SIFMA Letter.
    \1008\ See CME Letter.
    \1009\ Examples described in the guidance are illustrative and 
not exhaustive of the transactions, instruments or entities that 
could be considered evasive. In considering whether a transaction, 
instrument or entity is evasive, the CFTC will consider the facts 
and circumstances of each situation.
---------------------------------------------------------------------------

    One commenter suggested an alternative standard for a finding of 
evasion should be ``whether the transaction is lawful or not'' under 
the CEA, CFTC rules and regulations, orders, or other applicable 
federal, state or other laws.\1010\ The CFTC is not adopting this 
suggested alternative standard for evasion because to adopt this 
standard would blur the distinction between whether a transaction (or 
entity) is lawful and whether it is structured in a way to evade the 
Dodd-Frank Act and the CEA. The anti-evasion rules provided herein are 
concerned with the latter conduct, not the former.\1011\ Thus, the CFTC 
does not believe it is appropriate to limit the enforcement of its 
anti-evasion authority to only unlawful transactions.
---------------------------------------------------------------------------

    \1010\ See WGCEF Letter.
    \1011\ If a transaction is unlawful, the CFTC (or another 
authority) may be able to bring an action alleging a violation of 
the applicable rule, regulation, order or law.
---------------------------------------------------------------------------

2. Final Rules
(a) Rule 1.3(xxx)(6)
    The CFTC is adopting the Rule 1.3(xxx)(6) as proposed. As adopted, 
Rule 1.3(xxx)(6)(i) under the CEA generally defines as swaps those 
transactions that are willfully structured to evade the provisions of 
Title VII governing the regulation of swaps. Furthermore, rules 
1.3(xxx)(6)(ii) and (iii) effectuate CEA section 1a(47)(E)(i) and 
section 725(g) of the Dodd-Frank Act, respectively, and will be applied 
in a similar fashion as rule 1.3(xxx)(6)(i). Rule 1.3(xxx)(6)(ii) 
applies to currency and interest rate swaps that are willfully 
structured as foreign exchange forwards or foreign exchange swaps to 
evade the new regulatory regime for swaps enacted in Title VII. Rule 
1.3(xxx)(6)(iii) applies to transactions of a bank that are not under 
the regulatory jurisdiction of an appropriate Federal banking agency 
and where the transaction is willfully structured as an identified 
banking product to evade the new regulatory regime for swaps enacted in 
Title VII.
    Rule 1.3(xxx)(6)(iv) provides that in determining whether a 
transaction has been willfully structured to evade rules 1.3(xxx)(6)(i) 
through (iii), the CFTC will not consider the form, label, or written 
documentation dispositive.\1012\ This approach is intended to prevent 
evasion through clever draftsmanship of a form, label, or other written 
documentation.
---------------------------------------------------------------------------

    \1012\ See supra part II.D.1.
---------------------------------------------------------------------------

    Rule 1.3(xxx)(6)(v) further provides that transactions, other than 
transactions structured as securities, willfully structured to evade 
(as provided in rules 1.3(xxx)(6)(i) through (iii)) will be considered 
in determining whether a person is a swap dealer or major swap 
participant.
    Lastly, rule 1.3(xxx)(6)(vi) provides that rule 1.3(xxx)(6) will 
not apply to any agreement, contract or transaction structured as a 
security (including a security-based swap) under the

[[Page 48299]]

securities laws as defined in section 3(a)(47) of the Exchange 
Act.\1013\
---------------------------------------------------------------------------

    \1013\ 15 U.S.C. 78c(a)(47).
---------------------------------------------------------------------------

(b) Rule 1.6
    The CFTC is adopting rule 1.6 as proposed. Section 2(i) of the CEA 
states that the provisions of the CEA relating to swaps that were 
enacted by Title VII (including any rule prescribed or regulation 
promulgated thereunder) shall not apply to activities outside the 
United States unless, among other things, those activities ``contravene 
such rules or regulations as the [CFTC] may prescribe or promulgate as 
are necessary or appropriate to prevent the evasion of any provision of 
[the CEA] that was enacted by [Title VII].''
    Pursuant to this authority, rule 1.6(a), as adopted, makes it 
unlawful to conduct activities outside the United States, including 
entering into transactions and structuring entities, to willfully evade 
or attempt to evade any provision of the CEA as enacted under Title VII 
or the rules and regulations promulgated thereunder.
    In addition, rule 1.6(b) provides that in determining whether a 
transaction or entity has been entered into or structured willfully to 
evade, as provided in rule 1.6(a), the CFTC will not consider the form, 
label, or written documentation as dispositive.
    Rule 1.6(c) provides that an activity conducted outside the United 
States to evade, as described in proposed rule 1.6(a), shall be subject 
to the provisions of Subtitle A of Title VII of the Dodd-Frank Act. As 
the CFTC explained in the Proposing Release,\1014\ such provisions are 
necessary to fully prevent those who seek to willfully evade the 
regulatory requirements established by Congress in Title VII relating 
to swaps from enjoying any benefits from their efforts to evade.
---------------------------------------------------------------------------

    \1014\ Proposing Release at 29866.
---------------------------------------------------------------------------

    Lastly, rule 1.6(d) provides that no agreement, contract or 
transaction structured as a security (including a security-based swap) 
under the securities laws shall be deemed a swap pursuant to rule 1.6.
(c) Interpretation of the Final Rules
    The CFTC is providing an interpretation of the final rules in 
response to commenters, addressing (i) the applicability of the anti-
evasion rules to transactions that qualify for the forward exclusion, 
(ii) the applicability of the anti-evasion rules to transactions 
executed on a SEF, (iii) the treatment of evasive transactions after 
they are discovered, and (iv) documentation considerations.\1015\
---------------------------------------------------------------------------

    \1015\ The CFTC also is adopting the interpretive guidance from 
the Proposing Release, as proposed, but with certain clarifications. 
See infra part VII.A.3.
---------------------------------------------------------------------------

    With regard to the forward exclusion, the CFTC is clarifying, in 
response to a commenter,\1016\ that entering into transactions that 
qualify for the forward exclusion from the swap definition shall not be 
considered evasive. However, in circumstances where a transaction does 
not, in fact, qualify for the forward exclusion, the transaction may or 
may not be evasive depending on an analysis of all relevant facts and 
circumstances.\1017\
---------------------------------------------------------------------------

    \1016\ See COPE Letter (requesting clarification that 
transacting in the physical markets (e.g., entering into 
nonfinancial commodity forward contracts), as opposed to executing a 
swap, would not be considered evasion).
    \1017\ The CFTC is aware that there are circumstances where a 
forward contract can perform the same or a substantially similar 
economic function as a swap through alternative delivery procedures. 
Further, there are circumstances where a person who deals in both 
forwards and swaps may make decisions regarding financial risk 
assessment that will involve the consideration of regulatory 
obligations. The CFTC will carefully scrutinize the facts and 
circumstances associated with forward contracts.
---------------------------------------------------------------------------

    Concerning the applicability of the anti-evasion rules to 
transactions executed on a SEF, the CFTC is clarifying, in response to 
comments,\1018\ that a transaction that has been self-certified by a 
SEF (or a DCM), or that has received prior approval from the CFTC, will 
not be considered evasive.\1019\
---------------------------------------------------------------------------

    \1018\ See MarketAxess Letter (commenting that the anti-evasion 
rules should not apply to transactions executed on, or subject to 
the rules of, a SEF, because before a SEF may list a swap, it must 
self-certify or voluntarily obtain CFTC approval to list the 
product).
    \1019\ Pursuant to part 40 of the CFTC's regulations, 17 CFR 
Part 40, registered SEFs and DCMs must self-certify with the CFTC 
that any products that they list ``[comply] with the [CEA] and 
regulations thereunder'' and are liable for any false self-
certifications. Therefore, market participants that have entered 
into such transactions will not be considered to be engaging in 
evasion, while a SEF or DCM could be found to have falsely self-
certified.
---------------------------------------------------------------------------

    With respect to the treatment of evasive transactions after they 
are discovered, the CFTC is clarifying, in response to comments,\1020\ 
that in instances where one party willfully structures a transaction to 
evade but the counterparty does not, the transaction, which meets the 
swap definition under rule 1.3(xxx)(6), or is subject to the provisions 
of Subtitle A of Title VII pursuant to rule 1.6, will be subject to all 
CEA provisions and the regulations thereunder (as applied to the party 
who willfully structures a transaction to evade). In rare situations 
where there is a true ``innocent party,''\1021\ it will likely be due 
to fraud or misrepresentation by the evading party and the business 
consequences and remedies will be the same as for any such 
victim.\1022\ The CFTC will impose appropriate sanctions only on the 
willful evader for violations of the relevant provisions of the CEA and 
CFTC regulations since the individual agreement, contract or 
transaction was (and always should have been) subject to them.\1023\ 
Further, on a prospective basis for future transactions or instruments 
similar to those of the particular evasive swap, the CFTC will consider 
these transactions or instruments to be swaps within the meaning of the 
Dodd-Frank Act (as applied to both the party who willfully structures a 
transaction to evade and the ``innocent party'').
---------------------------------------------------------------------------

    \1020\ See WGCEF Letter (generally expressing concern that the 
penalty for anti-evasion is ``draconian'') and IECA Letter 
(commenting that the non-evading party should not become a party to 
an evasive ``swap'' transaction, and thus subject to the regulatory 
requirements of the Dodd-Frank Act.) .
    \1021\ The analysis of whether a party is ``innocent'' is based 
on the facts and circumstances of a particular transaction as well 
as a course of dealing by each of the parties.
    \1022\ This is not dissimilar to an enforcement action for 
trading illegal off-exchange futures contracts in violation of CEA 
section 4(a), 7 U.S.C. 6(a). The CFTC regularly seeks restitution 
for victims in enforcement actions where applicable. Additionally, 
victims retain their private rights of action for breach of contract 
and any related equitable remedies.
    \1023\ In considering which provisions of the CEA and CFTC 
regulations are relevant, the CFTC will evaluate which CEA 
provisions and CFTC regulations the evasive swap would have had to 
comply with had it not evaded the definition of swap (e.g., 
reporting, recordkeeping, clearing, etc.). However, where both 
parties have willfully structured to evade or attempted to evade the 
requirements of the Dodd-Frank Act, the CFTC may subject the 
agreement, contract, instrument, or transaction itself to the full 
regulatory regime and the willful evaders to applicable sanctions.
---------------------------------------------------------------------------

    Moreover, evasive transactions will count toward determining 
whether each evading party with the requisite intent is a swap dealer 
or major swap participant.\1024\ In response to a commenter's 
suggestion that, as proposed, rule 1.3(xxx)(6)(v) should require a 
pattern of transactions,\1025\ the CFTC is not requiring a pattern of 
evasive transactions as a prerequisite to prove evasion, although such 
a pattern may be one factor in analyzing whether evasion has occurred 
under rules 1.3(xxx)(6) or 1.6. Further, in

[[Page 48300]]

determining whether such a transaction is a swap, the CFTC will 
consider whether the transaction meets the definition of the term 
``swap'' as defined by statute and as it is further defined in this 
rulemaking.\1026\
---------------------------------------------------------------------------

    \1024\ In other words, the evasive transaction would count 
toward the relevant thresholds (e.g., de minimis (with respect to 
determining swap dealer status, if the evasive transaction 
constituted dealing activity) and substantial position (with respect 
to determining major swap participant status)).
    \1025\ See IECA Letter. This same commenter suggested that rule 
1.3(xxx)(6)(v) should be applied only to the authorities regarding 
evasion provided by Congress and refer to the entity structuring the 
evading transaction have been addressed above.
    \1026\ Thus, for example, if a person, in seeking to evade Title 
VII, structures a product that is a privilege on a certificate of 
deposit, the CFTC's anti-evasion rules would not be implicated 
because CEA section 1a(47)(B)(iii), 7 U.S.C. 1a(47)(B)(iii), 
excludes such a product from the swap definition.
---------------------------------------------------------------------------

    As an illustration of some of the foregoing concepts, if the market 
for foreign exchange forwards on a particular currency settles on a T+ 
4 basis, but two counterparties agree to expedite the settlement of an 
foreign exchange forward on such currency to characterize the 
transaction falsely as a spot transaction in order to avoid reporting 
the transaction, rule 1.3(xxx)(6)(i) would define the transaction as a 
swap. In this example, both parties may be subject to sanctions if they 
both have the requisite intent (i.e., willfully evaded). However, had 
the counterparty with the reporting obligation in this example 
convinced the other counterparty, by using a false rationale unrelated 
to avoiding reporting, to expedite the foreign exchange forward 
settlement in order to avoid reporting, then the only party that would 
be at risk for sanctions (i.e., the only party with the requisite 
intent) would be the counterparty with the reporting obligation who 
deceived the other counterparty.
    With regard to documentation considerations, as discussed above, 
the CFTC is adopting rules 1.3(xxx)(6)(iv) and 1.6(b), as 
proposed,\1027\ but is providing the following interpretation. As 
stated in the Proposing Release,\1028\ the structuring of instruments, 
transactions, or entities to evade the requirements of the Dodd-Frank 
Act may be ``limited only by the ingenuity of man.''\1029\ Therefore, 
the CFTC will look beyond manner in which an instrument, transaction, 
or entity is documented to examine its actual substance and purpose to 
prevent any evasion through clever draftsmanship--an approach 
consistent with the CFTC's case law in the context of determining 
whether a contract is a futures contract and the CFTC's interpretations 
in this release regarding swaps.\1030\ The documentation of an 
instrument, transaction, or entity (like its form or label) is a 
relevant, but not dispositive, factor in determining whether evasion 
has occurred.
---------------------------------------------------------------------------

    \1027\ Rules 1.3(xxx)(6)(iv) and 1.6(b) provide that ``in 
determining whether a transaction has been willfully structured to 
evade, neither the form, label, nor written documentation of the 
transaction shall be dispositive.''
    \1028\ Proposing Release at 29866.
    \1029\ Cargill v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971).
    \1030\ See supra part II.D.1.
---------------------------------------------------------------------------

Comments
    The CFTC received a number of comments on various aspects of 
proposed rules 1.3(xxx)(6) and 1.6.
    Several commenters requested clarity as to what types of 
transactions might be considered evasive under proposed rule 
1.3(xxx)(6) and 1.6.\1031\ One commenter requested that the CFTC 
clarify that transacting in the physical markets (e.g., entering into 
nonfinancial commodity forward contracts), as opposed to executing a 
swap, would not be considered evasion.\1032\ As discussed above, the 
CFTC has provided an interpretation regarding the applicability of the 
anti-evasion rules to transactions that qualify for the forward 
exclusion. Another commenter requested that the CFTC clarify that the 
anti-evasion rules would not apply to transactions executed on a SEF 
because, before a SEF may list a swap, it must self-certify or 
voluntarily obtain CFTC permission to list that product.\1033\ The CFTC 
has provided an interpretation discussed above to address this comment.
---------------------------------------------------------------------------

    \1031\ See CME Letter; COPE Letter; IECA Letter; MarketAxess 
Letter; and WGCEF Letter.
    \1032\ See COPE Letter.
    \1033\ See MarketAxess Letter.
---------------------------------------------------------------------------

    Two commenters expressed concern regarding the penalty to the 
counterparties to a transaction that is deemed to violate the CFTC's 
anti-evasion provisions.\1034\ Pursuant to the final rule, when a 
transaction violates the anti-evasion rules, the CFTC will consider the 
transaction a swap. One of these commenters said that the non-evading 
party should not unilaterally become a party to a swap, and thus be 
subject to the regulatory requirements of the Dodd-Frank Act.\1035\ 
This commenter believed the rule should be clear that only the 
``evading'' party would become a party to a swap, but the ``non-
evading'' party would not.\1036\ The other comments believed that a 
transaction that is determined to have violated the CFTC's anti-evasion 
rules should be considered a swap only if it meets all other aspects of 
the statutory definition of the term ``swap.'' \1037\ The CFTC agrees 
that the anti-evasion rules are not meant to ``punish the innocent,'' 
but rather to appropriately address the evading counterparty's or 
counterparties' failure to meet the requirements of the Dodd-Frank Act. 
Therefore, the CFTC has provided an interpretation described above 
about how a transaction, discovered to have evaded the CEA or the Dodd-
Frank Act (and therefore, a swap under rule 1.3(xxx)(6) or subject to 
the provisions of Subtitle A under rule 1.6) will be treated after the 
evasion is discovered.
---------------------------------------------------------------------------

    \1034\ See IECA Letter and WGCEF Letter.
    \1035\ See IECA Letter.
    \1036\ Id.
    \1037\ See WGCEF Letter.
---------------------------------------------------------------------------

    Furthermore, the CFTC agrees that a transaction that is determined 
to have violated the CFTC's anti-evasion rules will be considered a 
swap only if it meets the definition of the term ``swap,'' and has 
provided an interpretation to address this comment. In response to both 
comments, the CFTC also has provided an example to illustrate the 
concepts in the interpretation.
    The CFTC received one comment regarding rules 1.3(xxx)(6)(iv) and 
1.6(b). This commenter believed that a difference exists between 
``documentation,'' which contains terms, conditions, etc. of an 
agreement, and the ``form or label.'' \1038\ Thus, because a form or 
label may be duplicitously assigned to a transaction, this commenter 
agreed that neither the form nor the label should be dispositive.\1039\ 
However, because documentation contains the substance of an agreement, 
this commenter believed that documentation should be dispositive in 
determining whether a given contract has been entered to willfully 
evade because the substance of a contract is derived from its 
documentation.\1040\ Alternatively, this commenter requested that if 
the CFTC does not amend its proposal, the CFTC clarify what evidence or 
subject matter would be dispositive of willful evasion.\1041\ The CFTC 
disagrees with these comments and has provided an interpretation 
discussed above that the documentation of an instrument, transaction, 
or entity is a relevant, but not dispositive, factor. This view not 
only is consistent with CFTC case law, and the CFTC's interpretations 
herein, but reduces the possibility of providing a potential roadmap 
for evasion.
---------------------------------------------------------------------------

    \1038\ See CME Letter.
    \1039\ Id.
    \1040\ Id.
    \1041\ Id.
---------------------------------------------------------------------------

    Two commenters raised issues applicable to proposed rule 1.6 alone. 
One commenter believed that proposed rule 1.6 should not be adopted 
until the cross-border application of the swap provisions of Title VII 
is addressed.\1042\ The CFTC disagrees and believes that the rule 
provides sufficient clarity to market participants even though the CFTC 
has not yet finalized guidance

[[Page 48301]]

regarding the cross-border application of the swap provisions of the 
Dodd-Frank Act. The other commenters believed that the proposed rule 
text and interpretation does not fully explain how the CFTC would apply 
proposed rule 1.6 in determining whether a swap subject to foreign 
jurisdiction and regulated by a foreign regulator is evasive.\1043\ As 
stated above, an agreement, contract, instrument or transaction that is 
found to have been willfully structured to evade will be subject to CEA 
provisions and the regulations thereunder pursuant to rule 1.6(c).
---------------------------------------------------------------------------

    \1042\ See ISDA Letter.
    \1043\ See CME Letter.
---------------------------------------------------------------------------

3. Interpretation Contained in the Proposing Release
    The CFTC is restating the interpretation contained in the Proposing 
Release,\1044\ but is providing additional clarification regarding 
certain types of circumstances that may (or may not) constitute an 
evasion of the requirements of Title VII. However, the CFTC notes that 
each activity will be evaluated on a case-by-case basis with 
consideration given to all relevant facts and circumstances.
---------------------------------------------------------------------------

    \1044\ See Proposing Release at 29865.
---------------------------------------------------------------------------

    In developing its interpretation, the CFTC considered legislative, 
administrative, and judicial precedent with respect to the anti-evasion 
provisions in other Federal statutes. For example, the CFTC examined 
the anti-evasion provisions in the Truth in Lending Act,\1045\ the Bank 
Secrecy Act,\1046\ and the Internal Revenue Code.\1047\
---------------------------------------------------------------------------

