May 12, 2011

Proposed Product Definitions Under Title VII of Dodd-Frank

CFTC and SEC Propose Rules and Guidance to Further Define the Terms, Swap, Security-Based Swap, and Mixed Swaps
EXECUTIVE SUMMARY
The Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC, jointly with the CFTC, the Commissions) have issued a joint release proposing rules to define further certain terms in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) relating to swaps, security-based swaps, mixed swaps, and security-based swap agreements, and proposing interpretive guidance with respect to those terms (the Joint Proposed Rules). The release accompanying the Joint Proposed Rules (the Release) and the Joint Proposed Rules addresses, among other things: the regulatory treatment of insurance products; the exclusion of forward contracts from the swap and security-based swap definitions; the regulatory treatment of certain consumer and commercial contracts; the regulatory treatment of loan participations; the regulatory treatment of certain foreign-exchange related and other instruments; swaps and security-based swaps involving interest rates (or other rates) and yields; the application of the definition of narrow-based security index in distinguishing between certain indexed swaps and security-based swaps, including credit default swaps and index credit default swaps; and the specification of certain swaps and security-based swaps that are, and are not, mixed swaps.

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The Commissions request comments on all aspects of these proposals, including comments that would suggest alternative approaches to defining the terms discussed in the proposing release. Comments are due within 60 days after their publication in the Federal Register, which is expected to occur shortly. For further background on Dodd-Frank provisions that these proposed rules would implement, please see our memoranda entitled United States Adopts Historic Revision of Financial Services Regulation.

Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

Table of Contents
I. PROPOSED GUIDANCE AND DEFINITIONS RELATING TO SWAP AND SECURITYBASED SWAP ................................................................................................................................ 1 STATUTORY DEFINITION OF SWAP AND SECURITY-BASED SWAP ........................................................... 1 II. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS ........................................... 2 A. INSURANCE PRODUCTS ................................................................................................................ 2 B. FORWARD EXCLUSION FOR NON-FINANCIAL COMMODITIES ............................................................ 4 C. CONSUMER AND COMMERCIAL TRANSACTIONS.............................................................................. 5 D. LOAN PARTICIPATIONS ................................................................................................................. 6 III. PRODUCTS DEFINED AS SWAPS OR SECURITY-BASED SWAPS ................................................... 7 A. FOREIGN EXCHANGE PRODUCTS .................................................................................................. 7 B. FORWARD RATE AGREEMENTS ..................................................................................................... 8 C. CONTRACTS FOR DIFFERENCES.................................................................................................... 8 IV. TRANSACTIONS REGULATED BY FERC ............................................................................................. 8 V. RELATIONSHIP BETWEEN SWAP AND SECURITY-BASED SWAP DEFINITIONS ............................ 8 A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES OR OTHER MONETARY RATES THAT ARE SWAPS ................................................................................................................................. 9 B. TITLE VII INSTRUMENTS BASED ON YIELDS (INCLUDING GOVERNMENT OBLIGATIONS) ...................... 9 C. TOTAL RETURN SWAPS .............................................................................................................. 10 D. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT DEFAULT SWAPS ........................................................................................................... 11 E. TITLE VII INSTRUMENTS BASED ON FUTURES CONTRACTS ........................................................... 11 F. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS .......................................... 12 G. THE TERM NARROW-BASED SECURITY INDEX IN THE SECURITY-BASED SWAP DEFINITION.......... 12 1. Applicability of the Statutory Definition of Narrow-Based Security Index and Past Guidance of the Commissions to Title VII Instruments ............................... 12 2. Narrow-Based Security Index Criteria for Index Credit Default Swaps ...................... 14 a. Proposed Rules Regarding the Definitions of Issuers of Securities in a Narrow-Based Security Index and Narrow-Based Security Index for Index Credit Default Swaps ........................................................................... 14 i. Number and Concentration Percentages of Reference Entities or Securities .......................................................................................... 15 ii. Public Information Availability Regarding Reference Entities or Securities .......................................................................................... 15 iii. Treatment of Indexes Including Reference Entities that Are Issuers of Exempted Securities or Including Exempted Securities .. 17 3. Security Indexes ......................................................................................................... 17 4. Evaluation of Title VII Instruments on Security Indexes that Move from Broad-Based to Narrow-Based or Narrow-Based to Broad-Based ............................ 18 a. 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 ..................................................................................................... 19 H. METHOD OF SETTLEMENT FOR INDEX CREDIT DEFAULT SWAPS ................................................... 20 I. SECURITY-BASED SWAPS AS SECURITIES UNDER THE EXCHANGE ACT AND SECURITIES ACT ........ 21 -iProposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

VI. MIXED SWAPS ..................................................................................................................................... 21 A. SCOPE OF THE CATEGORY OF MIXED SWAP ................................................................................ 21 B. REGULATION OF MIXED SWAPS .................................................................................................. 21 C. REGULATION OF MIXED SWAPS ENTERED INTO BY DUALLY-REGISTERED DEALERS OR MAJOR PARTICIPANTS ................................................................................................................ 22 D. REGULATORY TREATMENT FOR OTHER MIXED SWAPS................................................................. 22 VII. SECURITY-BASED SWAP AGREEMENTS ........................................................................................ 23 VIII. PROCESS FOR REQUESTING INTERPRETATIONS OF CHARACTERIZATION OF A TITLE VII INSTRUMENT ............................................................................................................... 24 IX. ANTI-EVASION PROVISIONS .............................................................................................................. 25 A. TREATMENT OF SWAPS BY THE CFTC ........................................................................................ 25 B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC ............................................................... 27 X. DIFFERENCES IN TREATMENT BETWEEN SWAPS AND SECURITY-BASED SWAPS UNDER THE JOINT PROPOSED RULES .................................................................................... 27 A. ANTI-EVASION PROVISIONS ........................................................................................................ 27 B. INSURANCE ON SWAPS ............................................................................................................... 27 C. FUTURES ON FOREIGN SOVEREIGN DEBT.................................................................................... 28 D. INDEX PROVIDERS FOR CREDIT DEFAULT SWAPS ........................................................................ 28

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I. PROPOSED GUIDANCE AND DEFINITIONS RELATING TO SWAP AND SECURITY-BASED SWAP Pursuant to the regulatory framework established in Dodd-Frank, the CFTC has regulatory authority over swaps under the Commodity Exchange Act (CEA) and the SEC has regulatory authority over securitybased swaps under the Securities Exchange Act of 1934 (the Exchange Act). Section 712(d)(1) of Dodd-Frank provides that the Commissions, in consultation with the Board of Governors of the Federal Reserve System (the Board), must jointly further define the terms swap, security-based swap, and security-based swap agreement. Section 712(a)(8) of Dodd-Frank provides further that the

Commissions shall jointly prescribe such regulations regarding mixed swaps as may be necessary to carry out the purposes of Dodd-Frank. To assist the Commissions in further defining these products (as well as certain other definitions) and in prescribing regulations regarding mixed swaps as may be necessary to carry out the purposes of Dodd-Frank, the Commissions published an advance notice of proposed rulemaking (ANPR) in the Federal Register on August 20, 2010. Statutory Definition of Swap and Security-Based Swap Section 721 of Dodd-Frank defines a swap as any agreement, contract, or transaction that (subject to specified exclusions): 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 one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indexes, quantitative measures, or other financial or economic interests or property of any kind; 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; or provides on an executory basis for the exchange, on a fixed or contingent basis, of one or more payments based on the value or level of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indexes, 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, including specified commonly traded swaps.

Section 761 defines a security-based swap as an agreement, contract or transaction that is a swap and is based on: a narrow-based security index, including any interest therein or value thereof; a single security or loan, including any interest therein or value thereof; or

Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

the occurrence or non-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.

Security-based swaps, however, do not include agreements, contracts or transactions in which the underlying security is an exempted security, such as government security or municipal security, unless such agreement, contract or transaction is of the character or is commonly known in the trade as a put, call or other option. The Commissions have now proposed definitions of swap and security-based swap, as well as certain terms used in connection with those definitions. Moreover, the Commissions have proposed guidance with respect to the interpretation of those definitions. In the Release, the Commissions note that definitions of swap and security-based swaps under Dodd-Frank were detailed and thorough, such that the purpose of the Joint Proposed Rules are to clarify products that would and would not be regulated under Dodd-Frank and to provide additional guidance as to the differences between swaps, security-based swaps, and mixed swaps.

II. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS In response to questions for clarification raised in comment letters from market participants to the ANPR, the Commissions have provided interpretive guidance regarding the following products that are not swaps or security-based swaps. A. INSURANCE PRODUCTS The Release notes that the Commissions are aware of nothing in Title VII to suggest that Congress intended for insurance products to be regulated as swaps or security-based swaps. Section 722(b) of Dodd-Frank provides that a swap shall not be considered insurance and that swaps may not be regulated as an insurance contract under state laws. Accordingly, state or federally regulated insurance products that are provided by state or federally regulated insurance companies that otherwise could fall within the definition should not be considered swaps or security-based swaps so long as they satisfy the Joint Proposed Rules or comport with the related proposed interpretive guidance. Under the Joint Proposed Rules, a swap or security-based swap would not include an agreement, contract, or transaction that, by its terms or by law, as a condition of performance: requires the beneficiary of the agreement, contract, or transaction to have an insurable interest that is the subject of the agreement, contract, or transaction and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction; requires that a loss occur and be proved, and that any payment or indemnification therefor be limited to the value of the insurable interest;

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is not traded, separately from the insured interest, on an organized market or over-thecounter; and with respect to financial guaranty insurance only, in the event of payment default or insolvency of the obligor, any acceleration of payments under the policy is at the sole discretion of the insurer.

In addition, to be excluded from the swap and security-based swap definitions, the agreement, contract, or transaction must be provided: by a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies and that is subject to supervision by the insurance commissioner (or similar official or agency) of any state or by the United States, and such agreement, contract, or transaction is regulated as insurance under the laws of such state or the United States; by the United States or any of its agencies, or pursuant to a statutorily authorized program thereof; or in the case of reinsurance only, by a person located outside the United States to an insurance company that is eligible under the proposed rules, provided that: (i) such person is not prohibited by any law of any state or of the United States from offering such agreement, contract, or transaction to such an insurance company; (ii) the product to be reinsured meets the requirements under the proposed rules to be an insurance product; and (iii) the total amount reimbursable by all reinsurers for such insurance product cannot exceed the claims or losses paid by the insurer that wrote the risk transferred to the non-United States reinsurer.

An instrument must meet both criteria to be excluded from the definition of swap or security-based swap. Therefore, an instrument would be treated as a swap if it qualifies as an insurance product, but was not provided by a qualifying person or entity. The Commissions provided interpretive guidance that the following insurance products would be outside the scope of the definitions of swap and security-based swap under Dodd-Frank: surety bonds, life insurance, health insurance, long-term care insurance, title insurance, property and casualty insurance, and annuity products the income on which is subject to tax treatment under section 72 of the Internal Revenue Code. However, these products would have to be offered by a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies and that is subject to supervision by the insurance commissioner (or similar official or agency) of any state or by the United States, and such agreement, contract, or transaction is regulated as insurance under the laws of such state or the United States, to be excluded from the definition of swap or security-based swap. Finally, the CFTC believes that an insurance wrap of a swap may not be sufficiently different from the underlying swap to suggest that Congress intended the former to fall outside the definition of the term swap in Title VII. However, the SEC believes that, where an agreement, contract, or transaction is a security-based swap, the insurance of that security-based swap should not be regulated pursuant to Title VII, provided that the insurance meets the proposed requirements discussed above. The Release seeks -3Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

comments on whether the insurance wrap of a swap is sufficiently different (economically or otherwise) from the swap that is insured to justify different regulatory treatment. B. FORWARD EXCLUSION FOR NON-FINANCIAL COMMODITIES Dodd-Frank 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, from the definition of swap. The CFTC believes that the forward contract exclusion in Dodd-Frank for swaps should be read consistently with its established, historical understanding that a forward contract is a commercial merchandising transaction, designed to transfer ownership of the commodity and not to transfer solely its price risk. Currently, forward contracts are excluded from the definition of futures contracts and are not subject to the CEA or CFTC regulations. According to the Release, the CFTC reads the intended to be physically settled language 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 CFTCs analysis of whether a given contract is a forward contract or a futures contract. The Release also provides clarification regarding the treatment of book-out transactions that are permitted under the CFTCs 1990 Brent Interpretation,1 which stated that the 15-day Brent system crude oil contracts were forward contracts that were excluded from the CEA definition of future delivery, and were not futures contracts, notwithstanding the fact that counterparties could, and often did, terminate their contracts and forego deliveries of multiple, offsetting positions and instead negotiate payment-ofdifferences pursuant to a separate, individually-negotiated cancellation agreement referred to as a bookout. The Brent Interpretation noted that, 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. According to the Release, the principles underlying the Brent

Interpretation similarly should apply to the forward exclusion from the swap definition with respect to nonfinancial commodities. Therefore, book-out transactions would qualify for the forward exclusion for market participants that regularly make or take delivery of non-financial commodities in the ordinary course of their business, so long as the book-out transaction is effectuated through a subsequent, separately negotiated agreement. The Release provides clarification regarding the application of the CFTCs 1993 order exempting certain energy contracts from regulation under the CEA (the Energy Exemption) following the enactment of Dodd-Frank. The Energy Exemption extended the Brent Interpretation regarding the forward contract exclusion from the term future delivery to energy commodities other than oil. The Release notes that since the book-out provisions of the Brent Interpretation similarly should apply to the forward contract exclusion from the swap definition for nonfinancial commodities, the CFTC proposes to withdraw the Energy Exemption.

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The definition of swap in Dodd-Frank explicitly states that commodity options are swaps. However, the Release provides clarification regarding options embedded in forwards and states that the CFTC would continue to apply its historical guidance on the treatment of forward contracts in nonfinancial commodities that contain embedded options under Dodd-Frank.2 Under this analysis, a forward contract that contains an embedded commodity option or options would be considered an excluded nonfinancial commodity forward contract (and not a swap) if the embedded option(s): (i) can be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; (ii) do not target the delivery term, so that the predominant feature of the contract is actual delivery; and (iii) cannot be severed and marketed separately from the overall forward contract in which they are embedded. Therefore, if the embedded commodity option made delivery optional, the forward contract exclusion would not apply and the instrument would be subject to further review by the CFTC to determine its status. C. CONSUMER AND COMMERCIAL TRANSACTIONS As noted in the Release, the Commissions do not believe that Congress intended to include customary consumer and commercial agreements, contracts, or transactions in the definition of swap or securitybased swap. The Release provides interpretive guidance on the types of agreements, contracts, or transactions when entered into by consumers (natural persons or their agents) as principals primarily for personal, family, or household purposes should not be considered swaps or security-based swaps. Under this guidance, the following consumer transactions are not swaps or security-based swaps: 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 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);3 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; and consumer loans or mortgages with variable rates of interest or embedded interest rate options, including 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.

In addition to these consumer transactions, the Release provides proposed interpretive guidance regarding the following types of commercial agreements, contracts, or transactions, entered into pursuant to customary business arrangements that would not be considered swaps or security-based swaps: employment contracts and retirement benefit arrangements; sales, servicing, or distribution arrangements; agreements, contracts, or transactions for the purpose of effecting a business combination transaction;4

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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);5 mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables; fixed or variable interest rate commercial loans entered into by non-banks;6 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.

The proposed interpretive guidance is not meant to be exhaustive of the types of consumer or commercial transactions that should not be considered swaps or security-based swaps, as there may be similar types of transactions that would not be considered swaps or security-based swaps. To determine whether similar types of consumer or commercial agreements, contracts, and transactions are swaps or security-based swaps, the Commissions intend to consider the following characteristics and factors that are common to the consumer and commercial transactions described 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 (OTC); 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.

The Release notes that key components reflected in these characteristics that distinguish consumer and commercial agreements, contracts, and transactions from swaps and security-based swaps are: (i) the payment provisions of the arrangements are not severable and (ii) the agreement, contract, or transaction is not traded on an organized market or OTC and do not involve risk-shifting arrangements with financial entities, as would be the case for swaps and security-based swaps. D. LOAN PARTICIPATIONS The Release provides proposed guidance that the Commissions will not interpret the definition of swap or security-based swap to include loan participations in which the purchaser is acquiring (i) a current or future direct or indirect ownership interest in the underlying loan or (ii) a beneficial ownership interest in the economics of the underlying loan (a so-called true participation). The Commissions acknowledged -6Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

two types of loan participations offered in the market today LSTA-style participations and LMA-style participations.7 An LSTA-style participation provides for the sale of the underlying loan by the grantor and a purchase by the participant, which is intended to effect a true sale of the loan from the grantor to the participation and put the participants beneficial ownership interest in the loan beyond the reach of the grantors bankruptcy estate.8 On the other hand, an LMA-style participation does not effect a true sale of the loan, but rather creates a current debtor-creditor relationship between the grantor and the participant under which a future ownership interest is conveyed.9 Citing one commenter, the

Commissions acknowledged that the types of loan participations excluded from the definitions of swap and security-based swap are not synthetic transactions . . . because they are merely transfers of cash loan positions and [t]he ratio of underlying loan to participations is always one-to-one.10 The Release also goes on note that based on the facts and circumstances surrounding loan participations, loan participations may also be excluded from the definition of swap or security-based swap if the participations constituted securities under the federal securities laws or identified banking products under section 403(a) of the Legal Certainty for Bank Products Act of 2000,11 as amended by Dodd-Frank.

