The SEC and CFTC Issue Joint Rules Further Defining Swap Dealers and Major Swap Participants

The SEC and CFTC Issue Joint Rules Further Defining Swap Dealers and Major Swap Participants



I. Introduction

The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) (jointly, the Commissions), in consultation with the Board of Governors of the Federal Reserve System (Federal Reserve), have issued Final Rules (Final Rules) and interpretive guidance (Guidance or Release)1 on the further definition of the terms "swap dealer" (SD), "security-based swap dealer" (SSD), "major swap participant" (MSP), "major security-based swap participant" (MSSP) (MSP and MSSP jointly, major participant) and "eligible contract participant" (ECP).2 The Release also contains a joint interim final rule (Interim Final Rule) excluding from the SD determination swaps entered into for the purpose of hedging physical positions.

The Final Rules and Interim Final Rule will become effective 60 days from their publication in the Federal Register, except that the Final Rules that address which commodity pools can be considered ECPs will not take effect until the end of 2012. Comments on the Interim Final Rule will be due within 60 days of its publication. Because of the potential interplay between the exclusion from the mandatory clearing requirement for commercial end users that use swaps to hedge risk and the definition of SD, which, as discussed below, does not exclude non-financial entities, non-financial entities using swaps to hedge should consider submitting comments on the Interim Final Rule.

The SEC estimates that there should be fewer than 50 entities ultimately having to register as SSDs, and that between zero and five entities will likely have to register as MSSPs. The CFTC estimates that approximately 125 entities will have to register either as SDs or MSPs, although the Release notes that about 450 entities will likely need to perform an analysis to determine whether they satisfy either the SD or MSP definition.

This alert describes how the Final Rules differ from the rules previously proposed by the Commissions,3 which were discussed in a previous WilmerHale alert.4 While the Commissions chose to adopt many of the rules as proposed, there are some significant differences in the Final Rules, including:

(a) raising the amount of the de minimis exception from the definition of SD and SSD;

(b) providing a floor trader exclusion from the SD definition;

(c) promulgating an Interim Final Rule that excludes swaps entered into for the purpose of hedging physical positions from the determination of SD designation;

(d) establishing a safe harbor from the major participant designation;

(e) limiting the "Look Through" provision for retail Forex Pools to pools designed to evade regulation; and

(f) allowing a safe harbor from the "Look Through" provision for retail Forex Pools with total assets over $10 million.

Each of these changes is discussed in further detail below.

II. Swap Dealer and Security-Based Swap Dealer Definition

The statutory definition of an SD or SSD, as incorporated in the Final Rules, is a person that:

(a) holds itself out as a dealer in swaps;5

(b) makes a market in swaps;

(c) regularly enters into swaps with counterparties as an ordinary course of business for his or her own account; or

(d) engages in any activity causing it to be commonly known in the trade as a dealer or market-maker in swaps.

The term does not include a person that enters into swaps for its own account, either individually or in a fiduciary capacity, but not as a part of a "regular business."

A. Clarified Definitions and Concepts

The Guidance clarifies and expounds on several definitions and concepts in the SD and SSD definition.

1. Dealer-Trader Distinction

The Commissions declined to codify the dealer-trader distinction that has long been part of the SEC's interpretation of the Securities Exchange Act's (Exchange Act) definition of a "dealer," noting that the distinction may not be a perfect fit with the swap markets and that it needs to be adapted as appropriate. For example, the term "regularity" has a different meaning in swap markets than in many securities markets. Swaps (at least currently) are less standardized than most securities and are not significantly traded on exchanges or other trading systems. In addition, there is no separate "issuer" in swap markets since each counterparty to a swap may "in essence" be viewed as the "issuer" for that instrument, and thus the concept of an "inventory" is missing from the swap markets. Finally, in contrast to participants in the secondary market involving equity or debt securities, swap participants often have ongoing obligations over the life of the agreement and are thus "counterparties," rather than "customers."

However, the Commissions also note that the dealer-trader distinction provides an appropriate framework for determining which persons fall within the SD/SSD definition and which do not, as there are several commonalities between the definition of a dealer in this analysis and the Commissions' definition of an SD/SSD. These include: (a) seeking to profit by providing liquidity to the market by accommodating counterparties' demand for swaps; (b) holding oneself out as a dealer; (c) being known in the industry as a dealer; (d) using an interdealer broker; (e) advising counterparties on how to use swaps to meet their hedging goals; (f) structuring swaps for counterparties; (g) having a regular clientele; (h) actively advertising or soliciting clients in connection with swaps; (i) acting as a market-maker; and (j) helping to set the prices offered in the market. Accordingly, while the distinction has not been included in the Final Rules, it has been largely incorporated into the interpretive Guidance as the appropriate analytical framework.