    \1045\ 15 U.S.C. 1604(a) provides, in relevant part, that the 
Federal Reserve Board: shall prescribe regulations to carry out the 
purposes of this subchapter * * *. [T]hese regulations may contain 
such classifications, differentiations, or other provisions, and may 
provide for such adjustments and exceptions for any class of 
transactions, as in the judgment of the Board are necessary or 
proper to effectuate the purposes of this subchapter, to prevent 
circumvention or evasion thereof, or to facilitate compliance 
therewith.
    In affirming the Board's promulgation of Regulation Z, the 
Supreme Court noted that anti-evasion provisions such as section 
1604(a) evince Congress's intent to ``stress[] the agency's power to 
counteract attempts to evade the purposes of a statute.'' Mourning 
v. Family Publ'ns Serv., Inc., 411 U.S. 356, 370 (1973) (citing 
Gemsco v. Walling, 324 U.S. 244 (1945) (giving great deference to a 
regulation promulgated under similar prevention-of-evasion 
rulemaking authority in the Fair Labor Standards Act)).
    \1046\ 31 U.S.C. 5324 (stating, in pertinent part, that ``[n]o 
person shall, for the purpose of evading the reporting requirements 
of [the Bank Secrecy Act (BSA) or any regulation prescribed 
thereunder] * * * . structure or assist in structuring, or attempt 
to structure or assist in structuring, any transaction with one or 
more domestic financial institutions''). The Federal Deposit 
Insurance Corporation regulations implementing the BSA require banks 
to report transactions that ``the bank knows, suspects, or has 
reason to suspect'' are ``designed to evade any regulations 
promulgated under the Bank Secrecy Act.'' 12 CFR 353.3 (2010).
    \1047\ The Internal Revenue Code makes it unlawful for any 
person willfully to attempt ``in any manner to evade or defeat any 
tax * * * .'' 26 U.S.C. 7201. While a considerable body of case law 
has developed under the tax evasion provision, the statute itself 
does not define the term, but generally prohibits willful attempts 
to evade tax.
---------------------------------------------------------------------------

    The CFTC will not consider transactions, entities, or instruments 
structured in a manner solely motivated by a legitimate business 
purpose to constitute willful evasion (``Business Purpose Test''). 
Additionally, relying on Internal Revenue Service (``IRS'') concepts, 
when determining whether particular conduct is an evasion of the Dodd-
Frank Act, the CFTC will consider the extent to which the conduct 
involves deceit, deception, or other unlawful or illegitimate activity.
(a) Business Purpose Test
Interpretation
    Consistent with the Proposing Release,\1048\ the CFTC recognizes 
that transactions may be structured, and entities may be formed, in 
particular ways for legitimate business purposes, without any intention 
of circumventing the requirements of the Dodd-Frank Act with respect to 
swaps. Thus, in evaluating whether a person is evading or attempting to 
evade the swap requirements with respect to a particular instrument, 
entity, or transaction, the CFTC will consider the extent to which the 
person has a legitimate business purpose for structuring the instrument 
or entity or entering into the transaction in that particular manner. 
Although different means of structuring a transaction or entity may 
have differing regulatory implications and attendant requirements, 
absent other indicia of evasion, the CFTC will not consider 
transactions, entities, or instruments structured in a manner solely 
motivated by a legitimate business purpose to constitute evasion. 
However, to the extent a purpose in structuring an entity or instrument 
or entering into a transaction is to evade the requirements of Title 
VII with respect to swaps, the structuring of such instrument, entity, 
or transaction may be found to constitute willful evasion.\1049\
---------------------------------------------------------------------------

    \1048\ Proposing Release at 29867.
    \1049\ As the CFTC observed in the Proposing Release, a similar 
concept applies with respect to tax evasion. See Proposing Release 
at 29867 n. 324. A transaction that is structured to avoid the 
payment of taxes but that lacks a valid business purpose may be 
found to constitute tax evasion. See, e.g., Gregory v. Helvering, 
293 U.S. 465, 469 (1935) (favorable tax treatment disallowed because 
transaction lacked any business or corporate purpose). Under the 
``sham-transaction'' doctrine, ``a transaction is not entitled to 
tax respect if it lacks economic effects or substance other than the 
generation of tax benefits, or if the transaction serves no business 
purpose.'' Winn-Dixie Stores, Inc. v. Comm'r, 254 F.3d 1313, 1316 
(11th Cir. 2001) (citing Knetsch v. United States, 364 U.S. 361 
(1960)). ``The doctrine has few bright lines, but `it is clear that 
transactions whose sole function is to produce tax deductions are 
substantive shams.' '' Id. (quoting United Parcel Serv. of Am., Inc. 
v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001)). To be clear, 
though, while the Proposing Release references the use of the 
business purpose test in tax law, the CFTC is not using the 
legitimate business purpose consideration in the same manner as the 
IRS.
---------------------------------------------------------------------------

    Although some commenters suggest that the determination that there 
is a legitimate business purpose, and the use of that concept as a 
relevant fact in the determination of the possibility of evasion, will 
not provide appropriate clarity, it is a recognized analytical method 
and would be useful in the overall analysis of potentially willful 
evasive conduct.
    The CFTC fully expects that a person acting for legitimate business 
purposes within its respective industry will naturally weigh a 
multitude of costs and benefits associated with different types of 
financial transactions, entities, or instruments, including the 
applicable regulatory obligations. In that regard, and in response to 
commenters, the CFTC is clarifying that a person's specific 
consideration of regulatory burdens, including the avoidance thereof, 
is not dispositive that the person is acting without a legitimate 
business purpose in a particular case. The CFTC will view legitimate 
business purpose considerations on a case-by-case basis in conjunction 
with all other relevant facts and circumstances.
    Moreover, the CFTC recognizes that it is possible that a person 
intending to willfully evade Dodd-Frank may attempt to justify its 
actions by claiming that they are legitimate business practices in its 
industry; therefore, the CFTC will retain the flexibility, via an 
analysis of all relevant facts and circumstances, to confirm not only 
the legitimacy of the business purpose of those actions but whether the 
actions could still be determined to be willfully evasive. For example, 
a person may attempt to disguise a product that may be a swap by 
employing accounting practices that are not appropriate for swaps. 
Whether or not the method of

[[Page 48302]]

accounting or employed accounting practices are determined to be for 
legitimate business purposes, that alone will not be dispositive in 
determining whether it is willfully evasive according to either rule 
1.3(xxx)(6) or 1.6.
    Because transactions and instruments are regularly structured, and 
entities regularly formed, in a particular way for various, and often 
times multiple, reasons, it is essential that all relevant facts and 
circumstances be considered. Where a transaction, instrument, or entity 
is structured solely for legitimate business purposes, it is not 
willfully evasive. By contrast, where a consideration of all relevant 
facts and circumstances reveals the presence of a purpose that is not a 
legitimate business purpose, evasion may exist.
Comments
    Two commenters believed the proposed business purpose test is 
inappropriate for determining if a transaction is structured to evade 
Title VII.\1050\ One of these commenters stated that the CFTC 
misunderstood how the ``business purpose'' test is applied by the IRS 
in the tax evasion context resulting in misguided proposed interpretive 
guidance.\1051\ As stated above, the CFTC believes that it is 
appropriate to consider legitimate business purposes in determining if 
a transaction is structured to evade Title VII. In response to this 
comment, although the interpretation references the use of legitimate 
business purpose in tax law, the CFTC is not bound to use the 
legitimate business purpose consideration in the same manner as the IRS 
and, accordingly, is not adopting the IRS's interpretation.
---------------------------------------------------------------------------

    \1050\ See CME Letter and WGCEF Letter.
    \1051\ See CME Letter.
---------------------------------------------------------------------------

    Two commenters urged the CFTC to clarify that considering the costs 
of regulation is a legitimate business purpose when structuring a 
transaction. Accordingly, they request that the CFTC clarify that 
entering into a transaction to avoid costly regulations, even though 
that transaction could otherwise be structured as a swap, will not be 
considered per se evasion/evasive.\1052\ Finally, one commenter took 
issue with the statement that ``absent other indicia of evasion, [the 
CFTC] would not consider transactions, entities, or instruments in a 
manner solely motivated by a legitimate business purpose to constitute 
evasion.'' \1053\ Because ``transactions, entities, or instruments'' 
are rarely structured a certain way solely for one purpose, this 
commenter believed such a statement does not give market participants 
any relief or guidance.\1054\ The CFTC has addressed these comments 
received on the business purpose test through the clarifications to its 
interpretation discussed above and reiterates that the CFTC will 
consider all relevant facts and circumstances in determining whether an 
action is willfully evasive.
---------------------------------------------------------------------------

    \1052\ See ISDA Letter and WGCEF Letter.
    \1053\ See SIFMA Letter.
    \1054\ Id.
---------------------------------------------------------------------------

(b) Fraud, Deceit or Unlawful Activity
Interpretation
    When determining whether a particular activity constitutes willful 
evasion of the CEA or the Dodd-Frank Act, the CFTC will consider the 
extent to which the activity involves deceit, deception, or other 
unlawful or illegitimate activity. This concept was derived from the 
IRS's delineation of what constitutes tax evasion, as elaborated upon 
by the courts. The IRS distinguishes between tax evasion and legitimate 
means for citizens to minimize, reduce, avoid or alleviate the tax that 
they pay under the Internal Revenue Code.\1055\ Similarly, persons that 
craft derivatives transactions, structure entities, or conduct 
themselves in a deceptive or other illegitimate manner in order to 
avoid regulatory requirements should not be permitted to enjoy the 
fruits of their deceptive or illegitimate conduct.
---------------------------------------------------------------------------

    \1055\ Whereas permissible means of reducing tax (or ``tax 
avoidance,'' as the IRS refers to the practice) is associated with 
full disclosure and explanation of why the tax should be reduced 
under law, tax evasion consists of the willful attempt to evade tax 
liability, and generally involves ``deceit, subterfuge, camouflage, 
concealment, or some attempt to color or obscure events or to make 
things seem other than they are.'' The IRS explains:
    Avoidance of taxes is not a criminal offense. Any attempt to 
reduce, avoid, minimize, or alleviate taxes by legitimate means is 
permissible. The distinction between avoidance and evasion is fine, 
yet definite. One who avoids tax does not conceal or misrepresent. 
He/she shapes events to reduce or eliminate tax liability and, upon 
the happening of the events, makes a complete disclosure. Evasion, 
on the other hand, involves deceit, subterfuge, camouflage, 
concealment, some attempt to color or obscure events or to make 
things seem other than they are. For example, the creation of a bona 
fide partnership to reduce the tax liability of a business by 
dividing the income among several individual partners is tax 
avoidance. However, the facts of a particular investigation may show 
that an alleged partnership was not, in fact, established and that 
one or more of the alleged partners secretly returned his/her share 
of the profits to the real owner of the business, who, in turn, did 
not report this income. This would be an instance of attempted 
evasion. IRS, Internal Revenue Manual, part 9.1.3.3.2.1, available 
at http://www.irs.gov/irm/part9/irm_09-001-003.html#d0e169.
---------------------------------------------------------------------------

    Although it is likely that fraud, deceit, or unlawful activity will 
be present where willful evasion has occurred, the CFTC does not 
believe that these factors are prerequisites to an evasion finding. As 
stated throughout this release, the presence or absence of fraud, 
deceit, or unlawful activity is one fact (or circumstance) the CFTC 
will consider when evaluating a person's activity. That said, the anti-
evasion rules do require willfulness, i.e. ``scienter.'' In response to 
the commenter who requests the CFTC define ``willful conduct,'' the 
CFTC will interpret ``willful'' consistent with how the CFTC has in the 
past, that a person acts ``willfully'' when they act either 
intentionally or with reckless disregard.\1056\
---------------------------------------------------------------------------

    \1056\ See In re Squadrito, [1990-1992 Transfer Binder] Comm. 
Fut. L. Rep. (CCH) ] 25,262 (CFTC Mar. 27, 1992) (adopting 
definition of ``willful'' in McLaughlin v. Richland Shoe Co., 486 
U.S. 128 (1987)).
---------------------------------------------------------------------------

Comments
    One commenter, although generally supportive of the use of the IRS 
``tax evasion'' concept as a guidepost for this criterion, requested 
the CFTC provide examples of legitimate versus evasive conduct in a 
manner similar to what is contained in the Internal Revenue 
Manual.\1057\ The CFTC does not believe it is appropriate to provide an 
example because such an example may provide a guidepost for evasion.
---------------------------------------------------------------------------

    \1057\ See CME Letter.
---------------------------------------------------------------------------

    Two commenters suggested that a finding of fraud, deceit, or 
unlawful activity should be a prerequisite to any finding of 
evasion.\1058\ As noted above, the CFTC disagrees that such activity 
should be a prerequisite to a finding of evasion, but its presence or 
absence is one relevant fact and circumstance the CFTC will consider. 
Finally, one commenter requested further guidance defining willful 
conduct in the context of deliberate and knowing wrongdoing.\1059\ As 
noted above, the CFTC has considered the suggestion that the CFTC 
provide guidance on what defines ``willful behavior,'' with some 
commenters submitting that some definitional guidance should be offered 
or that the standard should be whether or not a transaction is 
``lawful.'' \1060\ The CFTC agrees with the need for legal clarity and 
believes that the concept of willfulness is a well-recognized legal 
concept of which there is substantial case law and legal commentary 
familiar to the financial industry.\1061\
---------------------------------------------------------------------------

    \1058\ See ISDA Letter and SIFMA Letter.
    \1059\ See ISDA Letter (citing U.S. v. Tarallo, 380 F.3d 1174, 
1187 (9th Cir. 2004), and Merck & Co. v. Reynolds, 130 S. Ct. 1784, 
1796 (2010)).
    \1060\ See CME Letter; ISDA Letter; and WGCEF Letter.
    \1061\ See supra note 1056.

---------------------------------------------------------------------------

[[Page 48303]]

B. SEC Position Regarding Anti-Evasion Rules

    Section 761(b)(3) of the Dodd-Frank Act grants discretionary 
authority to the SEC to define the terms ``security-based swap,'' 
``security-based swap dealer,'' ``major security-based swap 
participant,'' and ``eligible contract participant,'' with regard to 
security-based swaps, ``for the purpose of including transactions and 
entities that have been structured to evade'' subtitle B of Title VII 
(or amendments made by subtitle B).
    The SEC did not propose rules under section 761(b)(3) regarding 
anti-evasion but requested comment on whether SEC rules or interpretive 
guidance addressing anti-evasion with respect to security-based swaps, 
security-based swap dealers, major security-based swap participants, or 
ECPs were necessary. Two commenters responded to the request for 
comment and recommended that the SEC adopt anti-evasion rules and 
interpretive guidance.\1062\ One commenter suggested that the SEC model 
its anti-evasion rules and interpretive guidance on the CFTC's anti-
evasion rules.\1063\
---------------------------------------------------------------------------

    \1062\ See Barnard Letter and Better Markets Letter.
    \1063\ See Barnard Letter.
---------------------------------------------------------------------------

    The SEC is not adopting anti-evasion rules under section 761(b)(3) 
at this time. The SEC notes that since security-based swaps are 
``securities'' for purposes of the Federal securities laws, unless the 
SEC grants a specific exemption,\1064\ all of the SEC's existing 
regulatory authority will apply to security-based swaps. Since existing 
regulations, including antifraud and anti-manipulation provisions, will 
apply to security-based swaps, the SEC believes that it is unnecessary 
to adopt additional anti-evasion rules for security-based swaps under 
section 761(b)(3) at this time.
---------------------------------------------------------------------------

    \1064\ See Effective Date and Implementation infra part IX.
---------------------------------------------------------------------------

VIII. Miscellaneous Issues

A. Distinguishing Futures and Options From Swaps

    The Commissions did not propose rules or interpretations in the 
Proposing Release regarding distinguishing futures from swaps. One 
commenter requested that the CFTC clarify that nothing in the release 
was intended to limit a DCM's ability to list for trading a futures 
contract regardless of whether it could be viewed as a swap if traded 
over-the-counter or on a SEF, since futures and swaps are 
indistinguishable in material economic effects.\1065\ This commenter 
further recommended that the CFTC adopt a final rule that further 
interprets the statutory ``swap'' definition.\1066\
---------------------------------------------------------------------------

    \1065\ See CME Letter.
    \1066\ Id. CME suggested that the CFTC modify the futures 
contract exclusion in CEA Section 1a(47)(B)(i) so that the modified 
language would read as follows: (B) EXCLUSIONS.--The term `swap' 
does not include-- (i) any contract for the sale of a commodity for 
future delivery listed for trading by a designated contract market 
(or option on such contract) * * * CME believes that such a rule 
would clarify the scope of Section 4(a) of the CEA, which makes it 
illegal to trade a futures contract except on or subject to the 
rules of a DCM.
    CME believed that such a modification would clarify the scope of 
Section 4(a) of the CEA, 7 U.S.C. 6(a), which makes it unlawful to 
trade a futures contract except on or subject to the rules of a DCM.
---------------------------------------------------------------------------

    The CFTC declines to provide the requested clarification or adopt a 
rule. Prior distinctions that the CFTC relied upon (such as the 
presence or absence of clearing) to distinguish between futures and 
swaps may no longer be relevant.\1067\ As a result, it is difficult to 
distinguish between futures and swaps on a blanket basis as the 
commenter suggested. However, a case-by-case approach for 
distinguishing these products may lead to more informed decision-making 
by the CFTC. Moreover, the CFTC notes that a DCM may self-certify its 
contracts pursuant to Part 40 of the CFTC's rules,\1068\ subject to the 
CFTC's oversight authority. If a DCM has a view that a particular 
product is a futures contract, it may self-certify the contract 
consistent with that view. The DCM also has a number of other options, 
including seeking prior approval from the CFTC, requesting an 
interpretation, or requesting a rulemaking if it is in doubt about 
whether a particular agreement, contract or transaction should be 
classified as a futures contract or a swap.
---------------------------------------------------------------------------

    \1067\ See, e.g., Swap Policy Statement, supra note 214.
    \1068\ 17 CFR Part 40.
---------------------------------------------------------------------------

B. Transactions Entered Into by Foreign Central Banks, Foreign 
Sovereigns, International Financial Institutions, and Similar Entities

    The swap definition excludes ``any agreement, contract, or 
transaction a counterparty of which is a Federal Reserve bank, the 
Federal Government, or a Federal agency that is expressly backed by the 
full faith and credit of the United States.'' \1069\ Some commenters to 
the ANPR suggested that the Commissions should exercise their authority 
to further define the terms ``swap'' to similarly exclude transactions 
in which a counterparty is a foreign central bank, a foreign sovereign, 
an international financial institution (``IFI''),\1070\ or similar 
organization. ANPR commenters advanced international comity, national 
treatment, limited regulatory resources, limits on the Commissions' 
respective extraterritorial jurisdiction, and international 
harmonization as rationales for such an approach. The Proposing Release 
was silent on this issue.\1071\
---------------------------------------------------------------------------

    \1069\ CEA section 1a(47)(B)(ix), 7 U.S.C. 1a(47)(B)(ix).
    \1070\ For this purpose, we consider the ``international 
financial institutions'' to be those institutions defined as such in 
22 U.S.C. 262r(c)(2) and the institutions defined as ``multilateral 
development banks'' in the Proposal for the Regulation of the 
European Parliament and of the Council on OTC Derivative 
Transactions, Central Counterparties and Trade Repositories, Council 
of the European Union Final Compromise Text, Article 1(4a(a)) (March 
19, 2012). There is overlap between the two definitions, but 
together they include the following institutions: the International 
Monetary Fund, International Bank for Reconstruction and 
Development, European Bank for Reconstruction and Development, 
International Development Association, International Finance 
Corporation, Multilateral Investment Guarantee Agency, African 
Development Bank, African Development Fund, Asian Development Bank, 
Inter-American Development Bank, Bank for Economic Cooperation and 
Development in the Middle East and North Africa, Inter-American 
Investment Corporation, Council of Europe Development Bank, Nordic 
Investment Bank, Caribbean Development Bank, European Investment 
Bank and European Investment Fund. (The term international financial 
institution includes entities referred to as multilateral 
development banks. The International Bank for Reconstruction and 
Development, the International Finance Corporation and the 
Multilateral Investment Guarantee Agency are parts of the World Bank 
Group.) The Bank for International Settlements, which also submitted 
a comment, is a bank in which the Federal Reserve and foreign 
central banks are members. Another commenter, KfW, is a corporation 
owned by the government of the Federal Republic of Germany and the 
German State governments and backed by the ``full faith and credit'' 
of the Federal Republic of Germany.
    \1071\ But see Dissent of Commissioner Sommers, Proposing 
Release at 29899.
---------------------------------------------------------------------------