III. PRODUCTS DEFINED AS SWAPS OR SECURITY-BASED SWAPS In response to requests for clarification raised by commenters to the ANPR, the Release includes interpretive guidance regarding certain instruments that will be defined as swaps or security-based swaps. The Release notes that 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, nor may it be relevant whether the agreement, contract, or transaction is documented using an industry standard form agreement that is typically used for swaps and security-based swaps. Instead, the relevant question is whether the agreement, contract, or transaction falls within the definition of swap or security-based swap based on its terms and other characteristics. A. FOREIGN EXCHANGE PRODUCTS Section 721 of Dodd-Frank explicitly defines foreign exchange forwards and foreign exchange swaps as swaps, unless they are exempted by the Treasury Secretary.12 In response to questions from market participants, the Release clarifies that, notwithstanding a determination by the Treasury Secretary to exempt foreign exchange forwards and swaps, the following foreign exchange products would be defined as swaps: foreign currency options, non-deliverable forward contracts involving foreign exchange, currency swaps,13 and cross-currency swaps.

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B. FORWARD RATE AGREEMENTS The Release notes that a forward rate agreement (FRA) is an OTC contract for a single cash payment, due on the settlement date of a trade, based on a spot rate (predetermined by the parties) and a prespecified forward rate. Furthermore, an FRA does not involve nonfinancial commodities and is, therefore, outside the scope of the forward contract exclusion under Dodd-Frank. Given that an FRA provides for a future (executory) payment based on the transfer of interest rate risk between the parties, the Release provides that an FRA satisfies the definition of swap under Dodd-Frank. C. CONTRACTS FOR DIFFERENCES The Release describes a contract for differences (CFD) as 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. CFDs generally are traded OTC in a number of countries outside the United States. As a result, unless otherwise excluded from the definition of swap or security-based, the Release provides that a CFD may fall within the scope of the definition.14 Whether a CFD is a swap or securitybased swap will depend on the underlying product of that particular CFD transaction.

IV. TRANSACTIONS REGULATED BY FERC Section 722 of Dodd-Frank addresses how the CFTC should approach products regulated by the Federal Energy Regulatory Commission (FERC) that also may be subject to CFTC jurisdiction. Under the CFTCs Section 4(c) public interest waiver process, provided by Section 722 of Dodd-Frank, 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 will exempt such instruments or transactions from the requirements of the CEA. The Joint Proposed Rules establish a process to

determine the status of transactions in Regional Transmission Organization (RTO) and Independent System Operators (ISO), including financial transmission rights (FTR). Therefore, the Commissions are not addressing FTRs or other transactions in RTOs or ISOs within the Joint Proposed Rules.

V. RELATIONSHIP BETWEEN SWAP AND SECURITY-BASED SWAP DEFINITIONS The Release clarifies whether certain agreements, contracts, or transactions are swaps or security-based swaps (both, including mixed swaps, a Title VII instrument) based on characteristics including the specific terms and conditions of the instrument and the nature of the prices, rates, securities, indexes, or commodities upon which the Title VII instrument is based. However, a determination of whether a Title VII instrument is a swap, security-based swap or mixed swap should be made based on the facts and circumstances relating to such Title VII instrument at the time of execution and its status as a swap, security-based swap or mixed swap should not change throughout the life of the instrument, unless the instrument is amended or modified by the parties. -8Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES OR OTHER MONETARY RATES THAT ARE SWAPS As a general matter, 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. The Release notes that the rates referenced for the parties obligations under a swap are varied, and provides the following examples: Interbank Offered Rates, including LIBOR (regardless of currency); the Euro Interbank Offered Rate; the Canadian Dealer Offered Rate; and the Tokyo Interbank Offered Rate; Money Market Rates, including the Federal Funds Effective Rate; the Euro Overnight Index Average (EONIA); the EONIA Swap Index; the Australian dollar RBA Interbank Overnight Cash Rate; the Canadian Overnight Repo Rate Average; the Mexican interbank equilibrium interest rate; the NZD Official Cash Rate; the Sterling Overnight Interbank Average Rate; the Swiss Average Rate Overnight; and the Tokyo Overnight Average Rate; Government Target Rates, including 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; General Lending Rates: a general rate used for lending money, including 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, derived from an index of any of the foregoing or following rates, averages, or indexes, including a constant maturity rate (U.S. Treasury and certain other rates), 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 of any of the foregoing, such as overnight index swaps (OIS), so long as such rates are not based on a specific security, loan, or narrow-based group or index of securities; Other Monetary Rates, including the Consumer Price Index, the rate of change in the money supply, or an economic rate such as a payroll index; and Other Rates based on the volatility, variance, rate of change of (or the spread, correlation or difference between), or index-based forward spread agreements, references used to calculate the variable payments in index amortizing swaps, or correlation swaps and basis swaps, including the TED spread and the spread or correlation between LIBOR and an OIS.

B. TITLE VII INSTRUMENTS BASED ON YIELDS (INCLUDING GOVERNMENT OBLIGATIONS) The Release discusses a Title VII instrument in which one of the underlying references of the instrument is the yield of a debt security, loan or narrow-based security index. Where the term yield in a Title VII instrument is used as a proxy for the price or value of the debt security, loan, or narrow-based security index, that Title VII instrument would be a security-based swap (subject to the discussion below regarding exempt securities). However, where yield is being used to reference an interest rate or monetary rate, the Title VII instrument would be a swap (or potentially a mixed swap). The Release also includes proposed guidance clarifying that Title VII instruments based solely on the rates or yields of exempt securities, including U.S. Treasuries, will not be security-based swaps even -9Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

where the term yield is a proxy for price or value. The Commissions proposed guidance is based on the definition of security-based swap, which excludes any Title VII instrument that would be a securitybased 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.15 The Commissions note, however, that this exception does not apply to Title VII instruments whose underlying reference is the price, value or yield of a foreign government security, as foreign government securities were not exempted securities as of the date of enactment of the Futures Trading Act of 1982, and that such instruments could be security-based swaps. C. TOTAL RETURN SWAPS The Commissions also have provided proposed guidance regarding the treatment of a total return swap (TRS). If a TRS is based on a single security, a single loan or a narrow-based security index, the TRS will be treated as a security-based swap. However, if the TRS is based on either a broad-based equity index security or an exempted security described above, such as a U.S. Treasury, the Commissions believe such TRS will be a swap. The Commissions also address the variable interest rate financing payments that are typically received by a seller of a TRS. The proposed guidance expresses the Commissions view that these payments are incidental to the purpose of, and the risk that the counterparties assume in, entering into the TRS and are a form of financing that reflects the sellers 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. The proposed guidance indicates that the

inclusion of such payments, when acting merely as a financing component of a TRS, will not cause the TRS to be characterized as a mixed swap. However, the Release identifies three situations in which a TRS might be deemed to be a mixed swap: A TRS that includes additional payments that create interest rate or currency exposures that are unrelated to the financing of a TRS (such as adding or subtracting a spread to or from the financing rate or calculating the financing rate in a currency other than that of the underlying reference security or security index) may be a mixed swap; A TRS that embeds interest-rate optionality into the terms of the TRS designed to shift or limit interest rate exposure (such as by using a cap, collar, call or put) would be a mixed swap; or A TRS that is based on a single security, a single loan or a narrow-based security index and one or more non-security-based components (such as the price of a commodity or a currency) would be a mixed swap.