2. "Acting as a Market-Maker"

The Guidance also clarifies that "making a market" in swaps means "routinely standing ready to enter into swaps at the request or demand of a counterparty." The Guidance provides examples of what this means, including routinely: (a) quoting bid or offer prices, rates or other financial terms for swaps on an exchange; (b) responding to requests made directly (or indirectly through an interdealer broker) by potential counterparties for bid or offer prices, rates, etc.; (c) placing limit orders for swaps; or (d) receiving compensation for acting in a market-maker capacity on an organized exchange or trading system for swaps. Notwithstanding requests from commenters that the Final Rule require that an entity enter into swaps on both sides of the market as a prerequisite to market-maker status, the Commissions concluded, consistent with the proposed rule, that an entity can be a market-maker by offering swaps on only one side of the market.

3. "Ordinary Course of Business"

The Release also provides examples of "ordinary course of business" or "regular business," two concepts that the Guidance interprets as synonymous, including: (a) maintaining a separate profit and loss statement for swap activity or treating swap activity as a separate profit center; (b) having staff and resources allocated to dealer-type activities with counterparties, such as credit analysis, confirmation generation, collateral calls, etc.; and (c) entering into swaps with the purpose of satisfying the business or risk management needs of the counterparty.

4. Non-Dispositive Issues

Despite the comments the Commission received regarding the uniqueness of certain markets and market participants, the swap dealer definition does not contain per se exclusions for specific markets, such as the energy markets, or specific market participants, such as aggregators of swaps. There is also no exclusion for non-financial entities. However, the Release notes that, "[f]or example, a manufacturer, producer, processor, or merchant that enters into swaps to hedge its currency or interest rate risk, absent any facts and circumstances establishing dealing activity, is not a swap dealer,"6 since they are not likely to be engaging in dealer activities.

The Release also notes that whether an entity is registered as a futures commission merchant (FCM) or a broker-dealer or executes swaps on an exchange does not determine whether the entity is a swap dealer. The Guidance does indicate, however, that the CFTC is planning to consider, in conjunction with the upcoming Final Rules on capital requirements, reduced capital requirements for SDs that only execute swaps on exchanges for their proprietary funds.

B. De Minimis Exception

1. SD Definition

The Final Rules raise the $100 million threshold proposed initially for the exception from the definition of SD to a final threshold of $3 billion, with a phase-in threshold of $8 billion beginning with and for no more than five years after the date that swap data repositories (SDRs) first receive swap data. The Final Rules further require that within 30 months after this data begin to be reported to SDRs, the CFTC's staff must prepare a study of the swap markets, including the de minimis threshold. Then, within nine months of publication of the study, the CFTC must promulgate an order ending the phase-in period or propose new rules to change the de minimis threshold (and end the phase-in period). Notably, the proposed $25 million limitation on swap dealing with "special entity" counterparties is unchanged in the Final Rules, including during the phase-in period.

2. SSD Definition

In the Final Rules, the $3 billion de minimis threshold with the $8 billion phase-in is also applicable to security-based swaps that are credit default swaps (CDS). For other types of security-based swaps, however, the phase-in threshold will be $400 million, and will automatically reset, barring action by the SEC, to $150 million, no later than five years after the "data collection initiation date," which is the later of: (a) the last compliance date for the registration and regulatory requirements for SSDs and MSSPs; or (b) the first date on which compliance with the trade-by-trade reporting rules for credit-related and equity-related security-based swaps to a registered security-based SDR is required.

For "special entity" counterparties, the threshold on an entity's security-based swap dealing also remains at $25 million. In addition, unlike the proposed rules, which would have required that an entity have no more than 20 security-based swaps and 15 counterparties in order to be eligible for the de minimis exception, the Final Rules do not incorporate the proposed limits on the number of security-based swaps that a person may enter into in a dealing capacity or on the number of security-based swap counterparties a person may have when acting in a dealing capacity.

As to the phase-in, the SEC staff, like the CFTC staff, must similarly complete a study no later than three years after the "data collection initiation date." Then, within nine months after the publication of the study, the SEC can either end the phase-in period or propose different de minimis thresholds (and end the phase-in period). Without either action by the SEC, the phase-in period will automatically end five years after the "data collection initiation date." The phase-in period for security-based swaps will not apply to security-based swap dealing activity with counterparties that are natural persons unless the natural persons are ECPs.

3. Timing of Exception

Once the swap dealing of an entity that has relied on the de minimis exception passes the threshold, the entity will have two months, following the end of the month in which it no longer is able to take advantage of the exception, to register as an SD or SSD. Conversely, entities will be able to withdraw their registration as an SD or SSD if their dealing activity falls below the applicable threshold, but only if they have been a registered SD or SSD for at least 12 months.