Comments
    Several commenters asserted that swaps transactions to which an IFI 
is a counterparty should be excluded from the swap and security-based 
swap definitions.\1072\ In addition to the arguments noted above, 
commenters asserted that certain IFIs have been granted certain 
statutory immunities by the United States, and that regulation under 
the Dodd-Frank Act of their

[[Page 48304]]

activities would be inconsistent with the grant of these immunities.
---------------------------------------------------------------------------

    \1072\ See Letter from G[uuml]nter Pleines and Diego Devos, Bank 
for International Settlements, dated July 20, 2011; Letter from 
Jacques Mirante-P[eacute]r[eacute] and Jan De Bel, Council of Europe 
Development Bank, dated July 22, 2011; Letter from Isabelle Laurant, 
European Bank for Reconstruction and Development, dated July 22, 
2011; Letter from A. Querejeta and B. de Mazi[egrave]res, European 
Investment Bank, dated July 22, 2011; Letter from J. James Spinner 
and S[oslash]ren Elbech, Inter-American Development Bank, dated July 
22, 2011; Letter from Lutze-Christian Funke and Frank Czichowski, 
KfW, dated August 12, 2011; Letter from Heikki Cantell and Lars 
Eibeholm, Nordic Investment Bank, dated August 2, 2011; and Letter 
from Vicenzo La Via, World Bank Group, dated July 22, 2011.
---------------------------------------------------------------------------

    The CFTC declines to provide an exclusion from the swap definition 
along the lines suggested by these commenters.\1073\ An exclusion from 
the swap definition for swap transactions entered into by foreign 
sovereigns, foreign central banks, IFIs and similar entities, would 
mean that swaps entered into by such entities would be completely 
excluded from Dodd-Frank regulation. Their counterparties, who may be 
swap dealers or major swap participants, or security-based swap dealers 
or major security-based swap participants, would have no regulatory 
obligations with respect to such swaps. These regulated counterparties 
could develop significant exposures to the foreign sovereigns, foreign 
central banks, IFIs and similar entities, without the knowledge of the 
Commissions.
---------------------------------------------------------------------------

    \1073\ The commenters' suggested exclusion from the swap 
definition would also exclude their transactions from the security-
based swap definition, which is based on the definition of swap.
---------------------------------------------------------------------------

    In addition, swaps entered into by foreign sovereigns, foreign 
central banks, IFIs and similar entities undeniably are swaps. To be 
sure, the Commissions have adopted rules and interpretations to further 
define the term ``swap'' to exclude certain transactions, which prior 
to the enactment of the Dodd-Frank Act generally would not have been 
considered swaps. However, the CFTC is not using its authority to 
further define the term ``swap'' to effectively exempt transactions 
that are, in fact, swaps. While, as noted above, Congress included a 
counterparty-specific exclusion for swaps entered into by the Federal 
Reserve Board, the Federal government and certain government agencies, 
Congress did not provide a similar exemption for foreign central banks, 
foreign sovereigns, IFIs, or similar organizations.

C. Definition of the Terms ``Swap'' and ``Security-Based Swap'' as Used 
in the Securities Act

    The SEC is adopting a technical rule that provides that the terms 
``swap'' and ``security-based swap'' as used in the Securities Act 
\1074\ have the same meanings as in the Exchange Act \1075\ and the 
rules and regulations thereunder.\1076\ The SEC is adopting such 
technical rule to assure consistent definitions of these terms under 
the Securities Act and the Exchange Act.
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    \1074\ See section 2(a)(17) of the Securities Act, 15 U.S.C. 
77b(a)(17).
    \1075\ See sections 3(a)(69) of the Exchange Act, 15 U.S.C. 
78c(a)(69), and 3(a)(68) of the Exchange Act, 15 U.S.C. 78c(a)(68). 
The definitions of the terms ``swap'' and ``security-based swap'' in 
the Exchange Act are the same as the definitions of these terms in 
the CEA. See section 1a of the CEA, 7 U.S.C. 1a.
    \1076\ See rule 194 under the Securities Act.
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IX. Effective Date and Implementation

    Consistent with sections 754 and 774 of the Dodd-Frank Act, the 
final rules and interpretations will be effective October 12, 2012. The 
compliance date for the final rules and interpretations also will be 
October 12, 2012; with the following exceptions:
     The compliance date for the interpretation regarding 
guarantees of swaps will be the effective date of the rules proposed in 
the separate CFTC release when such rules are adopted by the CFTC.
     Solely for the purposes of the Order Granting Temporary 
Exemptions under the Securities Exchange Act of 1934 in Connection with 
the Pending Revision of the Definition of ``Security'' to Encompass 
Security-Based Swaps \1077\ and the Exemptions for Security-Based 
Swaps,\1078\ the compliance date for the final rules further defining 
the term ``security-based swap'' will be February 11, 2013.
---------------------------------------------------------------------------

    \1077\ 76 FR 39927 (Jul. 7, 2011) (``Exchange Act Exemptive 
Order''). The Exchange Act Exemptive Order grants temporary relief 
and provides interpretive guidance to make it clear that a 
substantial number of the requirements of the Exchange Act do not 
apply to security-based swaps as a result of the revised definition 
of ``security'' going into effect on July 16, 2011. The Exchange Act 
Exemptive Order also provided temporary relief from provisions of 
the Exchange Act that allow the voiding of contracts made in 
violation of those laws.
    \1078\ Rule 240 under the Securities Act, 17 CFR 230.240, rules 
12a-11 and 12h-1(i) under the Exchange Act 1934, 17 CFR 240.12a-11 
and 240.12h-1(i), and Rule 4d-12 under the Trust Indenture Act of 
1939, 17 CFR 260.4d-12 (``SB Swaps Interim Final Rules''). See also 
76 FR 40605 (Jul. 11, 2011). The SB Swaps Interim Final Rules 
provide exemptions under the Securities Act, the Exchange Act, and 
the Trust Indenture Act of 1939 for those security-based swaps that 
prior to July 16, 2011, were security-based swap agreements and are 
defined as ``securities'' under the Securities Act and the Exchange 
Act as of July 16, 2011, due solely to the provisions of the Dodd-
Frank Act. The SB Swaps Interim Final Rules exempt offers and sales 
of these security-based swaps from all provisions of the Securities 
Act, other than the Section 17(a) anti-fraud provisions, as well as 
exempt these security-based swaps from Exchange Act registration 
requirements and from the provisions of the Trust Indenture Act of 
1939, provided certain conditions are met.
---------------------------------------------------------------------------

    The CFTC believes that it is appropriate to make the compliance 
date for the interpretation regarding guarantees of swaps the same as 
the effective date of the rules proposed in the separate CFTC release 
when such rules are adopted by the CFTC in order to relieve market 
participants from compliance obligations that would arise as a result 
of the interpretation. As described in the Exchange Act Exemptive Order 
and as provided in the SB Swaps Interim Final Rules, the exemptions 
granted pursuant to the Exchange Act Exemptive Order and the SB Swaps 
Interim Final Rules will expire upon the compliance date of the final 
rules further defining the terms ``security-based swap'' and ``eligible 
contract participant.'' The final rules further defining the term 
``eligible contract participant,'' adopted in the Entity Definitions 
Release,\1079\ were published in the Federal Register on May 23, 2012. 
The compliance date and the effective date for such final rules is the 
same, July 23, 2012. The SEC believes that establishing a compliance 
date for the definition of ``security-based swap'' solely for purposes 
of the Exchange Act Exemptive Order and the SB Swaps Interim Final 
Rules that is February 11, 2013 (i.e. 120 days after the effective 
date) is appropriate because doing so will leave in place the 
exemptions granted by the Exchange Act Exemptive Order and the SB Swaps 
Interim Final Rules for a period of time that is sufficient to 
facilitate consideration of that order and rule. Specifically, the SEC 
will consider the appropriate treatment of security-based swaps under 
the provisions of the Exchange Act not amended by the Dodd-Frank Act 
before expiration of the exemptions set forth in the Exchange Act 
Exemptive Order, and will consider the appropriate treatment of 
security-based swaps for purposes of the registration provisions of the 
Securities Act, the registration provisions of the Exchange Act, and 
the indenture qualification provisions of the Trust Indenture Act of 
1939 before the expiration of the exemptions set forth in the SB Swaps 
Interim Final Rules.\1080\
---------------------------------------------------------------------------

    \1079\ See supra note 12.
    \1080\ The SEC has received a request for certain permanent 
exemptions upon the expiration of the exemptions contained in the 
Exchange Act Exemptive Order. See SIFMA SBS Exemptive Relief Request 
(Dec. 5, 2011), which is available at http://www.sec.gov/comments/s7-27-11/s72711-10.pdf. The SEC also has received comments regarding 
the exemptions under the Securities Act, the Exchange Act, and the 
Trust Indenture Act of 1939. See Letter from Kenneth E. Bentsen, 
Jr., Executive Vice President, Public Policy and Advocacy, SIFMA, 
and Robert Pickel, Chief Executive Officer, ISDA, dated Apr. 20, 
2012, which is available at http://www.sec.gov/comments/s7-26-11/s72611-5.pdf. The SEC is reviewing the request for exemptive relief 
and each related comment and will consider any appropriate actions 
regarding such request.
---------------------------------------------------------------------------

    If any provision of these final rules or interpretations, or the 
application thereof to any person or circumstance, is held to be 
invalid, such invalidity shall not affect other provisions or 
application of such provisions to other persons or circumstances that 
can be

[[Page 48305]]

given effect without the invalid provision or application.

X. Administrative Law Matters--CEA Revisions

A. Paperwork Reduction Act

1. Introduction
    The Paperwork Reduction Act of 1995 (``PRA'') imposes certain 
requirements on Federal agencies in connection with their conducting or 
sponsoring any collection of information as defined by the PRA.\1081\ 
An agency may not conduct or sponsor, and a person is not required to 
respond to, a collection of information unless it displays a currently 
valid control number. Certain provisions of this rule will result in 
new collection of information requirements within the meaning of the 
PRA. With the exception of the new ``book-out'' confirmation 
requirement discussed below, the CFTC believes that the burdens that 
will be imposed on market participants under rules 1.8 and 1.9 already 
have been accounted for within the SEC's calculations regarding the 
impact of this collection of information under the PRA and the request 
for a control number submitted by the SEC to OMB for rule 3a68-2 
(``Interpretation of Swaps, Security-Based Swaps, and Mixed Swaps'') 
and rule 3a68-4 (``Regulation of Mixed Swaps: Process for Determining 
Regulatory Treatment for Mixed Swaps''). In response to this 
submission, OMB issued control number 3235-0685. The responses to these 
collections of information will be mandatory.\1082\ The CFTC will 
protect proprietary information according to the Freedom of Information 
Act and 17 CFR part 145, headed ``Commission Records and Information.'' 
In addition, the CFTC emphasizes that section 8(a)(1) of the CEA \1083\ 
strictly prohibits the Commission, unless specifically authorized by 
the CEA, from making public ``data and information that would 
separately disclose the business transactions or market positions of 
any person and trade secrets or names of customers.'' The CFTC also is 
required to protect certain information contained in a government 
system of records pursuant to the Privacy Act of 1974.
---------------------------------------------------------------------------

    \1081\ 44 U.S.C. 3501 et seq.
    \1082\ As discussed below, the ``collection of information'' 
related to the new ``book out'' confirmation requirement was not 
included in the SEC's submission and will be the subject of a 
request for a control number by the CFTC to OMB.
    \1083\ 7 U.S.C. 12(a)(1).
---------------------------------------------------------------------------

2. Rules 1.8 and 1.9
    As discussed in the proposal, Rules 1.8 and 1.9 under the CEA will 
result in new ``collection of information'' requirements within the 
meaning of the PRA. Rule 1.8 under the CEA will allow persons to submit 
a request for a joint interpretation from the Commissions regarding 
whether an agreement, contract or transaction (or a class thereof) is a 
swap, security-based swap, or mixed swap. Rule 1.8 provides that a 
person requesting an interpretation as to the nature of an agreement, 
contract, or transaction as a swap, security-based swap, or mixed swap 
must provide the Commissions with the person's determination of the 
nature of the instrument and supporting analysis, along with certain 
other documentation, including a statement of the economic purpose for, 
and a copy of all material information regarding the terms of, each 
relevant agreement, contract, or transaction (or class thereof). The 
Commissions also may request the submitting person to provide 
additional information. In response to the submission, the Commissions 
may issue a joint interpretation regarding the status of that 
agreement, contract, or transaction (or class of agreements, contracts, 
or transactions) as a swap, security-based swap, or mixed swap.
    Rule 1.9 of the CEA enables persons to submit requests to the 
Commissions for joint orders providing an alternative regulatory 
treatment for particular mixed swaps. Under rule 1.9, a person will 
provide to the Commissions a statement of the economic purpose for, and 
a copy of all material information regarding, the relevant mixed swap. 
In addition, the person will provide the specific alternative 
provisions that the person believes should apply to the mixed swap, the 
reasons the person believes it would be appropriate to request an 
alternative regulatory treatment, and an analysis of: (i) The nature 
and purposes of the specified provisions; (ii) the comparability of the 
specified provisions to other statutory provisions of Title VII of the 
Dodd-Frank Act and the rules and regulations thereunder; and (iii) the 
extent of any conflicting or incompatible requirements of the specified 
provisions and other statutory provisions of Title VII and the rules 
and regulations thereunder. The Commissions also may request the 
submitting person to provide additional information.
(a) Information Provided by Reporting Entities
    The burdens imposed by rules 1.8 and 1.9 under the CEA are the same 
as the burdens imposed by the SEC's rules 3a68-2 and 3a68-4. Therefore, 
the burdens that will be imposed on market participants under rules 1.8 
and 1.9 already have been accounted for within the SEC's calculations 
regarding the impact of this collection of information under the PRA 
and the request for a control number submitted by the SEC to OMB.\1084\
(b) Information Collection Comments
---------------------------------------------------------------------------

    \1084\ 44 U.S.C. 3501-3521. See also 44 U.S.C. 3509 and 3510.
---------------------------------------------------------------------------

    In the Proposing Release, the CFTC invited public comment on the 
reporting and recordkeeping burdens discussed above with regard to 
rules 1.8 and 1.9. Pursuant to 44 U.S.C. 3506(c)(2)(B), the CFTC 
solicited comments in order to: (i) Evaluate whether the proposed 
collections of information are necessary for the proper performance of 
the functions of the CFTC, including whether the information will have 
practical utility; (ii) evaluate the accuracy of the CFTC's estimate of 
the burden of the proposed collections of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) minimize the burden of the 
collections of information on those who are to respond, including 
through the use of automated collection techniques or other forms of 
information technology.
    No comments were received with respect to the reporting and 
recordkeeping burdens discussed in the proposing release. In response 
to the request for a control number by the SEC, OMB issued control 
number 3235-0685.
3. Book-Out Confirmation
    As noted above, the CFTC believes that its interpretation which 
clarifies that oral book-out agreements must be followed in a 
commercially reasonable timeframe by a confirmation in some type of 
written or electronic form would result in a new ``collection of 
information'' requirement within the meaning of the PRA. Therefore, the 
CFTC is submitting the new ``book-out'' information collection to OMB 
for review in accordance with 44 U.S.C. 3506(c)(2)(A) and 5 CFR 
1320.8(d). The CFTC will, by separate action, publish in the Federal 
Register a notice on the paperwork burden associated with the 
interpretation's requirement that oral book-outs be followed in a 
commercially reasonable timeframe by confirmation in some type of 
written or electronic form in accordance with 5 CFR 1320.8 and 1320.10. 
If approved, this new collection of information will be mandatory.

[[Page 48306]]

B. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') requires that agencies 
consider whether the rules they propose will have a significant 
economic impact on a substantial number of small entities and, if so, 
provide a regulatory flexibility analysis respecting the impact.\1085\ 
A regulatory flexibility analysis or certification typically is 
required for ``any rule for which the agency publishes a general notice 
of proposed rulemaking pursuant to'' the notice-and-comment provisions 
of the Administrative Procedure Act, 5 U.S.C. 553(b).
---------------------------------------------------------------------------

    \1085\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------

    With respect to the proposed release, while the CFTC provided an 
RFA statement that the proposed rule would have a direct effect on 
numerous entities, specifically DCMs, SDRs, SEFs, SDs, MSPs, ECPs, 
FBOTs, DCOs, and certain ``appropriate persons'' who relied on the 
Energy Exemption,\1086\ the Chairman, on behalf of the CFTC, certified 
that the rulemaking would not have a significant economic effect on a 
substantial number of small entities. Comments on that certification 
were sought.
---------------------------------------------------------------------------

    \1086\ See 76 FR 29868-89.
---------------------------------------------------------------------------

    In the Proposing Release, the CFTC provided that it previously had 
established that certain entities subject to the CFTC's jurisdiction--
namely, DCMs, DCOs and ECPs--are not small entities for purposes of the 
RFA.\1087\ As the CFTC previously explained, because of the central 
role they play in the regulatory scheme concerning futures trading, the 
importance of futures trading in the national economy, and the 
financial requirements needed to comply with the regulatory 
requirements imposed on them under the CEA, DCMs and DCOs have long 
been determined not to be small entities.\1088\ Based on the definition 
of ECP in the Commodity Futures Modernization Act of 2000 (``CFMA'') 
and the legislative history underlying that definition, the CFTC 
determined that ECPs were not small entities.\1089\ In light of its 
past determination, and the increased thresholds on ECPs added by the 
Dodd-Frank Act making it more difficult for entities to qualify as an 
ECP, the CFTC determined in its proposed rulemakings that ECPs are not 
small entities.
---------------------------------------------------------------------------

    \1087\ See respectively, Policy Statement and Establishment of 
Definitions of ``Small Entities'' for Purposes of the Regulatory 
Flexibility Act, supra note 331, at 18619 (DCMs); A New Regulatory 
Framework for Clearing Organizations, 66 FR 45604, 45609 (Aug. 29, 
2001) (DCOs); Opting Out of Segregation, 66 FR 20740, 20743 (Apr. 
25, 2001) (ECPs).
    \1088\ See respectively, Policy Statement and Establishment of 
Definitions of ``Small Entities'' for Purposes of the Regulatory 
Flexibility Act, supra note 331, at 18619 (DCMs); A New Regulatory 
Framework for Clearing Organizations, 66 FR 45604, 45609, Aug. 29, 
2001 (DCOs).
    \1089\ See Opting Out of Segregation. 66 FR 20740, 20743, Apr. 
25, 2001 (ECPs).
---------------------------------------------------------------------------

    Furthermore, the CFTC provided that certain entities that would be 
subject to the proposed rule--namely SDs, MSPs, SDRs, SEFs, and FBOTs--
are entities for which the CFTC had not previously made a size 
determination for RFA purposes. The CFTC determined that these entities 
should not be considered small entities based on their size and 
characteristics analogous to non-small entities that pre-dated the 
adoption of Dodd-Frank,\1090\ and certified in rulemakings that would 
have an economic impact on these entities that these entities are not 
small entities for RFA purposes.\1091\
---------------------------------------------------------------------------