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D. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT DEFAULT SWAPS In the Release, the Commissions express their belief that a credit default swap (CDS) on either a single reference obligation or a single issuer would be characterized as a security-based swap. The definition of security-based swap includes a swap that is based on a single security or loan, including any interest therein or on the value thereof, as well as 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.16 The Commission believes these two prongs of the security-based swap definition bring a CDS on a single reference obligation or a single issuer squarely within the definition of security-based swap. The Commissions also note 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 single-name CDS transactions executed at the same time and documented under one ISDA Master Agreement, but in which a separate confirmation is sent for each CDS, should be treated as aggregation of single-name CDS transactions (rather than a single CDS on a group or index). In this case, the Commissions would treat each singlename CDS as a separate Title VII instrument, subject to characterization under the Commissions proposed rules and regulations. E. TITLE VII INSTRUMENTS BASED ON FUTURES CONTRACTS A Title VII instrument that is based on a futures contract will either be a swap, a security-based swap or a mixed swap depending on the nature of the futures contract, including the underlying reference of the futures contract. The Release clarifies that the Commissions view a Title VII instrument with an underlying reference that is a security future17 as a security-based swap and a Title VII instrument with an underlying reference that is a futures contract that is not a security future (with the exception of certain foreign government obligations, as discussed below) as a swap. In the case of a Title VII instrument based on a futures contract for a broad-based security index, such as the S&P 500, such instrument would be a security-based swap agreement (as discussed in more detail below). In the Release, the Commissions note that Title VII instruments involving futures contracts on foreign government debt securities present a unique circumstance. Indeed, while the Commissions have

proposed the guidance above for nearly all types of Title VII instruments based on futures contracts, the Commissions did not propose guidance on how Title VII instruments based on futures contracts for foreign government debt securities will be treated. Title VII instruments based on futures contracts of foreign government debt securities are unique because, pursuant to Rule 3a12-8 under the Exchange Act,18 futures contracts on certain foreign government debt securities are, subject to certain conditions, treated as exempted securities for purposes of the Exchange Act, while there is no similar exemption for the debt securities of those foreign government debt securities. As such, the Commissions recognize that there could potentially be differing regulatory treatments for Title VII instruments based on futures -11Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

contracts for foreign debt securities and Title VII instruments based directly on the foreign debt securities underlying futures contracts. Particularly, the Commissions express concern that there is potential for a Title VII instrument based on a futures contract for a foreign government debt obligation to either be used to avoid the application of the federal securities laws that otherwise would apply if the Title VII instrument was instead based on the foreign government debt security directly or to avoid the application of the CEA that otherwise would apply if the Title VII instrument was instead based on any other futures contract that is not a security future. The Commissions have specifically requested public comments on the question of how to regulate Title VII instruments based on futures contracts on foreign government debt securities. F. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS The Commissions recognize that certain fixed terms or conditions in a Title VII instrument may be established by reference to, or informed by, the value or level of a security, rate or other commodity at the time of the execution of the instrument. The Commissions have proposed guidance clarifying that the characterization of such a Title VII instrument would not depend on the characteristics of the relevant security, rate or other commodity used to fix the terms of a Title VII instrument, provided that the fixed term or condition is set at the time of execution of the Title VII instrument and that fixed term or condition may not vary over the life of the instrument. G. THE TERM NARROW-BASED SECURITY INDEX IN THE SECURITY-BASED SWAP DEFINITION As discussed above, a Title VII instrument will be a security-based swap if the underlying reference of the instrument is a narrow-based security index or a swap if the underlying reference is a security index that is not a narrow-based security index (a broad-based security index). Because the characterization of a Title VII instrument can depend on whether an underlying security index is a narrow-based security index or a broad-based security index, the Release proposes rules and guidance to distinguish between them. 1. Applicability of the Statutory Definition of Narrow-Based Security Index and Past Guidance of the Commissions to Title VII Instruments Both the CEA and the Exchange Act define a security index as a narrow-based security index if the following criteria are met, subject to certain exceptions: the index has nine or fewer component securities; a component security comprises more than 30% of the indexs weighting; the five highest weighted component securities in the aggregate comprise more than 60% of the indexs weighting; or the lowest weighted component securities comprising, in aggregate, 25% of the indexs weighting have an aggregate dollar value of average daily trading volume (ADTV) 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 indexs weighting, such securities shall be ranked from lowest to

-12Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

highest dollar value of ADTV and shall be included in the calculation based on their ranking starting with the lowest ranked security.19 The Commissions note that the statutory definition focuses on security indexes composed of equity securities and certain aspects of the definition are designed to take into account the trading patterns of individual stocks. The Commissions have previously expanded the definition of narrow-based security index to cover volatility indexes and debt security indexes by issuing guidance setting forth the criteria used to determine whether either a volatility index or a debt security index will be a narrow-based security index. A volatility index is an index composed of index options. In 2004, the Commissions issued a joint order to clarify that a volatility index is not narrow-based if it meets all of the specified criteria that consider the breadth of the underlying securities, as well as the listing and trading of the options. In July 2006, the Commissions issued joint rules (the July 2006 Rules) to define when an index of debt securities20 is not a narrow-based security index. Under the July 2006 Rules, an index of debt securities will not be a narrow-based security index if the following conditions are met: the index has more than nine debt securities issued by more than nine non-affiliated issuers; the securities of any issuer included in the index did not comprise more than 30 percent of the indexs weighting; and the securities of any five non-affiliated issuers in the index did not comprise more than 60 percent of the indexs weighting.

The July 2006 Rules imposed further requirements for a debt index to be a narrow-based security index. If the number and concentration limits described above were met, a debt security index will not be a narrow-based security index if the debt securities or the issuers of the debt securities included in the index meet 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 Exchange Act;21 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 Exchange Act22 and the rules promulgated thereunder; or the issuer of the security is a government of a foreign country or a political subdivision of a foreign country.23

Except as to the alternative treatment described below, the Commissions believe it is appropriate to use the existing rules and guidance regarding narrow-based security indexes described above to determine whether or not a Title VII instrument is based on a narrow-based security index. -13Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011 To that end, the

Commissions have proposed two new rules (proposed rule 1.3(yyy) under the CEA and proposed rule 3a68-3 under the Exchange Act; together, the Proposed Index Rules) that specifically provide that the term narrow-based security index for the purpose of the security-based swap definition will have the same meaning as the statutory definition in Section 1a(35) of the CEA and Section 3(a)(55) of the Exchange Act,24 and the rules, regulations, and orders issued by the Commissions relating to such definition. Accordingly, market participants would generally be able to rely on the existing regulatory framework regarding narrow-based security indexes to determine whether a Title VII instrument based on a security index (or security indexes) will be a swap or a security-based swap. 2. Narrow-Based Security Index Criteria for Index Credit Default Swaps A CDS would be a security-based swap if the underlying reference is a single entity, 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), a narrow-based security index or the issuers of securities in a narrow-based security index. A CDS where the underlying reference is a broad-based security index or the issuers of securities in a broad-based security index would be a swap. However, the Commissions expressed concern that the statutory definition of narrow-based security index and the existing guidance from the Commissions relating to the definition of narrow-based security index discussed above are not appropriate in the context of a CDS where the underlying reference is a group or index of entities or obligations of entities (index CDS), because neither the statutory definition nor the previous guidance was tailored to evaluate whether a security index is narrowly based for purposes of a CDS. To that end, the Commissions have proposed to further define the term securitybased 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. The statutory definition of security-based swap includes a Title VII instrument based on an occurrence or event relating to the issuers of securities in a narrowbased security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer.25 As such, the Commissions have proposed a definition of the term issuers of securities in a narrow-based security index in the context of the definition of security-based swap as applied to index CDS.26 a. Proposed Rules Regarding the Definitions of Issuers of Securities in a Narrow-Based Security Index and Narrow-Based Security Index for Index Credit Default Swaps The Commissions have proposed rules 1.3(zzz) and 1.3(aaaa) under the CEA and proposed rules 3a681a and 3a68-1b under the Exchange Act (together, the Proposed Index CDS Rules) to provide the appropriate criteria for determining whether an index composed of issuers of securities or an index composed of securities referenced by an index CDS is a narrow-based security index. Consistent with the Commissions prior guidance regarding narrow-based security indexes in the context of security futures, the Commissions believe that their regulations should ensure that there is sufficient public -14Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

information available about a predominant percentage of the issuers of the securities or the securities underlying the index to reduce the likelihood that broad-based security indexes referenced in index CDS or the component securities or issuers of securities in that index would be readily susceptible to manipulation. To accomplish this goal, the Commissions have proposed number and concentration

percentage criteria similar to those adopted for volatility indexes and security indexes of debt securities and public information availability criteria to be used in determining whether an index composed of issuers of securities or an index composed of securities referenced by an index CDS are narrow-based. i. Number and Concentration Percentages of Reference Entities or Securities

The first three criteria of the Commissions Proposed Index CDS Rules are similar to the first three criteria of the debt security index test described above. The term issuers of securities in a narrow-based

security index would include issuers of securities identified in an index in which: Number: There are nine or fewer non-affiliated issuers of securities that are reference entities27 in the index, provided that an issuer of securities shall not be deemed a reference entity 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 a 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 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 indexs 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 indexs weighting.

The term narrow-based security index with respect to an index CDS would include an index in which essentially the same criteria apply, substituting securities for issuers. The Commissions believe that, in light of the similar percentages approved by Congress and used by the Commissions regarding narrow-based security indexes in the security futures context, 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. Furthermore, the Commissions believe that the markets have had experience with respect to all of the criteria set forth above with respect to futures on equity indexes, volatility indexes and debt security indexes. ii. Public Information Availability Regarding Reference Entities or Securities In addition to the number and concentration percentage criteria discussed above, the Commissions have proposed public information availability criteria to be used in determining whether an index serving as the -15Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

underlying reference for an index CDS is narrow-based, designed to help insure that a broad-based security index serving as the underlying reference for an index CDS is not readily susceptible to manipulation. The criteria set forth below are intended to condition the characterization of an index as narrow-based on the likelihood that the information about a predominant percentage of the reference entities or securities in the index is publicly available. Except as discussed below, the Proposed Index CDS Rules provide that a security index would be considered narrow-based if any reference entity or security included in the index fails to meet any one of the following criteria: the reference entity or the issuer of the security is required to file reports pursuant to the Exchange Act or the regulations thereunder; the reference entity or the issuer of the security is eligible to rely on the exemption provided in Rule 12g3-2(b) under the Exchange Act;28 the reference entity or the issuer of the security has a worldwide market value of its outstanding common equity held by non-affiliates of $700 million or more; the reference entity or the issuer of the security (other than an issuing entity of an assetbacked security as defined in Section 3(a)(77) of the Exchange Act29) has outstanding securities that are notes, bonds, debentures, or evidences of indebtedness having a total remaining principal amount of at least $1 billion; the reference entity is an issuer of an exempted security, or the security is an exempted security, each as defined in Section 3(a)(12) of the Exchange Act30 and the rules promulgated thereunder (except a municipal security); the reference entity or the issuer of the security 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 is an issuing entity of asset-backed securities as defined in Section 3(a)(77) of the Exchange Act,31 such asset-backed securities were issued in a transaction registered under the Securities Act of 1933 (the Securities Act) and have publicly available distribution reports.

The Proposed Index CDS Rules provide that so long as the effective notional amounts allocated to reference entities or securities that satisfy the requirements above comprise at least 80 percent of the indexs weighting, the failure of one or more reference entities or securities to meet one of the criteria above will be disregarded if the effective notional amounts allocated to each such reference entity or security comprise less than 5 percent of the indexs weighting. The Commissions proposed additional criteria that may be used to satisfy the public information availability requirement for index CDS entered into between eligible contract participants (ECP) that are cleared by central counterparties operating pursuant to exemptive orders granted by the SEC.32 The views of the CFTC and the SEC differ with respect to the application of the publicly available information criteria. Accordingly, the Commissions are requesting public comment as to whether the public information availability criteria should apply to the extent that an index is compiled by an index provider that is not a party to an index CDS (a third-party index provider) and makes publicly available general information about the construction of the index, index rules, identity of components and -16Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

predetermined adjustments, and which is referenced by an index CDS that is offered on or subject to the rules of a designated contract market (DCM) or swap execution facility (SEF), or by direct access in the U.S. from a foreign board of trade (FBOT) that is registered with the CFTC. iii. Treatment of Indexes Including Reference Entities that Are Issuers of Exempted Securities or Including Exempted Securities The Proposed Index CDS Rules provide for alternative treatment of security indexes that include exempted securities or reference entities that are issuers of exempted securities. The Proposed Index CDS Rules provide that if a security index 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 constitute a narrow-based security index or issuers of securities in a narrow-based security index. The Proposed Index CDS Rules further provide that a security index comprised solely of securities that are, or reference entities that are issuers of, exempt securities (other than municipal securities) would not be a narrow-based security index or an index composed of issuers of securities in a narrow-based security index. Furthermore, a security index where some, but not all, of the securities are, or reference entities that are issuers of, exempt securities (other than municipal securities), such index will only be a narrow-based security if the index is narrow-based after disregarding the exempted securities or issuers of exempted securities. 3. Security Indexes A preliminary question in the case of some Title VII instruments is whether they are based on a security index or are an aggregation of security-based swaps on single securities, loans or issuers. The

Exchange Act defines an index as an index or group of securities, including any interest therein or based on the value thereof.33 The Release notes that, in most cases, a security index is designed to reflect the performance of a market or sector by reference to representative securities or interests in securities. The Release also notes, however, that market participants may enter into Title VII instruments where the underlying reference is a portfolio of securities, and the portfolio of securities may itself be a security index for purposes of determining whether a Title VII instrument is a swap or a security-based swap. The Commissions understand that a security portfolio could be labeled as such or could just be an aggregation 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 would need to be evaluated in accordance with the proposed guidance to determine whether it is a swap or a securitybased swap.

-17Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

The Commissions believe that where one or more counterparties have the direct or indirect discretion to change the composition of a security portfolio, such portfolio should be treated as a narrow-based security index for purposes of characterizing the Title VII instrument (regardless of the composition of the index or the weighting of the index components). However, where changes to a security portfolio are made based on pre-determined methodologies or criteria, and not at the direct or indirect discretion of one or both counterparties, such security portfolio should be characterized as a narrow-based or broadbased security index depending on its composition and the weighting of the component securities of the index. 4. Evaluation of Title VII Instruments on Security Indexes that Move from Broad-Based to Narrow-Based or Narrow-Based to Broad-Based The Release provides that the determination of whether a Title VII instrument is a swap, a security-based swap or a mixed swap is made at the execution of the Title VII instrument. In general, the

characterization of the Title VII instrument would not change from its initial characterization, even if the security index were to change from a broad-based to a narrow-based security index or a narrow-based to a broad-based security index. However, if the material terms of a Title VII instrument based on a security index are modified or amended, the underlying security index must be re-assessed to determine whether such security index is a narrow-based or broad-based security index. If the underlying security index has changed from a broad-based to a narrow-based security index, or a narrow-based to a broad-based security index, then the characterization of the modified or amended Title VII instrument would be determined by evaluating the underlying security index at the time of the modification or amendment. The Commissions have proposed guidance regarding the treatment of a Title VII instrument based on a security index where the character of the security index changes according to predetermined criteria or a predetermined self-executing formula set forth in the Title VII instrument at execution. Where the predetermined criteria or 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 during the duration of the instrument, the Title VII instrument based on such security index would be a mixed swap for the entire life of the instrument.34 The Commissions believe this guidance regarding the use of

predetermined criteria or predetermined self-executing formula would prevent potential gaming of the Commissions rules and guidance regarding security indexes and prevent potential regulatory arbitrage based on the migration of a security index from a broad-based to a narrow-based security index, or vice versa.

-18Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

a. 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 The Commissions recognize that security indexes underlying Title VII instruments that are traded on DCMs, SEFs, FBOTs, security-based SEFs, or national security exchanges (NSE) raise particular issues if an underlying security index migrates from broad-based to narrow-based or vice versa. As such, the Commissions proposed guidance clarifies that a market participant who enters into a swap based on a broad-based security index traded on or subject to the rules of a DCM, SEF or FBOT, or a securitybased swap based on a narrow-based security index traded on a security-based SEF or NSE, may hold such position until the swaps or security-based swaps expiration without any change in regulatory responsibilities, requirements or obligations. However, the Commissions note that, in the absence of regulatory action by them, if a market participant wants to offset its existing Title VII instrument or enter into a new one in the same manner, the participant may be prohibited from doing so if the characterization of the security index had migrated. The

Commissions believe it is important to address how to treat Title VII instruments traded on trading platforms where the underlying security index migrates from broad-based to narrow-based or vice versa, 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. In creating proposed rules to address this concern, the Commissions relied on the statutory text and related rules and regulations used by Congress and the Commissions with respect to a similar issue in the context of security futures. Congress provided a tolerance period in the definition of narrow-based security index in both the CEA and the Exchange Act35 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 underlying security index temporarily assumes characteristics that would render it a narrow-based security index under the statutory definition. The Commissions believe a similar concept should be applicable to Title VII instruments, and as such have drafted the Proposed Index Rules to provide tolerance periods for Title VII instruments that are traded on DCMs, SEFs, FBOTs, security-based SEFs or NSEs, as applicable. The Proposed Index Rules provide that the tolerance period for a broad-based security index underlying a swap traded on or subject to the rules of a DCM, SEF or FBOT will be triggered if such security index migrates from a broad-based to a narrow-based security index and either (i) such security index underlying a swap executed on or subject to the rules of a DCM, SEF or FBOT was not a narrow-based security index during the first 30 days of trading or (ii) such index was not a narrow-based index during every trading day of the six full calendar months preceding a date no earlier than 30 days prior to the commencement of trading of a swap on such index described in clause (i). Once the tolerance period is -19Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

triggered, the security index will not become a narrow-based security index until it has been narrow-based for more than 45 business days over three consecutive calendar months. However, if the security index does not satisfy either of the conditions in clauses (i) or (ii) above, no tolerance period will be available for such security index. The Proposed Index Rules provide the same tolerance period for a narrow-based security index underlying a swap traded on or subject to the rules of a security-based SEF or NSE that migrates to a broad-based security index under the conditions described above. In addition to the tolerance periods described above, the Proposed Index Rules also provide grace periods for narrow-based security indexes that migrate to broad-based security indexes and vice versa. During this grace period, Title VII instruments based on a security index that has migrated from broadbased to narrow-based or vice versa would be able to trade or clear on the platform on which Title VII instruments based on such security index were trading or clearing before the security index migrated. In each case, the grace period would be three calendar months for any security index that migrates for more than 45 business days in a period of three consecutive calendar months. During this grace period, a broad-based security index that has migrated to a narrow-based security index would not be treated as a narrow-based security index, and vice versa. The Commissions believe that this three month grace period would provide sufficient time for the migrated Title VII instruments to satisfy listing and clearing requirements applicable to swaps or security-based swaps, as applicable. The Commissions have also clarified in the Release that there would be no overlap between the tolerance and grace periods under the Proposed Index Rules and no re-triggering of the tolerance period. H. METHOD OF SETTLEMENT FOR INDEX CREDIT DEFAULT SWAPS The Commissions have expressed their belief that the method of settlement chosen by the parties to an index CDS following a credit event can also affect the characterization of the index CDS as a swap, security-based swap, or mixed swap. The Commissions believe that if an index CDS that is not based on a narrow-based security index under the Joint Proposed Rules provides for a mandatory physical settlement requiring the delivery of (and therefore the purchase and sale of) a non-exempted security (as discussed above) or a loan, such index CDS would be a mixed swap. However, if the index CDS that is not based on a narrow-based security index provides for mandatory cash settlement, such index CDS would be 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 or determined through a securities or loan auction (as provided in the market-standard ISDA agreements used by market participants).