    \1090\ See 76 FR 29868-89.
    \1091\ See respectively, Registration of Swap Dealers and Major 
Swap Participants, 77 FR 2613, 2620, Jan. 19, 2012 (swap dealers and 
major swap participants); Requirements for Derivatives Clearing 
Organizations, Designated Contract Markets, and Swap Execution 
Facilities Regarding the Mitigation of Conflicts of Interest, 75 FR 
63732, 63745, Oct. 18, 2010 (SEFs); Swap Data Repositories, 76 FR 
54538, 54575, Sept. 1, 2011; Registration of Foreign Boards of 
Trade, 76 FR 80674, 80698, Dec. 23, 2011 (FBOTs).
---------------------------------------------------------------------------

    Finally, the CFTC recognized that, in light of the CFTC's proposed 
withdrawal of the Energy Exemption, the proposed rule could have an 
economic impact on certain ``appropriate persons'' who relied on the 
Energy Exemption. The Energy Exemption listed certain ``appropriate 
persons'' that could rely on the exemption and also required that, to 
be eligible for this exemption, an ``appropriate person must have 
demonstrable capacity or ability to make or take delivery.'' The Energy 
Exemption stated: ``in light of the general nature of the current 
participants in the market, the CFTC believes that smaller commercial 
firms, which cannot meet [certain] financial criteria, should not be 
included.'' \1092\ Therefore, the CFTC did not believe that the 
``appropriate persons'' eligible for the Energy Exemption, and who may 
be affected by its withdrawal, are ``small entities'' for purposes of 
RFA. Moreover, as previously discussed, the CFTC is expanding the Brent 
Interpretation to all nonfinancial commodities for both swaps and 
future delivery definitions and is clarifying that certain alternative 
delivery procedures discussed in the Energy Exemption will not 
disqualify a transaction from the forward contract exclusion under the 
Brent Interpretation.\1093\ Thus, to the extent any entities, small or 
otherwise, relied on the Energy Exemption, such entities can now rely 
on the expanded Brent Interpretation to qualify for the forward 
contract exclusion. Accordingly, the withdrawal of the Energy Exemption 
will not result in a significant economic impact on any entities.
---------------------------------------------------------------------------

    \1092\ Energy Exemption, supra note 207.
    \1093\ See supra part II.B.2.(a)(i)(C).
---------------------------------------------------------------------------

    With respect to this rulemaking, which includes interpretations, as 
well as general rules of construction and definitions that will largely 
be used in other rulemakings, the CFTC received one comment respecting 
its RFA certification. The commenter, an association that represents 
producers, generators, processors, refiners, merchandisers and 
commercial end users of nonfinancial energy commodities, including 
energy and natural gas, contended that the CFTC's overall new 
jurisdiction under the Dodd-Frank Act over ``swaps'' and the burdens 
that the CFTC's rules place on nonfinancial entities, including small 
entities such as its members \1094\ that execute such swaps, can only 
be determined after the rules and interpretations in the product 
definitions rulemaking are finalized. Moreover, the commenter asserted 
that its small entity members seek to continue their use of 
nonfinancial commodity ``swaps'' only to hedge the commercial risks of 
their not-for profit public service activities. The commenter concluded 
that the CFTC should conduct a regulatory flexibility analysis for the 
entire mosaic of its rulemakings under the Dodd-Frank Act, taking into 
consideration the products definition rulemaking.
---------------------------------------------------------------------------

    \1094\ See ETA Letter. In general, ETA states that the Small 
Business Administration (``SBA'') has determined that many of its 
members are ``small entities'' for purposes of the RFA. Id. 
(references the comment letter filed by the NRECA, APPA and LLPC as 
the ``Not-for-Profit Electric Coalition'' in response to the 
Commodity Option NOPR's (76 FR 6095) assertion that there are no 
ECPs that are ``small entities'' for RFA purposes).
---------------------------------------------------------------------------

    The commenter did not provide specific information on how the 
further defining of the terms swap, security-based swap and security-
based swap agreement, providing regulations regarding mixed swaps, and 
providing regulations governing books and records requirements for 
security-based swap agreements would have a significant impact on a 
substantial number of small entities. Nonetheless, the CFTC has 
reevaluated this rulemaking in light of the commenter's statements. 
Upon consideration, the CFTC declines to consider the economic impacts 
of the entire mosaic of rules under the Dodd-

[[Page 48307]]

Frank Act, since an agency is only required to consider the impact of 
how it exercises its discretion to implement the statute through a 
particular rule. In all rulemakings, the CFTC performs an RFA analysis 
for that particular rule.
    Moreover, as the commenter mentioned, most of the transactions into 
which its members enter are based on nonfinancial commodities. The CFTC 
has provided interpretations in this release clarifying the forward 
exclusion in nonfinancial commodities from the swap definition (and the 
forward exclusion from the definition of ``future delivery''), 
including forwards with embedded volumetric options, and separately, 
has provided for a trade option exemption.\1095\ The CFTC also has 
provided an interpretation that certain customary commercial 
transactions are excluded from the swap definition.\1096\
---------------------------------------------------------------------------

    \1095\ See Commodity Options, 77 FR 25320, Apr. 27, 2012.
    \1096\ To the extent the transactions entered into by ETA 
members are traded or executed on Regional Transmission 
Organizations and Independent System Operators, or entered into 
between entities described in section 201(f) of the Federal Power 
Act, they may be addressed through the public interest waiver 
process described in CEA section 4(c)(6).
---------------------------------------------------------------------------

    Accordingly, for the reasons stated in the proposal and the 
foregoing discussion in response to the comment received, the CFTC 
continues to believe that the rulemaking will not have a significant 
impact on a substantial number of small entities. Therefore, the 
Chairman, on behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 
605(b) that the rules will not have a significant impact on a 
substantial number of small entities.

C. Costs and Benefits Considerations

    Section 15(a) of the CEA requires the CFTC to consider the costs 
and benefits of its actions before promulgating a regulation or issuing 
certain orders under the CEA.\1097\ Section 15(a) further specifies 
that the costs and benefits shall be evaluated in light of the 
following five broad areas of market and public concern: (1) Protection 
of market participants and the public; (2) efficiency, competitiveness, 
and financial integrity of markets; (3) price discovery; (4) sound risk 
management practices; and (5) other public interest considerations. The 
CFTC considers the costs and benefits resulting from its discretionary 
determinations with respect to the Section 15(a) factors. The CFTC also 
considers, qualitatively, costs and benefits relative to the status 
quo, that is, the pre-Dodd Frank Act regulatory regime, for historical 
context to help inform the reader.
---------------------------------------------------------------------------

    \1097\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------

    In the Proposing Release, the CFTC assessed the costs and benefits 
of the proposed rules in general, followed by assessments of the costs 
and benefits of each of the rules, taking into account the 
considerations described above. The CFTC also requested comment on 
these assessments, and a number of comments were received. In this 
Adopting Release, the CFTC will again assess the costs and benefits of 
the rules in general followed by the individual rules in this 
rulemaking, for each case taking into account the above considerations 
and the comments received. These costs and benefits, to the extent 
identified and, where possible, quantified have helped to inform the 
decisions of and the actions taken by the CFTC that are described 
throughout this release.
1. Introduction
    Prior to the adoption of Title VII, swaps and security-based swaps 
were by and large unregulated. The Commodity Futures Modernization Act 
of 2000 (``CFMA'') excluded financial over-the-counter swaps from 
regulation under the CEA, provided that trading occurred only among 
``eligible contract participants.'' \1098\ Swaps based on exempt 
commodities--including energy and metals--could be traded among ECPs 
without CFTC regulation, but certain CEA provisions against fraud and 
manipulation continued to apply to these markets. No statutory 
exclusions were provided for swaps on agricultural commodities by the 
CFMA, although they could be traded under certain regulatory exemptions 
provided by the CFTC prior to its enactment. Swaps based on securities 
were subject to certain SEC enforcement authorities, but the SEC was 
prohibited from prophylactic regulation of such swaps.
---------------------------------------------------------------------------

    \1098\ See 7 U.S.C. 1a(12) (2006).
---------------------------------------------------------------------------

    In the fall of 2008, an economic crisis threatened to freeze U.S. 
and global credit markets. The Federal government intervened to 
buttress the stability of the U.S. financial system.\1099\ The crisis 
revealed the vulnerability of the U.S. financial system and economy to 
wide-spread systemic risk resulting from, among other things, poor risk 
management practices of certain financial firms and the lack of 
supervisory oversight for financial institutions as a whole.\1100\ More 
specifically, the crisis demonstrated the need for regulation of the 
over-the-counter derivatives markets.\1101\
---------------------------------------------------------------------------

    \1099\ On October 3, 2008, President Bush signed the Emergency 
Economic Stabilization Act of 2008, which was principally designed 
to allow the U.S. Treasury and other government agencies to take 
action to help to restore liquidity and stability to the U.S. 
financial system (e.g., the Trouble Asset Relief Program--also known 
as TARP--under which the U.S. Treasury was authorized to purchase up 
to $700 billion of troubled assets that weighed down the balance 
sheets of U.S. financial institutions). See Public Law 110-343, 122 
Stat. 3765 (2008).
    \1100\ See Financial Crisis Inquiry Commission, ``The Financial 
Crisis Inquiry Report: Final Report of the National Commission on 
the Causes of the Financial and Economic Crisis in the United 
States,'' Jan. 2011, at xxvii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
    \1101\ Id. at 25 (concluding that ``enactment of * * * [the 
Commodity Futures Modernization Act of 2000 (``CFMA'')] to ban the 
regulation by both the Federal and State governments of over-the-
counter (OTC) derivatives was a key turning point in the march 
toward the financial crisis.''). See also id. at 343 (``Lehman, like 
other large OTC derivatives dealers, experienced runs on its 
derivatives operations that played a role in its failure. Its 
massive derivatives positions greatly complicated its bankruptcy, 
and the impact of its bankruptcy through interconnections with 
derivatives counterparties and other financial institutions 
contributed significantly to the severity and depth of the financial 
crisis.'') and id. at 353 (``AIG's failure was possible because of 
the sweeping deregulation of [OTC] derivatives, [* * *] including 
capital and margin requirements that would have lessened the 
likelihood of AIG's failure. The OTC derivatives market's lack of 
transparency and of effective price discovery exacerbated the 
collateral disputes of AIG and Goldman Sachs and similar disputes 
between other derivatives counterparties.'').
---------------------------------------------------------------------------

    On July 21, 2010, President Obama signed the Dodd-Frank Act into 
law. Title VII of the Dodd-Frank Act established a comprehensive new 
regulatory framework for swaps and security-based swaps. As discussed 
above, 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.\1102\
---------------------------------------------------------------------------

    \1102\ The CFTC has provided a table in the Appendix that cross-
references the costs and benefits considerations of the final rules 
effectuated by the Product Definitions in order to provide more 
transparency with respect to this qualitative assessment of the 
programmatic costs. See Appendix, ``Rules Effectuated by Product 
Definitions.'' The CFTC is not providing a quantitative estimate of 
total programmatic costs, because it cannot be reliably estimated at 
this time. Many rules have not been finalized, including capital and 
margin which may have significant costs. Any estimate made of the 
programmatic costs of the Product Definitions would be unreliable 
and therefore may be misleading.

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[[Page 48308]]

    Section 721 of the Dodd-Frank Act amends the Commodity Exchange Act 
(``CEA'') by adding definitions of the terms ``swap,'' ``security-based 
swap,'' and ``security-based swap agreement.'' Section 712(d)(1) 
provides that the CFTC and the SEC, in consultation with the Federal 
Reserve Board, shall jointly further define those terms. Section 
712(a)(8) 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 of the Dodd-Frank Act (``Title VII''). 
Section 712(d)(2) requires the Commissions, in consultation with the 
Federal Reserve Board, to jointly adopt rules governing books and 
records requirements for security-based swap agreements.
    Under the comprehensive framework for regulating swaps and 
security-based swaps established in Title VII, the CFTC is given 
regulatory authority over swaps, the SEC is given regulatory authority 
over security-based swaps, and the Commissions jointly are to prescribe 
such regulations regarding mixed swaps as may be necessary to carry out 
the purposes of Title VII. In addition, the SEC is given antifraud 
authority over, and access to information from, certain CFTC-regulated 
entities regarding security-based swap agreements, which are a type of 
swap related to securities over which the CFTC is given regulatory and 
enforcement authority.
    The statutory definitions of ``swap'' and ``security-based swap'' 
in Title VII are detailed and comprehensive. The Dodd-Frank Act directs 
the Commissions, among other things, to ``further define'' these terms; 
it does not direct the Commissions to provide definitions for them, 
which are already provided for in the statute. Thus, even in the 
absence of these rules, the Dodd-Frank Act would require regulating 
products that meet the statutory definitions of these terms as swaps 
and security-based swaps. Consequently, a large part of the costs and 
benefits resulting from the regulation of swaps and security-based 
swaps derives from the Dodd-Frank Act itself and not from these rules 
that further define swaps.
    Several commenters to the ANPR issued by the Commissions regarding 
the definitions expressed a concern that the product definitions could 
be read broadly to include certain types of transactions that 
previously had never been considered swaps or security-based swaps. In 
response to those comments, the rules and interpretations clarify that 
certain traditional insurance products, consumer and commercial 
agreements, and loan participations are not swaps or security-based 
swaps, which will increase legal certainty and lower the costs of 
assessing whether a product is a swap or security-based swap for market 
participants. In this regard, the rules and interpretations are 
intended to reduce unnecessary burdens on persons using such 
agreements, contracts, or transactions, the regulation of which under 
Title VII may not be necessary or appropriate to further the purposes 
of Title VII.
    In addition, the CFTC is clarifying the scope of the forward 
contract exclusion \1103\ for nonfinancial commodities from the 
statutory swap definition to provide legal certainty for market 
participants as to which transactions will qualify for the exclusion. 
In this regard, the CFTC is clarifying the circumstances under which 
market participants may rely on past CFTC guidance regarding the 
forward exclusion from the definition of ``future delivery,'' and in 
particular the Brent Interpretation for booked-out transactions,\1104\ 
with respect to the forward exclusion from the swap definition. The 
CFTC is extending the Brent Interpretation to all nonfinancial 
commodities, and is withdrawing the Energy Exemption as proposed, 
\1105\ with certain clarifications. The final interpretation with 
clarifications in response to comments should enhance legal certainty 
regarding the forward exclusions.
---------------------------------------------------------------------------

    \1103\ See supra part II.B.2.a).
    \1104\ See supra part II.B.2.a)i)(B).
    \1105\ See supra part II.B.2.a)i)(C).
---------------------------------------------------------------------------

    While the statutory definitions of swap and security-based swap are 
detailed and comprehensive, the rules further clarify whether 
particular types of transactions are swaps or security-based swaps. For 
example, foreign exchange forwards and swaps are defined as swaps, 
subject to the Treasury Secretary's determination to exempt them from 
the swap definition. The statute provides that certain provisions of 
the CEA apply to foreign exchange forwards and swaps, even if the 
Treasury Secretary determines to exempt them, and the rules reflect 
this. Specifically, these transactions still would be subject to 
certain requirements for reporting swaps, and swap dealers and major 
swap participants engaging in such transactions still would be subject 
to certain business conduct standards. The rules also clarify that, 
because certain foreign exchange products do not fall within the 
definitions of foreign exchange swap and forward, such products are not 
subject to the Treasury Secretary's determination to exempt. Outside of 
the foreign exchange suite of products, the rules and interpretations 
clarify that certain transactions are swaps or security-based swaps. 
These products include forward rate agreements, certain contracts for 
differences, swaptions and forward swaps. The rules and the 
interpretations are intended to increase clarity and legal certainty 
for market participants with respect to these products.
    Next this release addresses the relationship between swaps and 
security-based swaps and how to distinguish them. The Commissions are 
clarifying whether particular agreements, contracts or transactions 
that are subject to Title VII of the Dodd-Frank Act (which are referred 
to as ``Title VII Instruments'' in this release) are swaps, security-
based swaps or both (i.e., mixed swaps). In addition, the Commissions 
are clarifying the use of the term ``narrow-based security index'' in 
the security-based swap definition. In general, the CFTC has 
jurisdiction over Title VII instruments on broad-based security 
indexes, while the SEC has jurisdiction over Title VII instruments on 
narrow-based security indexes. This release clarifies that the existing 
criteria for determining whether a security index is narrow-based, and 
the past guidance of the Commissions regarding those criteria in the 
context of security futures, apply to Title VII instruments. Credit 
default swaps (``CDS'') also are subject to this same jurisdictional 
division--CDS on broad-based security indexes are regulated by the 
CFTC, while CDS on narrow-based security indexes (as well as CDS on 
single name securities or loans) generally are regulated by the SEC. 
This release provides new criteria tailored to CDS for determining 
whether a CDS is based on an index that is a narrow-based security 
index. Also, it explains the term ``index'' and adopts a final rule 
governing tolerance and grace periods for Title VII instruments on 
security indexes traded on trading platforms. These rules and 
interpretations generally are designed to provide clarity and enhanced 
legal certainty regarding the appropriate classification of Title VII 
instruments as swaps, security-based swaps or mixed swaps, so that 
market participants may ascertain the applicable regulatory 
requirements more easily.
    This release anticipates that mixed swaps, which are both swaps and 
security-based swaps, will be a narrow category, but lists a few 
examples of

[[Page 48309]]

mixed swaps and interprets how to distinguish one type of TRS that is a 
mixed swap from another that is not. This release addresses the 
regulatory treatment of bilateral, uncleared mixed swaps where one 
counterparty is a dual registrant with the CFTC and SEC. It also 
establishes a process for requesting a joint order from the Commissions 
to determine the appropriate regulatory treatment of mixed swaps that 
do not fall into the category of mixed swaps where one counterparty is 
a dual registrant. Concerning ``security-based swap agreements'' (or 
SBSAs), this release explains what types of transactions are SBSAs and 
includes rules that provide that there will not be additional books and 
records requirements regarding SBSAs other than those that have been 
proposed by the CFTC for swaps in order to avoid duplicative regulation 
and costs.
    This release also includes rules establishing a process for members 
of the public to request a joint interpretation from the Commissions 
regarding whether a Title VII instrument is a swap, security-based swap 
or a mixed swap. The process includes a deadline for a decision, as 
well as a requirement that if the Commissions do not issue a joint 
interpretation within the prescribed time period, each Commission must 
publicly provide the reasons for not having done so.
    Finally, this release includes anti-evasion rules and related 
interpretations adopted by the CFTC, which in general would apply to 
agreements, contracts, transactions and entities that are willfully 
structured to evade Dodd-Frank requirements.
2. Costs and Benefits of the Definitions--In General
    The rules and interpretations in this Adopting Release: further 
define the terms ``swap,'' ``security-based swap,'' and ``security-
based swap agreement;'' provide for the regulation of ``mixed swaps;'' 
and address books and records requirements for security-based swap 
agreements. In the discussion that follows, the CFTC considers the 
costs and benefits resulting from its own discretionary determinations 
with respect to the section 15(a) factors.
    There are ``programmatic'' costs and benefits as well as 
``assessment'' costs of the Product Definitions. Programmatic costs 
result from subjecting certain agreements, contracts, or transactions 
to the regulatory regime of Title VII.\1106\ Effectiveness of the 
Products Definitions will trigger effectiveness of any statutory 
provision or regulation that depends, in whole or in part, on the 
effectiveness of this final rulemaking. By fulfilling the statutory 
mandate, many of the programmatic benefits of Title VII and the CFTC's 
implementing regulations are triggered, including risk reduction, 
increasing transparency, and promoting market integrity and, by 
extension, the increased possibility of preventing or reducing the 
severity of another global financial crisis such as occurred in 2008. 
Delimiting the scope of the terms ``swap,'' ``security-based swap,'' 
``security-based swap agreement,'' and ``mixed swaps'' also helps to 
determine the scope of activities and entities that will be subject to 
the various Title VII regulatory requirements. Requirements for 
clearing and trade execution, capital and margin, business conduct, and 
reporting and recordkeeping, all of which have been or will be 
implemented in other CFTC rules, will lead to programmatic costs that 
have been or will be addressed in the CFTC's rules to implement those 
requirements. When considering the programmatic costs and benefits of 
the Product Definitions, the CFTC recognizes the scope of activities 
and entities affected by the further Product Definitions by reference 
to the other final rulemakings under Title VII accomplished to date. 
The costs that parties will incur to assess whether certain agreements, 
contracts, or transactions are ``swaps,'' ``security-based swaps,'' 
``security-based swap agreements,'' or ``mixed swaps'' that are subject 
to the Title VII regulatory regime, and, if so, costs to assess whether 
such Title VII instrument is subject to the regulatory regime of the 
SEC or the CFTC are referred to herein as assessment costs.
---------------------------------------------------------------------------