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I.

SECURITY-BASED SWAPS AS SECURITIES UNDER THE EXCHANGE ACT AND SECURITIES ACT

In the Release, the Commissions clarify that a security-based swap is a security under the Exchange Act and the Securities Act, pursuant to the provisions of Dodd-Frank, making security-based swaps subject to the Exchange Act and the Securities Act and the rules and regulations promulgated thereunder. However, the Commissions recognize that security-based swaps may differ from more traditional securities products, and have requested public comment on whether additional guidance may be necessary regarding the application of certain provisions of the Exchange Act and the Securities Act, and the rules and regulations promulgated thereunder, as they may apply to security-based swaps.

VI. MIXED SWAPS A. SCOPE OF THE CATEGORY OF MIXED SWAP Mixed swaps are Title VII instruments that meet the requirements for both swaps and security-based swaps. The Commissions have expressed their belief that the scope of the category of mixed swaps is narrow and is intended to ensure there are no gaps in the regulation of swaps and security-based swaps. The Release provides several examples of Title VII instruments that the Commissions believe would be mixed swaps, including Title VII instruments based on the value of one or more securities (or narrowbased security indexes) and one or more commodities (including portfolios consisting of both securities and commodities) and best of or out-performance swaps that require payment based on the higher of the performance of a security and a commodity (other than a security). The Commissions have also proposed guidance clarifying that a Title VII instrument will not be deemed a mixed swap solely because the instrument incorporates by reference a market standard agreement intended to establish a trading relationship between the counterparties that could be deemed to be a security-based swap (for example, due to default or termination events relating to the counterparties). The Commissions do not believe that these types of arrangements are meant to be included as mixed swaps and have proposed guidance that the incorporation of such an agreement in a Title VII instrument will not affect the characterization of the instrument. B. REGULATION OF MIXED SWAPS The Commissions are proposing parallel rules to provide for the regulation of mixed swaps (proposed rule 1.9 under the CEA and proposed rule 3a68-4 under the Exchange Act; together, the Proposed Mixed Swap Rules). The Proposed Mixed Swap Rules provide two different regulatory regimes for mixed swaps, based on the nature of the parties entering into the mixed swap. The Proposed Mixed Swap Rules provide one set of regulations for bilateral uncleared mixed swaps entered where at least one party is dually registered with both Commissions and a separate set of regulations for the regulation of all other mixed swaps, including rules establishing the process by which persons that are party to a mixed swap can request a joint order from the Commissions permitting such persons to comply only with certain -21Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

specified parallel provisions of either the CEA or the Exchange Act, and the related rules and regulations promulgated thereunder. C. REGULATION OF MIXED SWAPS ENTERED INTO BY DUALLY REGISTERED DEALERS OR MAJOR PARTICIPANTS Because the Commissions recognize that swap dealers and security-based swap dealers, or major swap participants and major security-based swap participants (such dealers and major participants are referred to as Major Participants) may be subject to potentially conflicting or duplicative requirements, the Proposed Mixed Swap Rules propose an alternative regulatory regime applicable to Major Participants when they enter into certain mixed swaps. To qualify for this alternative regulatory regime, a mixed swap (i) may be neither executed on nor subject to the rules of a DCM, NSE, SEF, security-based SEF or FBOT, (ii) may not be submitted to a derivatives clearing organization (DCO) or registered or exempt clearing agency to be cleared and (iii) must have at least one party registered as a Major Participant with both Commissions. If a mixed swap meets the requirements set forth above, such mixed swap would be subject to all applicable provisions of the federal securities laws (and the SEC rules and regulations promulgated thereunder) and only the following provisions of the CEA (and the CFTC rules and regulations promulgated thereunder): Examinations and information sharing: CEA Sections 4s(f) and 8;36 Enforcement: CEA Sections 2(a)(1)(B), 4(b), 4b, 4c, 6(c), 6(d), 6c, 6d, 9, 13(a), 13(b) and 23;37 Reporting to an SDR: CEA Section 4r;38 Real-time reporting: CEA Section 2(a)(13);39 Capital: CEA Section 4s(e);40 and Position Limits: CEA Section 4a.41

D. REGULATORY TREATMENT FOR OTHER MIXED SWAPS Because mixed swaps are both security-based swaps and swaps, any mixed swap that does not qualify for the alternative regulatory treatment described above will, absent a joint rule or order by the Commissions permitting an alternative regulatory approach, be subject to all of the provisions of the CEA and the Exchange Act (and all of the rules and regulations promulgated thereunder) that were added by or amended by Title VII of Dodd-Frank with respect to swaps or security-based swaps and, because security-based swaps are securities, the provisions of the Securities Act (and the rules and regulations promulgated thereunder), unless separate exemptive relief is granted. The Commissions recognize that such dual-regulation may not be appropriate in all cases, and as such, the Proposed Mixed Swap Rules propose a process by which any person who intends to list, trade, or clear a mixed swap (or a class thereof) that does not qualify for the alternative treatment described above may request that the Commissions jointly 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 with certain specified parallel -22Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

provisions of the CEA or the Exchange Act, rather than complying with the parallel provision in both the CEA and the Exchange Act. In order to make such a request, the Proposed Mixed Swap Rules require the person submitting the request to provide the following information, which is intended to allow the Commissions to make an informed judgment regarding the regulatory treatment of the particular mixed swap (or class of mixed swaps): all material information regarding the terms of the specified, or specified class of, mixed swap; the economic characteristics and purpose of the specified, or specified class of, mixed swap; the specified parallel provisions, and the reasons the person believes such specified parallel provisions would be appropriate for the mixed swap (or class thereof); an analysis of (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; and such other information as may be requested by either of the Commissions. 42

Under the Proposed Mixed Swap Rules, any person submitting such a request would have the opportunity to withdraw the request at any time before the Commissions issue a joint order in response to the request. Once a request has been submitted, and so long as the request is not withdrawn, and the Commissions have given public notice of the request and an opportunity for public comment, the Commissions may jointly issue an order permitting the requesting person (and any other person that subsequently lists, trades, or clears that class of mixed swap) to comply with certain parallel provisions of either the CEA or the Exchange Act. The Proposed Mixed Swap Rules instruct the Commissions to consider (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. The Proposed Mixed Swap Rules do not require the Commissions to issue a joint order in response to a request described above. However, upon receipt of such a request, the Commissions must either issue a joint order within 120 days of receipt (which such period shall be tolled during the public comment period) or publicly provide the reasons for not providing such an order.

VII. SECURITY-BASED SWAP AGREEMENTS Security-based swap agreements (SBSA) are swaps involving securities over which the CFTC has regulatory and enforcement authority and the SEC has antifraud, anti-manipulation, and anti-insider trading authority under the Exchange Act and Securities Act.43 The Release notes that a SBSA is a swap agreement, as defined in Section 206A of the Gramm-Leach-Bliley Act, of which a material term is based -23Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

on the price, yield, value, or volatility of any security or any group or index of securities, including any interest, but is not a security-based swap. Dodd-Frank amended the definition of swap agreement in Section 206A to eliminate the requirement that only ECPs were permitted to enter into swap agreements. Although there is no bright-line test to determine if an instrument is an SBSA, the Release provides several examples of SBSAs, including: swaps on a broad-based security index (i.e. a swap on a future on the S&P 500 index), 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, and a swap on a U.S. Treasury security or on certain other exempted securities, although not municipal securities. Section 712(d)(2)(B) of Dodd-Frank requires the Commissions, in consultation with the Board, to jointly adopt rules governing books and records requirements for SBSAs by swap data repositories (SDR) under the CEA, including uniform rules that specify the data elements that shall be collected and maintained by each SDR, and to adopt rules governing books and records for SBSAs, including daily trading records, for Major Participants. Given that the CFTC has proposed rules governing books and records for swaps,44 which would apply to swaps that also are SBSAs, the Release clarifies that the Joint Proposed Rules do not impose any additional books and records requirements regarding SBSAs, other than those already proposed for swaps.

VIII. PROCESS FOR REQUESTING INTERPRETATIONS OF CHARACTERIZATION OF A TITLE VII INSTRUMENT The Commissions recognize that the characterization of a Title VII instrument as a swap, security-based swap, or mixed swap may be a difficult question. As such, the Commissions have proposed rule 1.8 under the CEA and proposed rule 3a68-2 under the Exchange Act (together, the Proposed Interpretation Rules), which provide a process for market participants to request a joint interpretation by the Commissions regarding whether a particular Title VII instrument (or class of Title VII instruments) is a swap, security-based swap, or a mixed swap. The Commissions have modeled the Proposed

Interpretation Rules after Section 718 of Dodd-Frank, which establishes the process for determining the status of novel derivative products that may have elements of both securities and futures contracts. The Proposed Interpretation Rules provide that any person may request a joint interpretation of whether a particular Title VII instrument (or class of Title VII instruments) is a swap, a security-based swap, or a mixed swap by providing the commissions with: all material information regarding the terms of the Title VII instrument (or class of Title VII instruments); a statement of the economic characteristics and purpose of the Title VII instrument (or class of Title VII instruments);

-24Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

the requesting persons determination as to whether the Title VII instrument (or class of Title VII instruments) should be characterized as a swap, a security-based swap, or a mixed swap, including the basis for such determination; and such other information as may be requested by either Commission.45

Similar to the Proposed Mixed Swap Rules, the Proposed Interpretation Rules provide that a person who submits a request for interpretation may withdraw the request. However, unlike the Proposed Mixed Swap Rules, even if a request for an interpretation is withdrawn pursuant to the Proposed Interpretation Rules, the Commissions may still adopt an interpretation regarding the characterization of the Title VII instrument (or class of Title VII instruments). The Proposed Interpretation Rules further require either Commission to promptly notify the other if such Commission receives a proposal to list, trade, or clear a Title VII instrument (or class of Title VII instruments) that raises questions as to the appropriate characterization of such instrument (or class of instruments) as a swap, security-based swap, or mixed swap. The Proposed Interpretation Rules provide that either Commission, or their Chairmen jointly, may initiate the process for a joint interpretation as to the characterization of a Title VII instrument, even where no external request has been received, by submitting the information described above. The Proposed Interpretation Rules do not require the Commissions to issue a joint interpretation in response to a request for interpretation. However, upon receipt of such a request, the Commissions must either issue a joint interpretation within 120 days of receipt (which such period shall be tolled during the public comment period, if the Commissions seek public comment), publicly provide the reasons for not providing such an order, or issue a joint notice of proposed rulemaking to further define one or more of the terms swap, security-based swap, or mixed swap. The Proposed Interpretation Rules also

provide that any joint interpretation or proposed rulemaking shall be conducted by the Commissions in consultation with the Board.

IX. ANTI-EVASION PROVISIONS A. TREATMENT OF SWAPS BY THE CFTC Dodd-Frank contains various provisions designed to capture transactions and entities that have been structured to evade certain requirements of Dodd-Frank. Section 721(c) of Dodd-Frank requires the CFTC to further define swap in order to include transactions that have been designed to evade subtitle A of Title VII. Section 721 also directs the CFTC to ensure that instruments are not willfully structured as foreign exchange forwards or swaps, should the Treasury Secretary exempt foreign exchange forwards or swaps, to evade the regulatory requirements of Dodd-Frank. In addition, Section 722 of Dodd-Frank provides that the provisions of the CEA relating to swaps will not apply outside the U.S., unless those activities are designed to evade any provision of Dodd-Frank. And Section 725(g) of Dodd-Frank provides -25Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

that a product that is not regulated by a federal banking regulator, meets the definition of swap or security-based swap, but has been structured as an identified banking product for the purpose of evading Dodd-Frank, would not be eligible for the exclusion for identified banking products from the CEA. Pursuant to this authority, proposed rule 1.3(xxx)(6) under the CEA generally would provide that a transaction is a swap if it is willfully structured to evade any provision of Title VII of Dodd-Frank governing the regulation of swaps. Moreover, proposed rule 1.3(xxx)(6) would include specific provisions relating to currency and interest rate swaps that are willfully structured as foreign exchange forwards or foreign exchange swaps, and certain instruments willfully structured as identified banking products, in each case to evade those provisions of Dodd-Frank. Proposed rule 1.6 under the CEA would prohibit activities conducted outside the U.S., including entering into transactions and structuring entities, to willfully evade or attempt to evade any Dodd-Frank amended provision of the CEA or the rules and regulations promulgated by the CFTC thereunder. Any transaction that was willfully structured to evade Dodd-Frank would be considered in determining whether a person is a swap dealer or major swap participant, and any non-U.S. activity designed to evade Dodd-Frank would be subject to the swap provisions of the CEA enacted under Dodd-Frank. However, these proposed rules would not apply to any agreement, contract, or transaction structured as a security (including a securitybased swap) under the securities laws. In determining whether a transaction was willfully structured to evade Dodd-Frank, the Release noted that, consistent with the CFTCs case law in the context of determining whether a contract is a futures contract, the CFTC would look beyond the form of the transaction to examine its actual substance. The CFTC also provided interpretive guidance, based on legislative, administrative, and judicial precedent with respect to the anti-evasion provisions in other federal statutes, as to certain types of circumstances that may constitute an evasion of the requirements of Dodd-Frank. However, the Release states that, notwithstanding this guidance, the CFTC would maintain its ability to determine, on a case-by-case basis, whether a transaction or activity constitutes an evasion of Dodd-Frank. Business Purpose. The CFTC would consider the extent to which a person has a legitimate business purpose for structuring the instrument or entity or entering into the transaction in that particular manner, in evaluating whether a person is evading or attempting to evade the requirements of Dodd-Frank. Therefore, absent other indicia of evasion, the CFTC would not consider transactions, entities, or instruments structured in a manner solely motivated by a legitimate business purpose to constitute evasion. Fraud, Deceit, or Unlawful Activity. The Release notes that the Internal Revenue Service (the IRS) has distinguished between tax evasion and legitimate means for citizens to minimize, reduce, avoid, or alleviate the tax that they pay under the Internal Revenue Code, and this framework provides a useful guidepost for determining which types of activities should be considered to constitute an evasion of Dodd-26Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

Frank. A permissible method of reducing tax is associated with full disclosure and explanation of why the tax should be reduced under law. However, 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.46 Therefore, in determining whether a particular transaction or activity is designed to evade Dodd-Frank, the CFTC will consider the extent to which the conduct involves deceit, deception, or other unlawful or illegitimate activity. B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC Section 761(b)(3) of Dodd-Frank grants the SEC discretionary authority to define security-based swap to capture transactions that have been structured to evade subtitle B of Title VII. The SEC did not propose specific rules regarding anti-evasion in the Joint Proposed Rules, but seeks comments on whether SEC rules or interpretive guidance addressing anti-evasion regarding security-based swaps, security-based swap dealers, major security-based swap participants, or ECPs are necessary. The Release noted that the SEC may consider whether to propose anti-evasion rules based on comments received or after having experience with the new regulatory regime under subtitle B of Title VII.

X. DIFFERENCES IN TREATMENT BETWEEN SWAPS AND SECURITY-BASED SWAPS UNDER THE JOINT PROPOSED RULES At the CFTC open meeting to adopt the Joint Proposed Rules, CFTC Commissioner Dunn questioned CFTC staff on any differences in treatment between swaps and security-based swaps, to which the CFTC staff noted there were four areas of divergence. A. ANTI-EVASION PROVISIONS The Joint Proposed Rules would define as a swap any transaction that is willfully structured to evade the Title VII regulatory regime for swaps. There is no similar provision for security-based swaps. At the open meeting, the CFTC staff noted that while the CFTC was required to prevent evasion under Dodd-Frank, the SEC was only given the discretion to do so. B. INSURANCE ON SWAPS As discussed above, the CFTC believes that insurance on a swap should be defined as a swap, but the SEC does not believe that insurance on a security-based swap should be defined as a security-based swap. The CFTC staff noted at the open meeting that the insurance on a swap has many of the same characteristics of a swap, particularly insurance on credit default swaps where the insurer is taking on the economic exposure to the counterparty of the swap. The Commissions request comment on this issue generally.