    \1106\ See Appendix, ``Rules Effectuated by Product 
Definitions.''
---------------------------------------------------------------------------

    In general, many commenters have suggested that the statutory 
definitions of swap and security-based swap are overbroad in that they 
could be viewed to include agreements, contracts, and transactions that 
the market had not considered to be swaps or security-based swaps prior 
to the enactment of the Dodd-Frank Act, are (or could be) swaps or 
security-based swaps. Thus, in response to these comments, the CFTC has 
engaged in a qualitative analysis of various agreements, contracts, and 
transactions of which the CFTC is aware and that commenters have 
brought to its attention. Based on this analysis, the CFTC has 
established rules and interpretations to identify agreements, 
contracts, and transactions that are swaps or security-based swaps 
where the statutory definition may be inadequate or ambiguous. In 
developing the further definitions, the CFTC has endeavored to narrow 
the scope of the terms ``swap'' and ``security-based swap'' without 
excluding agreements, contracts and transactions that the CFTC has 
determined should be regulated as swaps and security-based swaps. 
Narrowing the scope of the statutory definitions should reduce the 
overall programmatic costs of Title VII because fewer agreements, 
contracts, and transactions will be subject to the full panoply of 
Title VII regulation. Narrowing the scope of the statutory definitions 
should also increase the net programmatic benefits of the CFTC's Title 
VII regulations because the CFTC is targeting in the Product 
Definitions rulemaking agreements, contracts and transactions that the 
CFTC has determined, after considering comments received and 
undertaking a qualitative analysis, are swaps or security-based swaps. 
The CFTC anticipates that applying the full panoply of Title VII 
regulation to only those agreements, contracts or transactions that the 
CFTC has determined are swaps or security-based swaps will be most 
effective in achieving the net benefits of Title VII regulation under 
the Dodd-Frank Act.
(a) Costs
    The scope of the terms ``swap,'' ``security-based swap,'' 
``security-based swap agreement,'' and ``mixed swap'' is an important 
factor in determining the range of activities and entities that will be 
subject to various requirements set forth in the Dodd-Frank Act, such 
as trade execution, clearing, reporting, registration, business 
conduct, and capital requirements. Complying with these requirements, 
which will be implemented in other rules by the CFTC, are programmatic 
costs, which also have been or will be addressed in the CFTC's rules to 
implement those requirements.\1107\
---------------------------------------------------------------------------

    \1107\ See Appendix, ``Rules Effectuated by Product 
Definitions.''
---------------------------------------------------------------------------

    The CFTC believes that the rulemaking to further define the terms 
``swap,'' ``security-based swap,'' ``security-based swap agreement,'' 
and ``mixed swap'' is consistent with how market participants 
understand these products. The further definitions increase legal 
certainty and thereby reduce assessment costs by clarifying that 
certain products that meet the requirements of the applicable rules and 
interpretations, such as traditional insurance products, are not swaps.
(b) Benefits
    Many of the benefits of Title VII and the CFTC's implementing 
regulations, including risk reduction, increasing

[[Page 48310]]

transparency, and promoting market integrity are programmatic benefits 
of the Products Definitions since they are effectuated by Product 
Definitions. These programmatic benefits are difficult to quantify and 
measure. Moreover, these benefits can be expected to manifest 
themselves over the long run and be distributed over the market as a 
whole.
    The CFTC believes that the final rules and interpretations can be 
consistently applied by substantially all market participants to 
determine which agreements, contracts, or transactions are, and which 
are not, swaps, security-based swaps, security-based swap agreements, 
or mixed swaps. The benefits of the individual rules and 
interpretations are discussed in their respective sections below.
(c) Comments and Consideration of Alternatives
    The CFTC requested comment on the costs and benefits of the 
proposed rules and interpretations regarding the definitions in general 
for market participants, markets and the public. Further, the CFTC 
requested comment as to whether there are any aspects of the proposed 
rules and interpretive guidance regarding the definitions that are both 
burdensome to apply and not helpful to achieving clarity as to the 
scope of the defined terms, and whether there are less burdensome means 
of providing clarity as to the scope of the defined terms.
    A commenter \1108\ argued that a proper cost-benefit analysis can 
only be performed once an integrated and complete mosaic of rules is 
available for analysis and doubted that the definitions impose no 
independent costs. The CFTC has considered, qualitatively, the costs 
and benefits of the entire mosaic of CFTC rules under the Dodd-Frank 
Act in this rulemaking. Due to data limitations and other uncertainty, 
the CFTC cannot perform a meaningful quantitative analysis, yet. The 
CFTC considers in this rulemaking the costs and benefits of how the 
Commissions are exercising their discretion in further defining the 
Product Definitions because Congress included in the Dodd-Frank Act 
statutory definitions of these terms, over which the CFTC has no 
discretion. Moreover, the CFTC has considered the independent costs 
(i.e. costs imposed through exercising its discretion) that the 
Products Definitions may impose through its determinations as discussed 
below.
---------------------------------------------------------------------------

    \1108\ See ETA Letter. See also IECA Letter II (requesting a 
comprehensive costs benefits analysis on all of Title VII).
---------------------------------------------------------------------------

    Another commenter \1109\ contended that the costs and benefits 
considerations in the Proposing Release were not based on any empirical 
data and are not consistent with the expected costs of compliance 
anticipated by market participants. However, the CFTC cannot do a 
comprehensive empirical analysis regarding costs and benefits of the 
Products Definitions before actual data is available when the swap 
regulatory regime has been implemented in full. Moreover, the CFTC did 
use some empirical estimates in its costs and benefits considerations 
in the Proposing Release, namely in assessment costs for the process to 
seek an interpretation of whether a product is a swap, security-based 
swap, or mixed swap, as well as in the process to determine regulatory 
treatment for mixed swaps.\1110\ Commenters did not submit data or 
other information to support an argument that the CFTC's estimates were 
inaccurate.
---------------------------------------------------------------------------

    \1109\ See WGCEF Letter.
    \1110\ See Proposing Release at 29874.
---------------------------------------------------------------------------

    Commenters \1111\ expressed concern about costs from regulatory 
uncertainty imposed on swaps market participants resulting from other 
Title VII rulemakings not yet being final. The consideration of 
thousands of letters and the process of due deliberation and reasoned 
decision-making by the CFTC has caused delays. Nevertheless, the CFTC 
is working with deliberate speed to complete the rulemakings, and 
eventually this particular type of legal uncertainty will be 
eliminated.
---------------------------------------------------------------------------

    \1111\ See FIA Letter; IIB Letter; and ISDA Letter.
---------------------------------------------------------------------------

    A commenter \1112\ requested that inter-affiliate swaps be exempt 
from the swap definition, arguing that regulating such swaps may 
increase costs to consumers and undermine efficiencies from the use of 
centralized hedging affiliates. The CFTC anticipates that it will 
address inter-affiliate swaps in a subsequent rulemaking.
---------------------------------------------------------------------------

    \1112\ See Shell Trading Letter.
---------------------------------------------------------------------------

    Several commenters \1113\ argued that foreign central banks, 
foreign sovereigns, international financial institutions, such as 
multilateral development banks, and similar organizations should be 
exempt from swap regulations, since regulations would impose costs on 
these entities. Specifically, a commenter \1114\ asserted that 
multilateral development banks should not have to register or be 
subject to clearing and margin requirements and requested that 
multilateral development banks' transactions be exempted from the 
definition of a swap. As explained above, these transactions are swaps. 
In addition, the proposed exclusion is overbroad because it would mean 
that swaps and security-based swaps entered into by foreign central 
banks, foreign sovereigns, international financial institutions, and 
similar organizations would be completely excluded from Dodd-Frank 
regulation. Their counterparties, who may be swap dealers and other 
regulated entities, would have no regulatory obligations with respect 
to such swaps, and could develop significant exposures without the 
knowledge of the CFTC, other regulators and market participants. If 
these transactions were not swaps, then no market participant would be 
obligated to report them to a U.S.-registered swap data repository or 
real-time report them. This lack of transparency might distort swap 
pricing and impede proper risk management in as much as the market may 
not be aware of the risk entailed in these opaque transactions and 
might thwart price discovery.
---------------------------------------------------------------------------

    \1113\ See CEB Letter; EIB Letter; and World Bank Letter.
    \1114\ See World Bank Letter.
---------------------------------------------------------------------------

    The Commissions did not propose rules or interpretations on how to 
distinguish futures from swaps. A commenter requested that the CFTC 
clarify that nothing in the release was intended to limit a DCM's 
ability to list for trading a futures contract regardless of whether it 
could be viewed as a swap if traded over-the-counter or on a SEF, since 
futures and swaps are ``indistinguishable in material economic 
effects.'' \1115\ The commenter further recommended that the CFTC adopt 
a final rule that amends the statutory definition of the term ``swap'' 
by adding to the futures contract exclusion in CEA Section 1a(47)(B)(i) 
the following language after the word ``delivery'': ``Listed for 
trading by a designated contract market.'' The same commenter believed 
that such a rule would clarify the scope of Section 4(a) of the 
CEA,\1116\ which makes it illegal to trade a futures contract except on 
or subject to the rules of a DCM.\1117\
---------------------------------------------------------------------------

    \1115\ See CME Letter.
    \1116\ 7 U.S.C. 6(a).
    \1117\ See CME Letter.
---------------------------------------------------------------------------

    Although it is potentially more costly to a DCM in terms of 
providing additional analysis to support listing a futures contract on 
its exchange, the CFTC is not adopting the distinction the commenter 
advocates. Prior distinctions that the CFTC relied upon (such as the 
presence or absence of clearing) to distinguish between futures and 
swaps

[[Page 48311]]

may no longer be relevant.\1118\ As a result, it is difficult to 
distinguish between futures and swaps on a blanket basis as the 
commenter suggested. However, a case-by-case approach for 
distinguishing these products may lead to more informed decision-making 
by the CFTC.
---------------------------------------------------------------------------

    \1118\ See, e.g., Swap Policy Statement, supra note 214.
---------------------------------------------------------------------------

    The CFTC notes that a DCM may self-certify its contracts pursuant 
to Part 40 of the CFTC's rules,\1119\ subject to the CFTC's oversight 
authority. If a DCM has a view that a particular product is a futures 
contract, it may self-certify the contract consistent with that view. 
The DCM also has a number of other options, including seeking prior 
approval from the CFTC, requesting an interpretation, or requesting a 
rulemaking if it is in doubt about whether a particular agreement, 
contract or transaction should be classified as a futures contract or a 
swap.
---------------------------------------------------------------------------

    \1119\ 17 CFR Part 40.
---------------------------------------------------------------------------

3. Costs and Benefits of Rules and Interpretations Regarding Insurance
    Rule 1.3(xxx)(4)(i) under the CEA clarifies that agreements, 
contracts or transactions that satisfy its provisions will not be swaps 
or security-based swaps. Specifically, the term ``swap'' and 
``security-based swap'' does not include an agreement, contract, or 
transaction under rule 1.3(xxx)(4)(i)(A) that, by its terms or by law, 
as a condition of performance on the agreement, contract, or 
transaction: (i) 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; (ii) requires that loss to 
occur and be proved, and that any payment or indemnification therefor 
be limited to the value of the insurable interest; (iii) is not traded, 
separately from the insured interest, on an organized market or over-
the-counter; and (iv) 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 (the ``Product Test'').
    Rule 1.3(xxx)(4)(i)(B) under the CEA provides that for an 
agreement, contract, or transaction that meets the Product Test to be 
excluded from the swap and security-based swap definitions as 
insurance, it must be provided: (i) By a person that is subject to 
supervision by the insurance commissioner (or similar official or 
agency) of any State or by the United States or an agency or 
instrumentality thereof, and such agreement, contract, or transaction 
is regulated as insurance applicable State law or the laws of the 
United States (the ``first prong''); (ii) directly or indirectly by the 
United States, any State, or any of their respective agencies or 
instrumentalities, or pursuant to a statutorily authorized program 
thereof (the ``second prong''); (iii) in the case of reinsurance only, 
by a person to another person that satisfies the Provider Test, 
provided that: such person is not prohibited by applicable State law or 
the laws of the United States from offering such agreement, contract, 
or transaction to such person that satisfies the Provider Test; the 
agreement, contract, or transaction to be reinsured satisfies the 
Product Test or is one of the Enumerated Products; and except as 
otherwise permitted under applicable State law, the total amount 
reimbursable by all reinsurers for such agreement, contract, or 
transaction may not exceed the claims or losses paid by the cedant; or 
(iv) in the case of non-admitted insurance by a person who: is located 
outside of the United States and listed on the Quarterly Listing of 
Alien Insurers as maintained by the International Insurers Department 
of the National Association of Insurance Commissioners; or meets the 
eligibility criteria for non-admitted insurers under applicable State 
law (the ``Provider Test'').
    In response to commenters' requests that the Commissions codify the 
proposed interpretation regarding certain enumerated types of insurance 
products in the final rules, the interpretation is being codified in 
paragraph (i)(C) of rule 1.3(xxx)(4) under the CEA. In addition, in 
response to comments, the Commissions are expanding and revising the 
list of traditional insurance products. As adopted, the rule provides 
that the terms ``swap'' and ``security-based swap'' will not include an 
agreement, contract, or transaction that is provided in accordance with 
the conditions set forth in the Provider Test and is one of the 
following types of products (collectively, ``Enumerated Products''): 
surety bonds; fidelity bonds; life insurance; health insurance; long-
term care insurance; title insurance; property and casualty insurance; 
annuities; disability insurance; insurance against default on 
individual residential mortgages (commonly known as private mortgage 
insurance, as distinguished from financial guaranty of mortgage pools); 
and reinsurance (including retrocession) of any of the foregoing. Based 
on comments received, the Commissions are adding three products to the 
list of products as proposed, adding reinsurance (including 
retrocession) of any of the traditional insurance products included in 
the list, and deleting a requirement applicable to annuities that they 
must be subject to tax treatment under section 72 of the Internal 
Revenue Code.
    The Commissions are also clarifying that the Product Test, the 
Provider Test and the Enumerated Products in the rules are a non-
exclusive safe harbor (the ``Insurance Safe Harbor''), such that if a 
product fails the Insurance Safe Harbor, that does not necessarily mean 
that the product is a swap or security-based swap--further analysis may 
be required in order to make that determination.
    Rule 1.3(xxx)(4)(ii) provides a ``grandfather'' for insurance 
transactions (as opposed to insurance products), pursuant to which 
transactions that are entered into on or before the effective date of 
the Product Definitions will not fall within the definition of swap or 
security-based swap, provided that, at such time that it was entered 
into, the transaction was provided in accordance with the Provider 
Test.
    The CFTC is interpreting the term ``swap'' (that is not a security-
based swap or mixed swap) to include a guarantee of such swap, to the 
extent that a counterparty to a swap position would have recourse to 
the guarantor in connection with the position. The CFTC is persuaded 
that when a swap has the benefit of a guarantee, the guarantee is an 
integral part of that swap. The CFTC finds that a guarantee of a swap 
(that is not a security-based swap or mixed swap) is a term of that 
swap that affects the price or pricing attributes of that swap. When a 
swap counterparty typically provides a guarantee as credit support for 
its swap obligations, the market will not trade with that counterparty 
at the same price, on the same terms, or at all without the guarantee. 
The guarantor's resources are added to the analysis of the swap; if the 
guarantor is financially more capable than the swap counterparty, the 
analysis of the swap becomes more dependent on the creditworthiness of 
the guarantor. The CFTC anticipates that a ``full recourse'' guarantee 
would have a greater effect on the price of a swap than a ``limited'' 
or ``partial recourse'' guarantee; nevertheless, the CFTC is 
determining that the presence of any guarantee with recourse, no matter 
how robust, is price forming and an integral part of a guaranteed swap. 
The CFTC's

[[Page 48312]]

interpretation of the term ``swap'' to include guarantees of swap does 
not limit or otherwise affect in any way the relief provided by the 
Insurance Grandfather. In a separate release, the CFTC will address the 
practical implications of interpreting the term ``swap'' to include 
guarantees of swaps (the ``separate CFTC release'').
(a) Costs
    A market participant will need to ascertain whether an agreement, 
contract, or transaction satisfies the criteria set forth in rule 
1.3(xxx)(4). This analysis will have to be performed prior to entering 
into the agreement, contract, or transaction to ensure that the relief 
provided by the Insurance Safe Harbor is available. The CFTC expects 
that potential costs associated with any possible uncertainty cited by 
commenters as to whether an agreement, contract, or transaction that 
the participants consider to be insurance could instead be regulated as 
a swap would be greater without the Insurance Safe Harbor than the cost 
of the analysis under the final rule herein.
    Although the Insurance Safe Harbor is designed to mitigate costs 
associated with legal uncertainty and misclassification of products, to 
the extent that it inadvertently fails to exclude certain types of 
insurance products from the definitions, these failures could lead to 
costs for market participants entering into agreements, contracts, or 
transactions. Some insurance products might inadvertently be subjection 
to regulation as swaps. To the extent that the Insurance Safe Harbor 
leads to the inadvertent misclassification of some swaps as insurance, 
costs for market participants entering into agreements, contracts, or 
transactions that are inadvertently regulated as insurance products, 
and not as swaps, may increase.\1120\ Similarly, insurance products 
inadvertently mischaracterized as swaps could impose additional costs 
on market participants, who could be required to meet certain 
regulatory requirements applicable to swaps.
---------------------------------------------------------------------------

    \1120\ Improperly characterizing swaps as insurance may 
theoretically cause market participants that are not licensed 
insurance companies to become licensed insurance companies, if 
applicable, thus imposing costs of complying with state insurance 
regulation.
---------------------------------------------------------------------------

    Assessment costs should be minimal or non-existent for traditional 
insurance products,\1121\ but for a new and novel insurance product 
that is more complex, the costs of analysis may be greater. 
Nevertheless, it is anticipated that such cases will be infrequent. 
Moreover, it may be difficult to assess whether products that do not 
fall within the Insurance Safe Harbor are swaps or security-based swaps 
rather than insurance. Market participants may need to request an 
interpretation from the Commissions regarding such products, or obtain 
an opinion of counsel, which will involve certain costs.\1122\ However, 
the CFTC expects such cases will arise less frequently in light of the 
increased clarity provided by the rule. An alternative to a safe harbor 
approach under the rule--that failure to meet the rule and 
interpretation would automatically mean that the product is a swap and 
not insurance--would likely impose greater costs on market participants 
and result in more frequent misclassification of products.
---------------------------------------------------------------------------