-27Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

C. FUTURES ON FOREIGN SOVEREIGN DEBT As discussed above, the Commissions did not agree on how a Title VII instrument on a futures contract on a foreign government debt security should be characterized and expressed concern that, based on its characterization, a Title VII instrument based on a futures contract for a foreign government debt obligation could either be used to avoid the application of the federal securities laws or to avoid the application of the CEA. The CFTC believes that treating Title VII instruments based on these futures contracts as security-based swaps, while the underlying futures come under the CEA, may undermine the CFTCs antifraud and anti-manipulation authorities provided under Section 753 of Dodd-Frank. However, the SEC believes that if such a Title VII instrument is characterized as a swap, then the provisions of Dodd-Frank enacted to ensure that there are not 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. As a result, the Joint Proposed Rules are silent on the characterization of such Title VII instruments, and the Release specifically seeks comment as to how the Commissions should characterize these instruments. D. INDEX PROVIDERS FOR CREDIT DEFAULT SWAPS As addressed above, the SEC and the CFTC disagree over whether the public information availability criteria should apply to a security index compiled by a third-party index provider. The SEC does not believe that an index compiled by a third-party index provider should be excepted from the public information availability test under the proposed rules for index CDS. However, the CFTC believes that its oversight of DCMs, SEFs, and registered FBOTs will help ensure that information about an index compiled by a third-party index provider that is the underlying reference of an index CDS traded on these platforms is publicly available and is not readily susceptible to manipulation. * * *

Copyright Sullivan & Cromwell LLP 2011 -28Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

ENDNOTES
1 2

Statutory Interpretation Concerning Forward Transactions, 55 FR 39188, Sept. 25, 1990. CFTC Interpretive Statement, Characteristics Distinguishing Cash and Forward Contracts and Trade Options, 50 Fed. Reg. 39,656 (1985). The Release notes that these types of transactions involve physical delivery which is deferred for convenience or necessity and thus can be viewed as being similar to forward purchase agreements (sometimes with embedded options, in the case of those with price caps). While the CFTC has traditionally treated forward contracts as commercial merchandising transactions, the Commissions view consumer agreements, contracts, and transactions involving periodic or future purchases of consumer products and services, such as agreements to purchase energy commodities to heat or cool consumers homes, as transactions that are not swaps. These business combination transactions include 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. The Release notes that these lending arrangements are traditional borrower/lender arrangements documented using a loan agreement or indenture, as opposed to a synthetic lending arrangement documented in the form of a total return swap. The Legal Certainty for Bank Products Act of 2000, as amended by Section 725(g)(2) of DoddFrank, provides that under certain circumstances, the CEA shall not apply to, and the CFTC shall not exercise regulatory authority over, identified banking products, and identified banking products shall not be defined as swaps or security-based swaps. The LSTA is The Loan Syndications and Trading Association. The LMA is the Loan Market Association. Release at 66, citing the letter from R. Bram Smith, Executive Director, The Loan Syndications and Trading Association, Jan. 25, 2011 (the January LSTA Letter). Release at 66, citing the January LSTA Letter and the letter from Elliot Ganz, General Counsel, The Loan Syndications and Trading Association, Mar. 1, 2011 (the March LSTA Letter). Release at 66, citing the March LSTA Letter. 7 U.S.C. 27a(a). Under Section 721 of Dodd-Frank, a foreign exchange forward is defined as a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange. A foreign exchange swap is a transaction that solely involves (A) 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 (B) 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. On April 29, 2011, the Secretary of the Treasury issued a proposed determination to exempt foreign exchange swaps and foreign exchange forwards from the definition of swap. For additional information on the proposed exemption, please see our memoranda entitled Proposed Treasury Exemption for Foreign Exchange Swaps and Forwards, dated May 11, 2011.

10 11 12

13

As noted above, the CEA defines a foreign exchange forward or a foreign exchange swap as a transaction that solely involved the specified exchange of currencies. The Release notes that currency swaps and cross-currency swaps are not foreign exchange forwards or swaps as defined in the CEA because, although they may involve an exchange of foreign currencies, they also require contingent or variable periodic payments in different currencies.

-29Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

ENDNOTES (CONTINUED)
14

The Release notes that in certain circumstances, the SEC may determine that a particular CFD on an equity security 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. Section 3(a)(68)(C) of the Exchange Act, 15 U.S.C. 76c(a)(68)(C). When used throughout this memorandum, references to an exempted security shall refer to this definition of exempted security. Section 3(a)(68)(A)(ii)(II)-(III) of the Exchange Act, 15 U.S.C. 78c(a)(68)(A)(ii)(II)(III). A security future is specifically 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). 17 CFR 240.3a12-8. See Section 3(a)(55)(B) of the Exchange Act, 15 U.S.C. 78c(a)(55)(B), and CEA Section 1a(35)(A), 7 U.S.C. 1a(35)(A). The statutory exceptions for security indexes that are not narrowbased, despite meeting these criteria, are set forth in Section 3(a)(55)(C) of the Exchange Act, 15 U.S.C. 78c(a)(55)(B), and CEA Section 1a(35)(B), 7 U.S.C. 1a(35)(B). Under the rules, debt securities include notes, bonds, debentures, or other evidence of indebtedness. See CFTC Rule 41.15(a)(1)(i), 17 CFR 41.15(a)(1)(i), and Exchange Act Rule 3a55-4(a)(1)(i), 17 CFR 240.3a55-4(a)(1)(i). 15 U.S.C. 78m or 78o(d). 15 U.S.C. 78c(a)(12). The July 2006 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). 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55). Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15 U.S.C. 78c(a)(68)(A)(ii)(III). The Commissions were very clear in stating that these definitions would only be applicable to index CDS. For purposes of this rule: i) a reference entity would be affiliated with another entity if it controls, is controlled by, or is under common control with, that entity; ii) control would mean ownership of 20 percent or more of an entitys equity, or the ability to direct the voting of 20 percent or more of the entitys voting equity; and iii) the term reference entity would include an issuer of securities, an issuing entity of asset-backed securities, and a single reference entity or group of affiliated entities; provided that an issuing entity of an asset-backed security shall not be affiliated with any other issuing entity or issuer under this proposed definition. 17 CFR 240.12g3-2(b). 15 U.S.C. 78c(a)(77). 15 U.S.C. 78c(a)12. 15 U.S.C. 78c(a)(77).

15

16 17

18

19

20

21 22 23

24 25 26

27

28 29 30 31

-30Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

ENDNOTES (CONTINUED)
32

For such index CDS, an index would be considered narrow-based if a reference entity or security included in the index does not meet any of the criteria above or any one of the following additional criteria: the reference entity or the issuer of the security (other than issuing entities of asset-backed securities) provides to the public or to such eligible contract participant information about such reference entity or issuer pursuant to Rule 144A(d)(4) under the Securities Act; financial information about the reference entity (other than an issuing entity of asset-backed securities) is otherwise publicly available; or in the case of an asset-backed security, or a reference entity that is an issuing entity of assetbacked securities, 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 as well such asset-backed securities.

Under the Proposed Index CDS Rules, the same exceptions for reference entities or securities described above would be applicable to the expanded criteria applicable to index CDS between ECPs. Therefore, as long as 80 percent of the indexs weighting satisfies one of the public information availability criteria, the failure of one or more reference entities or securities to meet such criteria will not cause the index to be narrow-based so long as any such reference entity or security does not comprise more than five percent of the indexs weighting.
33 34

See section 3(a)(68)(E) of the Exchange Act, 15 U.S.C. 78c(a)(68)(E). The Commissions provide the example of a Title VII instrument where at execution the instrument provides that the security index serving as the underlying reference for the instrument will decrease from 20 to 5 securities after six months, such that the security index would become a narrow-based security index. 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). 7 U.S.C. 6s(f) and 12, respectively. 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 9 and 15, 13b, 13a-1, 13a-2, 13, 13c(a), 13c(b), and 26, respectively. 7 U.S.C. 6r. 7 U.S.C. 2(a)(13). 7 U.S.C. 6s(e). 7 U.S.C. 6a. The Release does not discuss when requests will be made public or whether requests may be initially submitted on a confidential basis. Dodd-Frank requires certain CFTC registrants, such as DCOs and SEFs, to keep records regarding SBSAs open to inspection and examination by the SEC upon request. These include proposed rules on Swap Data Recordkeeping and Reporting Requirements, Reporting, Recordkeeping and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants. The Release does not discuss when requests will be made public or whether requests may be initially submitted on a confidential basis. The Release notes that the Internal Revenue Manual of the IRS states 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

35

36 37

38 39 40 41 42

43

44

45

46

-31Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

ENDNOTES (CONTINUED) deceit, subterfuge, camouflage, concealment, some attempt to color or obscure events or to make things seem other than they are.

-32Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011

ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan &

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-33Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011 SC1:3041397.3C