    \1121\ The CFTC anticipates that traditional insurance products 
will either be easy to identify from the list of Enumerated Products 
or will unambiguously satisfy the Products Test.
    \1122\ The CFTC believes that $27,000 represents a reasonable 
estimate of the upper end of the range of the costs to undertake the 
legal analysis of the status of an agreement, contract, or 
transaction as a swap or security-based swap. The average cost 
incurred by market participants in connection with assessing whether 
an agreement, contract, or transaction is a swap or security-based 
swap is based upon the estimated amount of time that staff believes 
will be required for both in-house counsel and outside counsel to 
apply the definition. Staff estimates that some agreements, 
contracts, or transactions will clearly satisfy the Insurance Safe 
Harbor, Insurance Grandfather and an in-house attorney, without the 
assistance of outside counsel, will be able to make a determination 
in less than one hour. Based upon data from SIFMA's Management & 
Professional Earnings in the Securities Industry 2011 (modified by 
SEC staff to account for an 1800-hour-work-year and multiplied by 
5.35 to account for bonuses, firm size, employee benefits and 
overhead), staff estimates that the average national hourly rate for 
an in-house counsel is $378. If an agreement, contract, or 
transaction is more complex, the CFTC estimates the analysis will 
require approximately 30 hours of in-house counsel time and 40 hours 
of outside counsel time. The CFTC estimates the costs for outside 
legal services to be $400 per hour. This is based on an estimated 
$400 per hour cost for outside legal services. This is the same 
estimate used by the SEC for these services in the release involving 
Exemptions for Security-Based Swaps Issued By Certain Clearing 
Agencies, Release No. 33-9308 (Mar. 30, 2012), 77 FR 20536 (Apr. 5, 
2012). Accordingly, on the high end of the range the CFTC estimates 
the cost to be $27,340 ($11,340 (based on 30 hours of in-house 
counsel time [multi] $378) + $16,000 (based on 40 hours of outside 
counsel [multi] $400). The estimate is rounded to two significant 
digits to avoid the impression of false precision of the estimate.
---------------------------------------------------------------------------

    The CFTC is interpreting the term ``swap'' (that is not a security-
based swap or mixed swap) to include a guarantee of such swap, to the 
extent that a counterparty to a swap position would have recourse to 
the guarantor in connection with the position. The CFTC anticipates 
minimal or no assessment costs from the interpretation with respect to 
guarantees of swaps.\1123\ The CFTC does, however, anticipate that 
there will be some programmatic costs associated with the requirements 
that it will propose for guarantees of swaps in the separate CFTC 
release.\1124\ The CFTC will carefully consider those costs in that 
rulemaking.
---------------------------------------------------------------------------

    \1123\ Because a guarantee is a common and well-understood 
product, that has been used in commerce since long before the 
existence of swaps markets, the CFTC anticipates that whether a 
guarantee is present or not will be obvious.
    \1124\ As a result of interpreting the term ``swap'' (that is 
not a security-based swap or mixed swap) to include a guarantee of 
such swap, to the extent that a counterparty to a swap position 
would have recourse to the guarantor in connection with the 
position, and based on the reasoning set forth in the Entity 
Definitions Release in connection with major swap participants, the 
CFTC will not deem holding companies to be swap dealers as a result 
of guarantees to certain U.S. entities that are already subject to 
capital regulation. This interpretation mitigates the programmatic 
costs imposed on potential swap dealers by not attributing to a 
guarantor swap positions of a guaranteed entity that is already 
subject to capital regulation.
---------------------------------------------------------------------------

(b) Benefits
    Subjecting traditional insurance products to Title VII could, 
absent exception, prevent individuals who are not ECPs from obtaining 
insurance to protect their properties or families against accidental 
hazards or risks,\1125\ or require insurance sold to individuals who 
are not ECPs to be traded on exchanges and be cleared. The Commissions 
have found no evidence that Congress intended them to be regulated as 
swaps or security-based swaps. In light of the above considerations, 
the Commissions have determined to provide the Insurance Safe Harbor 
and Insurance Grandfather in the final rules in order to assure market 
participants that those agreements, contracts, or transactions that 
meet their conditions will not fall within the swap or security-based 
swap definitions. Limiting the number of unexpected product 
classification outcomes for market participants provides the benefit of 
predictability when entering into their transactions
---------------------------------------------------------------------------

    \1125\ An individual is considered an ECP if the individual 
``has amounts invested on a discretionary basis, the aggregate of 
which is in excess of--(i) $10,000,000; or (ii) $5,000,000 and who 
enters into the agreement, contract, or transaction in order to 
manage the risk associated with an asset owned or liability 
incurred, or reasonable likely to be owned or incurred, by the 
individual.'' Section 1a(18)(A)(xi) of the CEA, 7 U.S.C. 
1a(18)(A)(xi).
---------------------------------------------------------------------------

    The business of insurance is already subject to established pre-
Dodd-Frank Act regulatory regimes. Requirements that may work well for 
swaps and security-based swaps may not be appropriate for traditional 
insurance products. To the extent that the final rules distinguish 
insurance from swaps and security-based swaps, the CFTC should be able 
to tailor rules for specific

[[Page 48313]]

products that are swaps or security-based swaps to achieve Title VII 
regulatory objectives. In adopting the Insurance Safe Harbor, the CFTC 
has sought to achieve those net benefits that may be obtained from not 
supplanting existing insurance regulation that are consistent with the 
regulatory objectives of Title VII.
    Without the Insurance Safe Harbor, market participants might be 
more uncertain about whether an agreement, contract, or transaction is 
an insurance product rather than a swap. Rule 1.3(xxx)(4) is intended 
to reduce the potential uncertainty of what constitutes a swap by 
setting forth clear and objective criteria for distinguishing an 
agreement, contract, or transaction that is insurance from a swap. 
Providing such an objective rule and explanation mitigates the 
potential additional costs of petitioning the Commissions, or obtaining 
an opinion of counsel, about whether an agreement, contract, or 
transaction is insurance or a swap.
    The objective criteria provided by the rule also will aid sound 
risk management practices because it will be easier for market 
participants to decide whether a particular agreement, contract, or 
transaction is insurance or a swap.
    Further, the CFTC anticipates that the interpretation of the term 
``swap'' to include guarantees of swaps and the separate CFTC release 
will provide programmatic benefits by enabling the CFTC and market 
participants to receive more price-forming data about swaps, which may 
help improve price discovery for swaps. The CFTC will carefully 
consider these and other benefits in the separate CFTC release.
(c) Comments and Consideration of Alternatives
    The CFTC requested comment on the costs and benefits of proposed 
rule 1.3(xxx)(4) and interpretive guidance to distinguish between 
insurance products and swaps for market participants, markets, and the 
public. Several commenters \1126\ argued that any additional 
requirement beyond the requirement of the rules that a product is a 
regulated insurance product creates legal uncertainty and imposes 
costs. Specifically, a commenter \1127\ asserted that it is a burden to 
introduce conditions that are neither universal nor fundamental, such 
as showing a continuing risk of loss for some insurance contracts. 
Another commenter \1128\ argued that legal uncertainty may result in 
conflicting interpretations, which can be a significant burden for 
financial guaranty transactions that typically require the delivery of 
a legal opinion.
---------------------------------------------------------------------------

    \1126\ See AFGI Letter; AIA Letter; and ISDA Letter.
    \1127\ See ISDA Letter.
    \1128\ See AFGI Letter.
---------------------------------------------------------------------------

    The Commissions have expanded the list of insurance products 
excluded from the swap definition to cover certain traditional 
insurance products that commenters have brought to their attention and 
that the Commissions have determined are not swaps. The Commissions are 
also clarifying that the Insurance Safe Harbor does not imply or 
presume that an agreement, contract or transaction that does not meet 
its requirements is a swap or security-based swap, but will require 
further analysis of the applicable facts and circumstances, including 
the form and substance of the agreement, contract, or transaction, to 
determine whether it is insurance, and thus not a swap or security-
based swap. With regard to financial guaranty in particular, the 
acceleration of payment criterion is designed to reflect market 
practice and aid appropriate product classification. The Commissions 
are stating that they intend to interpret concepts upon which the 
Product Test relies that are derived from state law consistently with 
the existing and developing laws of the relevant state(s) governing the 
agreement, contract, or transaction in question. However, the 
Commissions note their authority to diverge from state law if the 
Commissions become aware of evasive conduct. While the CFTC cannot 
anticipate under what circumstances or how often the Commissions might 
diverge from state law, the CFTC believes that there will be more 
consistent than inconsistent interpretations. Accordingly, the rules do 
not present the increased burden or legal uncertainty that these 
commenters suggested.
    Several commenters also requested that the Commissions codify the 
proposed interpretive guidance regarding enumerated insurance products 
in rule text on the basis that codification would enhance legal 
certainty, and thereby reduce costs.\1129\ The Commissions have decided 
to include a list of products in rule text in response to these 
commenters concerns.
---------------------------------------------------------------------------

    \1129\ See ACLI Letter; NAIC Letter; and RAA Letter.
---------------------------------------------------------------------------

    A commenter proposed that the sole test for determining whether an 
agreement, contract or transaction is insurance should be whether it is 
subject to regulation as insurance by the insurance commissioner of the 
applicable state(s).\1130\ While the commenter's test is potentially 
easier and thus may be less costly to apply than the Commissions' test, 
it would be inadequate because, as explained in section II.B.1.(d) 
above, it would essentially delete the product prong of the insurance 
safe harbor, and thus begging the question of how to distinguish 
insurance from swaps and security-based swaps and allowing state 
insurance regulators to supplant the Commissions' role in further 
defining, or determining what is, a swap. Further, market participants 
might misconstrue the commenter's test in close cases to mean that any 
activity permitted by the insurance commissioner of the relevant 
state(s) may not be regulated as swaps or security-based swaps. 
However, insurance companies are in many circumstances permitted by 
state insurance regulators to enter into swaps or security-based swaps, 
illustrating that the fact that while an insurance company may enter 
into an agreement, contract or transaction, it does not necessarily 
mean that such agreement, contract or transaction is insurance. 
Further, the domain of insurance regulation may change and then this 
commenter's test would induce an evolving boundary between state and 
CFTC regulation.
---------------------------------------------------------------------------

    \1130\ See MetLife Letter.
---------------------------------------------------------------------------

    Several commenters suggested an approach in which insurance 
products that qualify for the exclusion contained in section 3(a)(8) of 
the Securities Act of 1933 would be excluded from the swap 
definition.\1131\ One commenter argued that ``Section 3(a)(8) has long 
been recognized as the definitive provision as to where Congress 
intends to separate securities products that are subject to SEC 
regulation from `insurance' and `annuity' products that are to be left 
to state insurance regulation'' and that the section 3(a)(8) criteria 
are well understood and have a long history of interpretation by the 
SEC and the courts.\1132\ Other commenters suggest that because section 
3(a)(8) includes both a product and a provider requirement, if the 
Commissions include it in their final rules, it should be a requirement 
separate from the Product Test and the Provider Test, and should extend 
to insurance products that are securities.\1133\
---------------------------------------------------------------------------

    \1131\ See supra note 162
    \1132\ See supra note 163.
    \1133\ See supra note 164.
---------------------------------------------------------------------------

    While the Commissions agree that the section 3(a)(8) criteria have 
a long history of interpretations by the SEC and the courts, the 
Commissions find that it is inappropriate to apply the section 3(a)(8) 
criteria in this context. Although section 3(a)(8) contains some

[[Page 48314]]

conditions applicable to insurance providers that are similar to the 
prongs of the Provider Test, it does not contain any conditions that 
are similar to the prongs of the Product Test. Moreover, section 
3(a)(8) provides an exclusion from the Securities Act and the CFTC has 
no jurisdiction under the Federal securities laws. Congress directed 
both agencies to further define the terms ``swap'' and ``security-based 
swap.'' As such, the Commissions find that it is more appropriate to 
have a standalone rule that incorporates features that distinguish 
insurance products from swaps and security-based swaps and over which 
both Commissions will have joint interpretative authority.
    Another commenter proposed the following test for an agreement, 
contract, or transaction to be insurance:

    [It] [e]xists for a specified period of time;
    Where the one party to the contract promises to make one or more 
payments such as money, goods or services;
    In exchange for another party's promise to provide a benefit of 
pecuniary value for the loss, damage, injury, or impairment of an 
identified interest of the insured as a result of the occurrence of 
a specified event or contingency outside of the parties' control; 
and
    Where such payment is related to a loss occurring as a result of 
a contingency or specified event.\1134\
---------------------------------------------------------------------------

    \1134\ See NAIC Letter.

    This test may not represent a less costly alternative to the 
Commissions' test in light of its complexity, and in any event would 
not distinguish swaps and security-based swaps from insurance more 
effectively than the Commissions' test for two reasons. The 
requirements of a specified term and the payment of premiums are 
present in both insurance products and in agreements, contracts, or 
transactions that are swaps or security-based swaps, and therefore such 
requirements do not help to distinguish between them. A test based 
solely on these requirements, then, would be over-inclusive and exclude 
from the Dodd-Frank regulatory regime agreements, contacts, and 
transactions that have not traditionally been considered insurance. 
Also, the third and fourth requirements of the commenter's test 
collapse into the Product Prong's requirement that the loss must occur 
and be proved, and any payment or indemnification therefor must be 
limited to the value of the insurable interest.
    Another commenter offered a 3-part test\1135\ in lieu of the 
Commissions' test:
---------------------------------------------------------------------------

    \1135\ See also CAI Letter and Nationwide Letter.
---------------------------------------------------------------------------

    (1) The insurance contract must be issued by an insurance company 
and subject to state insurance regulation;
    (2) The insurance contract must be the type of contract issued by 
insurance companies; and
    (3) The insurance contract must not be of a type that the CFTC and 
SEC determine to regulate.\1136\
---------------------------------------------------------------------------

    \1136\ See ACLI ANPR Letter.
---------------------------------------------------------------------------

    The commenter stated that its approach does not contain a 
definition of insurance, and for that reason believes that is 
preferable to the Commissions' approach, which it believes creates 
legal uncertainty because any attempted definition of insurance has the 
potential to be over- or under-inclusive.\1137\
---------------------------------------------------------------------------

    \1137\ See ACLI Letter.
---------------------------------------------------------------------------

    While the commenter's test may appear simpler on its face, the CFTC 
does not believe that it represents a less costly alternative. The 
first two requirements of the commenter's test do not help to 
distinguish swaps from insurance; the third provides no greater 
certainty than the Commissions' facts and circumstances approach. 
Moreover, as discussed in section II.B.1(d) above, the Commissions' 
rules and related interpretations are not intended to define insurance. 
Rather, they provide a safe harbor for certain types of traditional 
insurance products by reference to factors that may be used to 
distinguish insurance from swaps and security-based swaps. Agreements, 
contracts, and transactions that do not qualify for the Insurance Safe 
Harbor may or may not be swaps, depending upon the facts and 
circumstances. Thus, the Commissions' test neither creates legal 
uncertainty as suggested by the commenter, nor the costs associated 
with such uncertainty.
    Another commenter proposed different approaches for existing 
products and new products. According to the commenter, if an existing 
type of agreement, contract or transaction is currently reportable as 
insurance in the provider's regulatory and financial reports under a 
state or foreign jurisdiction's insurance laws, then that agreement, 
contract or transaction would be insurance rather than a swap or 
security-based swap. On the other hand, for new products, if this 
approach is inconclusive, the commenter recommended that the 
Commissions use the product prong of the Commissions' test only.\1138\
---------------------------------------------------------------------------

    \1138\ See AIA Letter.
---------------------------------------------------------------------------

    The commenter's proposal may represent a less costly alternative 
than the Commissions' test. However, rather than treating existing 
products and new products differently, the Commissions as discussed 
above are providing ``grandfather'' protection for agreements, 
contracts, and transactions entered into on or before the effective 
date of the Products Definitions. Moreover, the commenter's test would 
eliminate the provider test for new products, which the Commissions 
believe is important to help prevent products that are swaps or 
security-based swaps from being characterized as insurance.
    In sum, the CFTC finds that, while some of the alternatives 
proposed by commenters may appear less costly to apply than the 
Commissions' test, in all cases they would sweep out of the Dodd-Frank 
Act regulatory regime for swaps agreements, contracts, and transactions 
that have not historically been considered insurance, and that should, 
in appropriate circumstances, be regulated as swaps or security-based 
swaps. Accordingly, the CFTC does not find these alternative tests 
proposed by commenters to be better tools than the Insurance Safe 
Harbor for limiting the scope of the statutory definitions of swap and 
security-based swap. Excluding agreements, contracts, and transactions 
that are, in fact, swaps from the further definition of the term 
``swap'' is inconsistent with the CFTC's regulatory objectives and 
could increase risk to the U.S. financial system.
    Three commenters provided comments regarding the treatment of 
guarantees of swaps. Two commenters \1139\ opposed treating insurance 
or guarantees of swaps as swaps. Suggesting that the products are not 
economically similar, one commenter argued that insurance wraps of 
swaps do not ``necessarily replicate the economics of the underlying 
swap, and only following default could the wrap provider end up with 
the same payment obligations as a wrapped defaulting swap 
counterparty.'' \1140\ This commenter also stated that the non-
insurance guarantees are not swaps because the result of most 
guarantees is that the guarantor is responsible for monetary claims 
against the defaulting party, which in this commenter's view is a 
different obligation than the arrangement provided by the underlying 
swap itself.\1141\
---------------------------------------------------------------------------

    \1139\ See AFGI Letter, ISDA Letter.
    \1140\ ISDA Letter.
    \1141\ Id.
---------------------------------------------------------------------------

    One commenter supported treating financial guaranty insurance of a 
swap or security-based swap as itself a swap or a security-based swap. 
This commenter argued that financial guaranty insurance of a swap or 
security-based swap transfers the risk of counterparty non-performance 
to the guarantor, making it an embedded and essential feature of the 
insured swap or

[[Page 48315]]

security-based swap. This commenter further argued that the value of 
such swap or security-based swap is largely determined by the 
likelihood that the proceeds from the financial guaranty insurance 
policy will be available if the counterparty does not meet its 
obligations.\1142\ This commenter maintained that financial guaranty 
insurance of swaps and security-based swaps serves a similar function 
to credit default swaps in hedging counterparty default risk.\1143\
---------------------------------------------------------------------------

    \1142\ See Better Markets Letter.
    \1143\ See Better Markets Letter.
---------------------------------------------------------------------------

    While the CFTC is not further defining guarantees of swaps to be 
swaps, the CFTC is persuaded that when a swap (that is not a security-
based swap or mixed swap) has the benefit of a guarantee, the guarantee 
and related guaranteed swap should be analyzed together. The events 
surrounding the failure of AIG Financial Products (``AIGFP'') highlight 
how guarantees can cause major risks to flow to the guarantor.\1144\ 
The CFTC finds that the regulation of swaps and the risk exposures 
associated with them, which is an essential concern of the Dodd-Frank 
Act, would be less effective if the CFTC did not interpret the term 
``swap'' to include a guarantee of a swap.
---------------------------------------------------------------------------

    \1144\ ``AIGFP's obligations were guaranteed by its highly rated 
parent company * * * an arrangement that facilitated easy money via 
much lower interest rates from the public markets, but ultimately 
made it difficult to isolate AIGFP from its parent, with disastrous 
consequences.'' Congressional Oversight Panel, The AIG Rescue, Its 
Impact on Markets, and the Government's Exit Strategy 20 (2010).
---------------------------------------------------------------------------

    Two commenters cautioned against unnecessary and duplicative 
regulation. One commented that, because the underlying swap, and the 
parties to it, will be regulated and reported to the extent required by 
Title VII, there is no need for regulation of non-insurance 
guarantees.\1145\ The other commented that an insurance policy on a 
swap would be subject to state regulation; without addressing non-
insurance guarantees, this commenter stated that additional Federal 
regulation would be duplicative.\1146\ The CFTC disagrees with these 
arguments. As stated above, the CFTC is treating financial guaranty 
insurance of swaps and all other guarantees of swaps in a similar 
manner because they are functionally or economically similar products. 
If a guarantee of a swap is not treated as an integral part of the 
underlying swap, price forming terms of swaps and the risk exposures 
associated with the guarantees may remain hidden from regulators and 
may not be regulated appropriately. Moreover, treating guarantees of 
swaps as part of the underlying swaps ensures that the CFTC will be 
able to take appropriate action if, after evaluating information 
collected with respect to the guarantees and the underlying swaps, such 
guarantees of swaps are revealed to pose particular problems in 
connection with the swaps markets. The separate CFTC release clarifies 
the limited practical effects of the CFTC's interpretation, which 
should address industry concerns regarding duplicative regulation.
---------------------------------------------------------------------------

    \1145\ See ISDA Letter.
    \1146\ See AFGI Letter.
---------------------------------------------------------------------------

    One commenter also argued that regulating financial guaranty of 
swaps as swaps would cause monoline insurers to withdraw from the 
market, which could adversely affect the U.S. and international public 
finance, infrastructure and structured finance markets, given that 
insuring a related swap often is integral to the insurance of municipal 
bonds and other securities.\1147\ The CFTC finds this argument 
unpersuasive. The CFTC understands that the 2008 global financial 
crisis severely affected most monolines and only one remains active in 
U.S. municipal markets. Thus, it appears that the monolines have, for 
the most part, already exited these markets. In addition, as stated 
above, the separate CFTC release clarifies the limited practical 
effects of the CFTC's interpretation, which should address industry 
concerns.
---------------------------------------------------------------------------

    \1147\ See AFGI Letter. Of the members of AFGI, only Assured 
Guaranty (or its affiliates) is currently writing financial guaranty 
insurance policies on U.S. municipal obligations.
---------------------------------------------------------------------------

4. Costs and Benefits of the Withdrawing the Energy Exemption and 
Interpretation Regarding the Forward Contract Exclusion From the Swap 
Definition
    The CFTC is clarifying that the forward contract exclusion from the 
swap definition for nonfinancial commodities should be read 
consistently with the forward contract exclusion from the CEA 
definition of the term ``future delivery.'' In that regard, the CFTC is 
retaining the Brent Interpretation and extending it to apply to all 
nonfinancial commodities, and withdrawing the Energy Exemption, which 
had extended the Brent Interpretation regarding the forward contract 
exclusion from the term ``future delivery'' to energy commodities other 
than oil, as it is no longer necessary. Although the CFTC is 
withdrawing the Energy Exemption, the CFTC is providing that certain 
alternative delivery procedures, such as physical netting agreements, 
that are mentioned in the Energy Exemption, are consistent with the 
intent of the book out provision in the Brent Interpretation--provided 
that the parties had a bona fide intent, when entering into the 
transactions, to make or take (as applicable) delivery of the commodity 
covered by those transactions. The CFTC also is providing an 
interpretation regarding documentation of orally booked-out 
transactions.
    In addition, the CFTC is clarifying that its prior guidance 
regarding commodity options embedded in forward contracts should be 
applied as well to the treatment of forward contracts in nonfinancial 
commodities that contain embedded options under the Dodd-Frank Act. The 
final interpretation also explains the CFTC's position with regard to 
forwards with embedded volumetric optionality, including an explanation 
of how it would treat some of the specific contracts described by 
commenters, such as full requirements contracts. It also explains the 
CFTC's view with respect to certain contractual provisions, such as 
liquidated damages and renewable/evergreen provisions that do not 
disqualify the transactions in which they are contained from the 
forward exclusions. The CFTC has also provided an interpretation 
regarding nonfinancial commodities, including environmental 
commodities, and interpretations concerning physical exchange 
transactions, fuel delivery agreements, certain physical commercial 
agreements, and energy management agreements.
(a) Costs
    The CFTC's statement that it will construe the forward contract 
exclusion consistently with respect to the definitions of the terms 
``swap'' and ``future delivery,'' as discussed herein, will not impose 
any new material costs on market participants. It also will establish a 
uniform interpretation of the forward contract exclusion from the 
definitions of both statutory terms, which will avoid the significant 
costs that some commenters state would result if the forward contract 
exclusion were construed differently in these two contexts.\1148\ In 
addition, the CFTC's

[[Page 48316]]

clarification regarding the continued viability of the alternative 
delivery procedures in the Energy Exemption should reduce costs to the 
industry by conferring legal certainty that their transactions may 
continue to have these procedures without losing their eligibility for 
the forward exclusions.
---------------------------------------------------------------------------

    \1148\ See EEI Letter (``Without legal certainty as to the 
regulatory treatment of their forward contracts, EEI's members and 
other end users who rely on the forward contract exclusion likely 
will face higher transaction costs due to greater uncertainty. These 
increased transaction costs may include: (i) More volatile or higher 
commodity prices; and (ii) increased credit costs, in each case 
caused by changes in market liquidity as end users change the way 
they transact in the commodity markets. A single regulatory approach 
that uses the same criteria to confirm that a forward contract is 
excluded from the Commission's jurisdiction over swaps and futures 
will reduce this uncertainty and the associated costs to end 
users.'' (footnote omitted)).
---------------------------------------------------------------------------

    As noted in section II.B.2.(a)(ii) above, the CFTC has explained 
its position regarding nonfinancial commodities. This should help the 
industry to determine whether their transactions are eligible for the 
forward exclusions, and consequently reduce costs to the industry for 
transactions involving non-financial commodities such as renewable 
energy credits that may be eligible for the forward exclusions. The 
final interpretation regarding forwards with embedded volumetric 
optionality should reduce costs to the industry, because these 
transactions may qualify for the forward exclusions from the swap and 
``future delivery'' definitions. The explanation of how the CFTC will 
view specific contracts mentioned by commenters under this 
interpretation should enhance legal certainty and thereby reduce costs.
    The clarification that certain contractual provisions do not 
disqualify transactions from the forward exclusion also should reduce 
costs to the industry by providing increased legal certainty that these 
provisions will not render their transactions subject to Dodd-Frank Act 
regulation. Similar cost reductions should be achieved through enhanced 
legal certainty provided by the CFTC's interpretations of physical 
exchange transactions, fuel delivery agreements, and certain physical 
commercial agreements, all of which may qualify for the forward 
exclusions under these interpretations. The interpretation regarding 
energy management agreements, which provides that the fact that a 
particular transaction is done under the auspices of such agreements 
does not alter the nature of that transaction, should likewise enhance 
legal certainty and reduce costs. While the CFTC's interpretation 
regarding documentation of oral book-outs--that an oral book-out be 
followed by a confirmation in a commercially reasonable time in written 
or electronic form--may impose costs for industries that do not 
document their orally booked out transactions, the CFTC believes that 
this requirement is consistent with prudent business practices and is 
necessary to prevent abuse of the Brent safe harbor.
    Market participants will need to assess whether products are 
forward contracts that qualify for the forward exclusions from the swap 
and future delivery definitions, and may need to request an 
interpretation regarding such products, or obtain an opinion of 
counsel, which will involve certain costs. \1149\
---------------------------------------------------------------------------

    \1149\ The CFTC believes that $20,000 represents a reasonable 
estimate of the upper end of the range of the costs to undertake the 
legal analysis of the status of an agreement, contract, or 
transaction as a forward contract that qualifies for the forward 
exclusions. The average cost incurred by market participants in 
connection with assessing whether an agreement, contract, or 
transaction is a forward contract is based upon the estimated amount 
of time that staff believes will be required for both in-house 
counsel and outside counsel to apply the definition. The staff 
estimates that costs associated with determining whether an 
agreement, contract, or transaction is a forward contract will range 
up to $20,000 after rounding to two significant digits. Staff 
estimates that some agreements, contracts, or transactions will 
clearly fall within the Brent safe harbor, and an internal attorney, 
without the assistance of outside counsel, will be able to make a 
determination in less than one hour. Based upon data from SIFMA's 
Management & Professional Earnings in the Securities Industry 2011 
(modified by CFTC staff to account for an 1800-hour-work-year and 
multiplied by 5.35 to account for bonuses, firm size, employee 
benefits and overhead), staff estimates that the average national 
hourly rate for an internal attorney is $378. If an agreement, 
contract, or transaction is more complex, the CFTC estimates the 
analysis will require approximately 20 hours of in-house counsel 
time and 30 hours of outside counsel time. The CFTC estimates the 
costs for outside legal services to be $400 per hour. Accordingly, 
on the high end of the range the CFTC estimates the cost to be 
$19,560 ($7,560 (based on 20 hours of in-house counsel time x $378) 
+ $12,000 (based on 30 hours of outside counsel x $400) which is 
then rounded to two significant digits to $20,000.
---------------------------------------------------------------------------

(b) Benefits
    The CFTC's interpretations regarding the forward exclusions should 
provide market participants with greater legal certainty regarding 
whether their transactions qualify for the forward exclusion from the 
swap definition, which should facilitate commercial merchandising 
activity. For example, the interpretation regarding forwards with 
embedded volumetric options should facilitate commercial merchandising 
activity of the electricity, natural gas, and other industries that 
employ these contracts where delivery quantities are flexible, while 
the conditions in the interpretations should help to assure that these 
contracts are bona fide forwards.
    In addition, the interpretation should result in the appropriate 
classification of transactions as commercial merchandising transactions 
(and thus forward contracts) that are not subject to Title VII 
regulation. This will enhance market participants' efficient use of the 
swaps markets and, as described above, reduce costs on industry. 
Documenting oral book-outs should promote good business practices and 
aid the CFTC in preventing evasion through abuse of the forward 
exclusion. Finally, the CFTC's interpretation regarding commercial 
market participants should ensure that the forward exclusions may only 
be used for commercial merchandising activity and not for speculative 
purposes. \1150\
---------------------------------------------------------------------------

    \1150\ If contracts are being used for speculative purposes they 
are probably swaps and should be subject regulation under Title VII.
---------------------------------------------------------------------------

    The CFTC's position regarding nonfinancial commodities should help 
the industry to determine whether their transactions are eligible for 
the forward exclusions, which should facilitate commercial 
merchandising activity for transactions involving non-financial 
commodities such as renewable energy credits that may be eligible for 
the forward exclusions.
(c) Comments and Consideration of Alternatives
    The CFTC requested comment in the Proposing Release on the costs 
and benefits of the proposed interpretive guidance regarding the 
forward contract exclusion and the withdrawal of the Energy Exemption 
for market participants, markets and the public.
    Several commenters requested that the CFTC codify its proposed 
guidance regarding the forward contract exclusion in rule text to 
provide greater legal certainty, which they argued may mitigate 
costs.\1151\ However, upon consideration, the CFTC is not codifying its 
interpretation in rule text. As discussed in section II.B.2.(a)(i), 
above, the CFTC has never codified its prior interpretations of the 
forward contract exclusion with respect to the future delivery 
definition as a rule or regulation. Publishing an interpretation in 
this release is consistent with the manner in which the CFTC has 
interpreted the forward exclusion in the past. The additional research 
costs associated with an interpretation as opposed to codification in 
the Code of Federal Regulations will be small, because the CFTC has 
placed this interpretation, and all other product interpretations, in 
this adopting release for the convenience of practitioners. Moreover, 
courts may rely upon agency interpretations; thus, the CFTC believes 
that codification would not mitigate costs much.
---------------------------------------------------------------------------

    \1151\ See BGA Letter; COPE Letter; ETA Letter; FERC Staff 
Letter; and Just Energy Letter.

---------------------------------------------------------------------------

[[Page 48317]]

    Some commenters\1152\ argued that physical options should be 
considered forward contracts excluded from the definition of a swap, 
because increased regulation would cause harm to physical commodity 
markets without providing significant benefits. The statutory 
definition of ``swap'' provides that options--including physical 
options--are swaps. Accordingly, the CFTC may not exclude such options 
from the swap definition. Further, treating physical options as forward 
contracts would be inconsistent with longstanding CFTC precedent. 
Nonetheless, the CFTC has provided relief using its plenary authority 
under CEA Section 4c(b)\1153\ over commodity options through the trade 
option exemption. While certain capacity contracts on RTOs and ISOs and 
certain contracts entered into by section 201(f) entities may be 
considered options and therefore would be swaps, regulation of these 
contracts may be addressed through the public interest waiver process 
in CEA section 4(c)(6).
---------------------------------------------------------------------------

    \1152\ See Just Energy Letter; NEMA Letter; NGSA/NCGA Letter; 
ONEOK Letter; and WGCEF Letter.
    \1153\ 7 U.S.C. 6c(b).
---------------------------------------------------------------------------

    Several commenters\1154\ argued that renewable energy credits 
should not be swaps; rather, renewable energy credits should be 
considered nonfinancial commodities eligible for the forward exclusion 
from the swap definition. They asserted that swap regulations would 
raise transaction costs making it more difficult and expensive to 
support renewable energy. The CFTC is clarifying that renewable energy 
credits are nonfinancial commodities and that transactions therein are 
eligible for the forward exclusion if they satisfy the terms thereof. 
So if these transactions meet the forward exclusion, they will bear no 
increased costs.
---------------------------------------------------------------------------

    \1154\ See 3Degrees Letter; AWEA Letter; CERP Letter; EMA 
Letter; GreenX Letter; PMAA/NEFI Letter; REMA Letter; and WGCEF 
Letter.
---------------------------------------------------------------------------

    A commenter\1155\ requested that tolling contracts be considered 
forwards and not swaps, seeking to avoid unnecessary cost of regulatory 
uncertainty and unintended conflict between the CFTC and other 
regulators. The CFTC has not provided blanket interpretations regarding 
particular products in the rulemaking, but has provided an 
interpretation regarding the forward contract exclusions provided above 
in section II.B.2. To the extent a commenter still is uncertain about 
the treatment of a specific type of transaction, the commenter may 
request an interpretation from the CFTC.
---------------------------------------------------------------------------

    \1155\ See California Utilities Letter.
---------------------------------------------------------------------------

    Another commenter argued more generally that any embedded option 
(for example, price, quantity, delivery point, delivery date, contract 
term) that does not permit a unilateral election of financial 
settlement based upon the value change in an underlying cash market 
should not render the contract a swap.\1156\ While the commenter's 
approach with respect to ``any'' embedded option may result in lower 
costs for market participants because more contracts likely would be 
excluded as forwards from the swap definition and thus not be subject 
to regulation under the Dodd-Frank Act, such an expansive approach may 
inappropriately classify contracts as forwards. The CFTC is providing 
an interpretation with respect to forwards with embedded volumetric 
options to address commenters' concerns. The CFTC is also explaining 
its position above regarding price optionality, optionality with 
respect to delivery points and delivery dates specifically in response 
to the commenter's letter, and optionality as to certain contract terms 
(such as evergreen and renewal provisions) to address particular 
concerns raised by commenters.
---------------------------------------------------------------------------

    \1156\ See COPE Letter, Appendix.
---------------------------------------------------------------------------

    Another commenter suggested that an option to purchase or sell a 
physical commodity, whether embedded in a forward contract or stand 
alone, should either (i) fall within the statutory forward exclusion 
from the swap definition, or (ii) alternatively, if deemed by the CFTC 
to be a swap, should be exempt from the swap definition pursuant to a 
modified trade option exemption pursuant to CEA Section 4c(b).\1157\ 
Although this proposal may on its face appear to be simpler than the 
CFTC's, it is substantively similar to the one the CFTC is adopting. 
The CFTC has modified the proposed interpretive guidance regarding 
forwards with embedded options as discussed in section II.B.2.(b)(ii) 
above; contracts with embedded options that are swaps under the final 
interpretation may nevertheless qualify for the modified trade option 
exemption recently adopted by the CFTC.\1158\ The CFTC is not adopting 
an approach that forwards with any type of embedded option should fall 
within the statutory forward exclusion from the swap definition. Such 
an approach would be overbroad because it would exclude contracts that 
are not appropriately classified as forwards. The commenter also 
requested that trade option exemptions be granted for physical 
commodities. The costs and benefits of the trade option exemption are 
addressed in that rulemaking.
---------------------------------------------------------------------------

    \1157\ See WGCEF Letter; 7 U.S.C. 6c(b).
    \1158\ See Commodity Options, 77 FR 25320, April 27, 2012. 17 
CFR 32.3. Encana Marketing (USA) Inc. (``Encana'') believes that the 
guidance on forwards with embedded options should include embedded 
physical delivery options because it asserts that many of the 
contracts currently used by participants in the wholesale natural 
gas market contain an option for the physical delivery of natural 
gas. See Encana Letter. To the extent that Encana's comment goes 
beyond volumetric optionality, commodity options are discussed above 
in section II.B.2.(b)(i).
---------------------------------------------------------------------------

    Another commenter urged the CFTC to broadly exempt commercial 
forward contracting from swap regulation by generally excluding from 
the swap definition any forward contract with embedded optionality 
between end users ``whose primary purpose is consistent with that of an 
`end user', and in which any embedded option is directly related to 
`end use.' ''\1159\
---------------------------------------------------------------------------

    \1159\ See NMPF Letter.
---------------------------------------------------------------------------

    While this alternative may appear to be less costly than the CFTC's 
interpretation, its vagueness may create significant legal uncertainty 
about the scope of the forward exclusion, which may increase costs on 
market participants. Even if this approach does represent a lower cost 
alternative, however, it is overbroad and likely would result in the 
inappropriate classification of transactions as forward contracts, and 
thus would not achieve the CFTC's objective of appropriately 
classifying transactions that should qualify for the forward 
exclusions.
    Another commenter believed that the CFTC's ``facts and 
circumstances'' approach to forwards with embedded options does not 
provide the legal certainty required by nonfinancial entities engaging 
in commercial contracts in the normal course of business.\1160\ The 
commenter further argued that many option-like contract terms could be 
determined to ``target the delivery term'' under a facts and 
circumstances analysis. Accordingly, the commenter believed that the 
CFTC should provide in its rules that an embedded option or embedded 
optionality will not result in a nonfinancial forward being a swap

[[Page 48318]]

unless: (1) Delivery is optional; (2) financial settlement is allowed; 
and (3) transfer and trading of the option separately from the forward 
is permitted.\1161\
---------------------------------------------------------------------------

    \1160\ See ETA Letter at 19 n. 47. Similarly, COPE comments that 
a nonfinancial commodity forward contract that, ``by its terms,'' is 
intended to settle physically should be permitted to contain 
optionality without being transformed into a swap unless such 
optionality negates the physical settlement element of the contract. 
That is, if one party can exercise an option to settle the contract 
financially based upon the value change in an underlying cash 
market, then the intent for physical settlement is not contained in 
``the four corners of the contract'' and may render the contract a 
swap. COPE Letter. While COPE's approach may impose less costs on 
market participants (as more transactions likely would qualify for 
the forward exclusion, as discussed in section II.B.2.(b)(ii), 
above, the CFTC has eschewed approaches to the forward exclusion 
that rely on the ``four corners of the contract,'' which can provide 
a roadmap to evasion of statutory requirements.
    \1161\ See ETA Letter.
---------------------------------------------------------------------------

    The CFTC has long applied a facts and circumstances approach to the 
forward exclusion, including with respect to forwards with embedded 
options, an approach with which market participants are familiar. That 
approach balances the need for legal certainty against protecting 
market participants, market integrity and the risk of providing 
opportunities for evasion.\1162\ By contrast, the commenter's bright-
line approach may be simpler to apply, but could undermine market 
integrity and creates greater evasion opportunities. Moreover, the 
CFTC's additional interpretation noted above, including clarification 
about the meaning of the phrase ``target the delivery term,'' and 
forwards with embedded volumetric optionality, provides enhanced legal 
certainty in response to the commenter's concerns, which should 
mitigate the costs of the CFTC's approach to market participants.\1163\
---------------------------------------------------------------------------

    \1162\ See also NCFC Letter (supporting the CFTC's guidance 
because it provides legal certainty).
    \1163\ See also Commodity Options, 77 FR 25320, 25324 n. 25, 
April 27, 2012 (discussing the CFTC's conclusion that an ``option[] 
to redeem'' under the USDA Commodity Credit Corporation's marketing 
loan program constitutes a cotton producer's contractual right to 
repay its marketing loan and ``redeem'' the collateral (cotton) to 
sell in the open market).
---------------------------------------------------------------------------

    Another commenter \1164\ stated its view that the full costs of 
applying the Dodd-Frank regulatory apparatus to physical energy 
transactions, or of energy companies being forced to abandon full-
requirements bilateral contracting will significantly increase the 
costs to be paid by U.S. consumers. The CFTC is sensitive to these 
concerns. The CFTC is providing relief for full-requirements contracts 
so long as they satisfy the conditions set forth in the interpretation.
---------------------------------------------------------------------------

    \1164\ See IECA II Letter.
---------------------------------------------------------------------------

    The CFTC is also providing relief for other types of physical 
energy contracts that may qualify for the forward exclusions. 
Separately, the CFTC has provided relief for trade options in another 
rulemaking.\1165\
---------------------------------------------------------------------------

    \1165\ See Commodity Options, 77 FR 25320, April 27, 2012.
---------------------------------------------------------------------------

5. Loan Participations
    In the Proposing Release, the Commissions proposed guidance that 
they do not interpret the swap and security-based swap definitions to 
include loan participations in which: (i) The purchaser is acquiring a 
current or future direct or indirect ownership interest in the related 
loan; and (ii) the loan participations are ``true participations'' (the 
participant acquires a beneficial ownership interest in the underlying 
loans). One commenter expressed concern with the second prong of the 
proposed guidance. Specifically, the commenter said that the ``true 
participation'' requirement may result in the improper classification 
of loan participations as swaps, because LMA-style loan participations 
may not qualify. Moreover, because of legal uncertainty associated with 
the ``true participation'' terminology derived from U.S. bankruptcy 
law, LSTA-style loan participations may be subject to improper 
classification as well. The commenter proposed an alternative test 
described in section II.B.3., above.
    The Commissions largely are adopting the recommendation from the 
commenter regarding the Commissions' proposed guidance concerning loan 
participations as not swaps or security-based swaps, with certain 
modifications. This reduces costs for market participants because the 
Commissions' test for loan participations from the proposal included a 
``true participation'' requirement that commenters suggested is subject 
to legal uncertainty. Benefits of the rule include enhanced legal 
certainty that loan participations that meet the requirements of the 
interpretation are not swaps, which should facilitate loan 
participation market activity.
6. Interpretation Regarding Commercial/Consumer Transactions
    The Commissions are stating that certain customary consumer and 
commercial transactions that have not previously been considered swaps 
or security-based swaps do not fall within the statutory definitions of 
those terms. Specifically with regard to consumer transactions, the 
Commissions are adopting as proposed the interpretation that certain 
transactions entered into by consumers (natural persons) as principals 
or their agents primarily for personal, family or household purposes 
would not be considered swaps or security-based swaps. The Commissions 
have added to the list of consumer transactions certain residential 
fuel storage contracts; service contracts; consumer options to buy, 
sell or lease real or personal property; and certain consumer 
guarantees of loans (credit cards, automobile, and mortgage). The 
Commissions have also clarified that consumer transactions used to 
purchase nonfinancial energy commodities are not swaps or security-
based swaps. With respect to commercial transactions, the Commissions 
are adopting as proposed the interpretation that certain commercial 
transactions involving customary business arrangements (whether or not 
involving a for-profit entity) would not be considered swaps or 
security-based swaps. The Commissions also are clarifying that 
commercial loans by the Federal Home Loan Banks and Farm Credit 
Institutions are not swaps. Finally, the Commissions are explaining the 
factors characteristic of consumer and commercial transactions that the 
Commissions will consider in determining whether other consumer and 
commercial transactions that are not specifically listed in the 
interpretation should be considered swaps or security-based swaps.
(a) Costs
    The CFTC believes that the forgoing interpretation should mitigate 
costs because it increases legal certainty that specific customary 
consumer and commercial transactions are not swaps or security-based 
swaps subject to Dodd-Frank regulation. As a result of this 
interpretation, consumers and industry participants will not have to 
seek legal advice regarding whether these transactions are swaps or 
security-based swaps. The interpretation regarding commercial loans 
made by the Federal Home Loan Banks and Farm Credit Institutions also 
reduces costs by not subjecting these transactions to additional Dodd-
Frank Act regulation. To the extent a customary consumer or commercial 
transaction is not included in the interpretation, consumers and market 
participants may incur costs in seeking an interpretation from the 
Commissions regarding the status of their transactions or an opinion of 
counsel. However, the CFTC has emphasized that the lists are not 
exclusive, and has provided the factors it will consider for 
determining whether other consumer and commercial transactions that are 
not specifically listed in the interpretation should be considered 
swaps or security-based swaps, which should assist consumers and market 
participants in deciding whether to seek an interpretation and thus 
mitigate these costs.
(b) Benefits
    The foregoing interpretation provides increased legal certainty 
benefits for market participants and should ensure that customary 
consumer and commercial transactions, which have never been considered 
swaps or security-based swaps, will not be subject to Dodd-Frank Act 
regulation, and may facilitate consumer and

[[Page 48319]]

commercial activity. As discussed above, the interpretation regarding 
the factors that the Commissions will consider in determining whether 
transactions that are not listed in the interpretation are swaps or 
security-based swaps should assist market participants in determining 
whether to seek an interpretation regarding such transactions. 
Therefore, this interpretation helps to mitigate costs of legal 
uncertainty.
(c) Comments and Consideration of Alternatives
    Several commenters believed that the proposed interpretive guidance 
regarding consumer/commercial transactions does not provide sufficient 
legal certainty and request that the Commissions codify such guidance 
in regulations in order to provide greater legal certainty, which may 
mitigate costs.\1166\ The Commissions decline to codify the 
interpretation into rule text. The interpretation is intended to 
provide guidance to assist consumers and commercial and non-profit 
entities in evaluating whether certain arrangements that they enter 
into will be regulated as swaps or security-based swaps. The 
interpretation is intended to allow the flexibility necessary, 
including the consideration of the applicable facts and circumstances 
by the Commissions, in evaluating consumer and commercial arrangements 
to ascertain whether they may be swaps or security-based swaps. The 
representative characteristics and factors taken together are 
indicators that a consumer or commercial arrangement is not a swap or 
security-based swap, and the Commissions have provided specific 
examples demonstrating how these characteristics and factors apply to 
some common types of consumer and commercial arrangements. However, as 
the interpretation is not intended to be a bright-line test for 
determining whether a particular consumer or commercial arrangement is 
a swap or security-based swap, if the particular arrangement does not 
meet all of the identified characteristics and factors, the arrangement 
will be evaluated based on its particular facts and circumstances. 
Also, the courts may rely on the interpretation and as such, the CFTC 
does not believe that the adoption of rule text as opposed to an 
interpretation will mitigate costs associated with perceived legal 
uncertainty.\1167\
---------------------------------------------------------------------------

    \1166\ See ETA Letter; ICEA Letter; and Just Energy Letter.
    \1167\ The additional research costs associated with an 
interpretation as opposed to codification in the Code of Federal 
Regulations will be small, because the CFTC has placed this 
interpretation, and all other products interpretations, in this 
adopting release for the convenience of practitioners.
---------------------------------------------------------------------------

    A commenter \1168\ asserted that Federal courts will have to hear 
more disputes, because proposed CFTC jurisdiction would pre-empt 
significant aspects of state and Federal law concerning the purchase 
and sale of goods and services. This rulemaking includes safe-harbors 
from the definition of a swap for customary consumer and commercial 
transactions. The Commissions have expanded the list of consumer 
transactions that are excluded from the swap definition. While it may 
be possible that Federal courts will nevertheless hear more disputes, 
that would be a result of the statutory swap definition and not from 
the interpretation being adopted by the Commissions (which should 
reduce the number of such disputes).
---------------------------------------------------------------------------

    \1168\ See IECA Letter.
---------------------------------------------------------------------------

    Another commenter \1169\ agreed with the general factors proposed 
for identifying agreements, contracts, or transactions that are not 
swaps, but requested additional clarity with respect to particular 
transactions. Specifically, the commenter requested that commercial 
loans and financing facilities with embedded interest rate options 
should not be considered swaps. To clarify, interest rate options are 
swaps. As discussed in section II.B.3. above, plain vanilla interest 
rate options embedded in a loan, such as rate locks, rate caps and rate 
collars, are not swaps. If a product is more complex, it may be 
appropriate for the CFTC to consider it in response to a specific 
request for interpretation.
---------------------------------------------------------------------------

    \1169\ See FCC Letter.
---------------------------------------------------------------------------

7. Residential Exchange Program (``REP'')
    The REP \1170\ was established by Congress ``[t]o extend the 
benefits of low cost Federal System hydro power to residential and 
small farm electric power consumers throughout the Pacific Northwest 
Region.'' \1171\ A commenter requests that the CFTC further define the 
term ``swap'' to exclude consumer benefits under the Pacific Northwest 
Electric Power Planning and Conservation Act of 1980 (``Northwest Power 
Act'') \1172\ and transactions under the REP \1173\ to allow a subsidy 
to continue to be received by residential and small farm utilities.
---------------------------------------------------------------------------

    \1170\ The BPA refers to the implementation of Section 5(c) of 
the Northwest Power Act, 16 U.S.C. 839c(c), as the ``Residential 
Exchange Program.''
    \1171\ Id. at 3.
    \1172\ 16 U.S.C. Chapter 12H.
    \1173\ See Bonneville Letter.
---------------------------------------------------------------------------

    The Commissions do not consider the REP transactions described by 
the commenter to be swaps or security-based swaps. Consequently, this 
rulemaking clarifies that Dodd-Frank regulatory costs will not be 
imposed on REPs and allows the subsidy to continue to be provided to 
residential and small farm utilities.
8. Costs and Benefits of Rule Regarding Foreign Exchange Products and 
Forward Rate Agreements
    CFTC rule 1.3(xxx)(2) under the CEA explicitly defines the term 
``swap'' to include an agreement, contract, or transaction that is a 
cross-currency swap, currency option, foreign currency option, foreign 
exchange option, foreign exchange rate option, foreign exchange 
forward, foreign exchange swap, forward rate agreement, and non-
deliverable forward involving foreign exchange, unless such agreement, 
contract, or transaction is otherwise excluded by section 1a(47)(B) of 
the CEA. Rule 1.3(xxx)(3) provides that: (i) A foreign exchange forward 
or a foreign exchange swap shall not be considered a swap if the 
Secretary of the Treasury makes the determination described in CEA 
section 1a(47)(E)(i); and (ii) notwithstanding any such determination, 
certain provisions of the CEA will apply to such a foreign exchange 
forward or foreign exchange swap (specifically, the reporting 
requirements in section 4r of the CEA \1174\ and regulations thereunder 
and, in the case of a swap dealer or major swap participant that is a 
party to a foreign exchange swap or foreign exchange forward, the 
business conduct standards in section 4s of the CEA \1175\ and 
regulations thereunder). Rule 1.3(xxx)(3) further clarifies that a 
currency swap, cross-currency swap, currency option, foreign currency 
option, foreign exchange option, foreign exchange rate option, or non-
deliverable forward involving foreign exchange is not a foreign 
exchange forward or foreign exchange swap subject to a determination by 
the Secretary of the Treasury as described in the preamble.
---------------------------------------------------------------------------

    \1174\ 7 U.S.C. 6r.
    \1175\ 7 U.S.C. 6s.
---------------------------------------------------------------------------

    The Commissions are also clarifying that a bona fide foreign 
exchange spot transaction, i.e., a foreign exchange transaction that is 
settled on the customary timeline \1176\ of the relevant

[[Page 48320]]

spot market, is not within the definition of the term ``swap.'' In 
addition, the interpretation clarifies that retail foreign currency 
options described in CEA Section 2(c)(2)(B) are not swaps. This 
clarification allows market participants to engage in these 
transactions with non-ECP customers who would otherwise have to engage 
in on-exchange transactions.
---------------------------------------------------------------------------

    \1176\ As discussed in section II.C.2.(c) above, in general, a 
foreign exchange transaction will be considered a bona fide spot 
transaction if it settles via an actual delivery of the relevant 
currencies within two business days. However a foreign exchange 
transaction with a longer settlement period concluding with the 
actual delivery of the relevant currencies may be considered a bona 
fide spot transaction depending on the customary timeline of the 
relevant market. In particular, a foreign exchange transaction that 
is entered into solely to effect the purchase or sale of a foreign 
security is a bona fide spot transaction where certain conditions 
are met.
---------------------------------------------------------------------------

(a) Costs
    In complying with rule 1.3(xxx)(2), a market participant will need 
to ascertain whether an agreement, contract, or transaction is a swap 
under the definition. This analysis will have to be performed upon 
entering into the agreement, contract, or transaction. However, any 
costs associated with this analysis are expected to be less than the 
costs of doing the same analysis absent the rule, particularly given 
potential confusion in the event of a determination by the Secretary of 
the Treasury that foreign exchange forwards and/or foreign exchange 
swaps not be considered swaps. To the extent that rule 1.3(xxx)(2) 
improperly includes certain types of agreements, contracts, and 
transactions in the swap definition, and therefore the imposition of 
additional requirements and obligations, these requirements and 
obligations could lead to costs for market participants entering into 
such agreements, contracts, or transactions. However, the CFTC has 
carefully considered each of the agreements, contracts and transactions 
described above that it is further defining as swaps under rule 
1.3(xxx)(2) and believe that they are appropriately classified as such, 
subject to the statutory exclusions.
(b) Benefits
    Because the statutory definition of the term ``swap'' includes a 
process by which the Secretary of the Treasury may determine that 
certain agreements, contracts, and transactions that meet the statutory 
definition of a ``foreign exchange forward'' or ``foreign exchange 
swap,'' respectively,\1177\ shall not be considered swaps, the CFTC is 
concerned that application of the definition, without further 
clarification, may cause uncertainty about whether, if the Secretary of 
the Treasury makes such a determination, certain agreements, contracts, 
or transactions would be swaps. Rule 1.3(xxx)(3) increases legal 
certainty that a currency swap, cross-currency swap, currency option, 
foreign currency option, foreign exchange option, foreign exchange rate 
option, or non-deliverable forward involving foreign exchange, is a 
swap (unless it is otherwise excluded by the statutory definition of 
the term ``swap''). The rule also increases legal certainty that 
reporting requirements, and business conduct requirements for swap 
dealers and major swap participants, are applicable to foreign exchange 
forwards and foreign exchange swaps even if the Secretary of the 
Treasury determines that they should not be considered swaps, and is 
consistent with the statute. The CFTC also is concerned that confusion 
could be generated by the ``forward'' label of non-deliverable forwards 
involving foreign exchange, and forward rate agreements. Rule 
1.3(xxx)(2) increases legal certainty that these types of agreements, 
contracts, and transactions are swaps.
---------------------------------------------------------------------------

    \1177\ CEA section 1a(24), 7 U.S.C. 1a(24)(definition of a 
``foreign exchange forward''); CEA section 1a(25), 7 U.S.C. 
1a(25)(definition of a ``foreign exchange swap'').
---------------------------------------------------------------------------

    Providing such a rule to market participants to determine whether 
certain types of agreements, contracts, or transactions are swaps 
alleviates additional costs to persons of inquiring with the 
Commissions, or obtaining an opinion of counsel, about whether such 
agreements, contracts, or transactions are swaps. In addition, such a 
rule regarding the requirements that apply to foreign exchange forwards 
and foreign exchange swaps that are subject to a determination by the 
Secretary of the Treasury similarly alleviates additional costs to 
persons of inquiring with the Commissions, or obtaining an opinion of 
counsel, to determine the requirements that are applicable to such 
foreign exchange forwards and foreign exchange swaps. As with the other 
rules comprising the Product Definitions, enhanced legal certainty will 
help market participants to engage in sound risk management practices, 
which will benefit both market participants and the public.
    The interpretation concerning bona fide foreign exchange spot 
transactions should result in the appropriate classification of such 
transactions as not subject to Dodd-Frank Act regulation. The 
interpretation regarding retail foreign currency options subject to CEA 
Section 2(c)(2)(B) as not swaps provides clarity and reduces costs for 
market participants, who could not offer the product to non-ECP 
customers off-exchange in accordance with the provisions of CEA Section 
2(c)(2)(B).
    In addition, including certain FX transactions, forward rate 
agreements and certain other transactions in the swap definition 
protects the public by explicitly subjecting these transactions to 
Dodd-Frank regulation.
(c) Comments and Consideration of Alternatives
    The CFTC requested comment as to the costs and benefits of proposed 
rules 1.3(xxx)(2) and (3). As discussed in the preamble, some 
commenters \1178\ argued that non-deliverable foreign exchange forward 
transactions should be regulated as foreign exchange forwards, because 
regulating them as swaps would increase the cost of hedging foreign 
currency exposures in emerging markets.
---------------------------------------------------------------------------

    \1178\ See CEIBA Letter; Covington Letter; ISDA Letter; and MFA 
Letter.
---------------------------------------------------------------------------

    Non-deliverable forward transactions do not satisfy the statutory 
definition of foreign exchange forwards, as explained in section 
II.C.2.(b)(ii), supra. They do satisfy the swap definition, however. 
Accordingly, the CFTC lacks discretion not to define them as swaps.
9. Costs and Benefits of Rule Regarding Title VII Instruments on 
Futures on Foreign Sovereign Debt Under Exchange Act Rule 3a12-8
    Rule 1.3(bbbb) provides that a Title VII instrument that is based 
on or references a qualifying foreign futures contract on the debt 
securities of one or more of the 21 enumerated foreign governments is a 
swap and not a security-based swap if the Title VII instrument 
satisfies the following conditions:
     The futures contract on which the Title VII instrument is 
based or that is referenced must be a qualifying foreign futures 
contract (as defined in rule 3a12-8) on the debt securities of any one 
or more of the 21 enumerated foreign governments that satisfies the 
conditions of rule 3a12-8;
     The Title VII instrument is traded on or through a board 
of trade (as defined in section 1a(6) of the CEA);
     The debt securities on which the qualifying foreign 
futures contract is based or referenced and any security used to 
determine the cash settlement amount pursuant to the fourth condition 
below are not registered under the Securities Act or the subject of any 
American depositary receipt registered under the Securities Act;
     The Title VII instrument may only be cash settled; and
     The Title VII instrument is not entered into by the issuer 
of the securities upon which the qualifying

[[Page 48321]]

foreign futures contract is based or referenced (including any security 
used to determine the cash payment due on settlement of such Title VII 
instrument), an affiliate (as defined in the Securities Act and the 
rules and regulations thereunder) \1179\ of the issuer, or an 
underwriter with respect to such securities.
---------------------------------------------------------------------------

    \1179\ See, e.g., rule 405 under the Securities Act, 17 CFR 
230.405.
---------------------------------------------------------------------------

    Only those Title VII instruments that are based on qualifying 
foreign futures contracts on the debt securities of the 21 enumerated 
foreign governments and that satisfy these five conditions will be 
swaps. The final rules are intended to provide consistent treatment 
(other than with respect to method of settlement) of qualifying foreign 
futures contracts and Title VII instruments based on qualifying foreign 
futures contracts on the debt securities of the 21 enumerated foreign 
governments.\1180\ The Commissions understand that many of the 
qualifying foreign futures contracts on the debt securities of the 21 
enumerated foreign governments trade with substantial volume through 
foreign trading venues under the conditions set forth in rule 3a12-8 
\1181\ and permitting swaps on such futures contracts subject to 
similar conditions would not raise concerns that such swaps could be 
used to circumvent the conditions of rule 3a12-8 and the Federal 
securities laws concerns that such conditions are intended to 
protect.\1182\ Further, providing consistent treatment for qualifying 
foreign futures contracts on the debt securities of the 21 enumerated 
foreign governments and Title VII instruments based on futures 
contracts on the debt securities of the 21 enumerated foreign 
governments will allow trading of these instruments through DCMs on 
which such futures are listed. There may also be cross-margining 
benefits when different contracts are margined at the same derivatives 
clearing organization, such as may be the case if a swap on a futures 
contract and a corresponding futures contract trade on the same DCM. 
This cross-margining would enhance sound risk management practices.
---------------------------------------------------------------------------

    \1180\ The Commissions note that the final rules provide 
consistent treatment of qualifying foreign futures contracts on the 
debt securities of the 21 enumerated foreign governments and Title 
VII instruments based on qualifying foreign futures contracts on the 
debt securities of the 21 enumerated foreign governments unless the 
Title VII instrument is entered into by the issuer o