C. Floor Trader Exclusion from SD Definition

The Final Rules provide that swaps that a person enters into in his or her capacity as a registered floor trader are not counted in determining whether such person is an SD, provided that the person: (a) enters into swaps solely with proprietary funds for that trader's own account on or subject to the rules of a designated contract market (DCM) or SEF; (b) submits each such swap for clearing to a derivatives clearing organization (DCO); (c) is not an affiliated person of a registered SD; (d) does not, directly or through an affiliated person, negotiate the terms of swap agreements, other than price and quantity, or participate in a "request for quote process" subject to the rules of a DCM or SEF; (e) does not directly, or through an affiliated person, offer or provide swap clearing services to third parties; (f) does not, directly or through an affiliated person, enter into swaps that would qualify as hedging physical positions or hedging or mitigating commercial risk, with the exception of swaps that are executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction; (g) does not participate in any market making program offered by a DCM or SEF; and (h) complies with the record keeping and risk management requirements of relevant CFTC regulations with respect to each such swap as if it were an SD.

D. Exclusion from SD Determination for Swaps in Connection with IDI's Origination of a Loan

1. Timing of Originating Loan and Entering Swap

The SD definition in Commodity Exchange Act (CEA) Section 1a(49)(A) (but not the definition of SSD in the Exchange Act) provides that an insured depository institution (IDI) is not to be considered an SD "to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer." The Guidance interprets the statutory phrase to mean that the swap must be directly connected to the IDI's "process of originating" the loan to the customer and cannot be "reasonably stretched to cover the entire term of every loan that an IDI makes to its customers." The IDI's swaps in connection with customer loan origination will be disregarded in determining whether the IDI is an SD. The Final Rules lay out a number of requirements an IDI must satisfy to have its swaps disregarded. Importantly, disregarded swaps must nevertheless still be reported to an SDR.

In response to comments regarding the timing of swaps in connection with loan origination, the Final Rules allow swaps that meet the other requirements of the rules, and that are entered into within 90 days before or 180 days after the date of execution of the loan agreement or any transfer of principal to the borrower under the loan, to be excluded from the SD determination. The aggregate notional amount of the swaps in connection with the financial terms of the loan may not at any time be more than the aggregate amount of the customer's borrowings under the loan at that time. The Final Rules also add that the exclusion applies to swaps between an IDI and a loan borrower that are required to be in place under the IDI's loan underwriting criteria as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business. Notably, the term "loan" does not include any synthetic loan, including a loan credit default swap or loan total return swap. It also does not include any sham transaction.

2. IDIs that are Part of a Loan Syndicate

In general, the IDI must be the sole source of the funds under the loan. The Final Rules, however, also take into account IDIs that are members of a loan syndicate or purchase or obtain a loan through assignment or participation. Thus, an IDI that is committed to be the source of at least 10 percent of the maximum principal amount of the loan may rely on the exclusion. Alternatively, if the IDI does not meet the 10 percent threshold, the exclusion may apply only if the aggregate notional amount of all of the IDI's swaps with the customer, related to the financial terms of the loan, is no more than the amount lent by the IDI to the customer.

The Final Rules allow the exclusion to apply to a swap regardless of whether the notional amount of the swap is different from the amount of the loan. The Release notes, however, that in all cases, the aggregate notional amount of all swaps entered into by the borrower with any person in connection with the financial terms of the loan at any time may not be more than the aggregate principal amount outstanding under the loan at that time.

3. Hedging and Other Considerations

The Release further clarifies that eligibility for the hedging exclusion for loan origination-related swaps is not governed by whether a swap hedges some or all of the risk nor by whether the IDI later transfers or terminates the loan in connection with which the swap was entered into (as long as the swap meets the requirements of the exclusion and is not a sham). The exclusion is not available, however, for swaps used by the IDI to hedge its own risks. It is limited to hedging the risks of loan origination-related swaps with a customer.

E. Other Exclusions

The Final Rules provide that swaps between majority-owned affiliates are excluded from the determination of whether an entity is an SD or SSD. Further, swaps (but not security-based swaps) between cooperatives and their member that are based on physical commodities (not, for example, rate swaps), are also excluded from the determination of whether an entity is an SD. The Final Rules require, however, that cooperatives must report these swaps to an SDR and must have appropriate risk management policies and procedures.

F. Interim Final Rule Excluding Certain Hedging Swaps from SD Definition

Interim Final Rule 1.3(ggg)(6)(iii) excludes from the SD analysis swaps entered into for the purpose of hedging physical positions (but not swaps that just have the effect of hedging). In order to avail oneself of the exclusion, the Interim Final Rule requires that:

(a) the person enter into the swap for the purpose of offsetting or mitigating its price risks that arise from the potential change in the value of one or several: (i) assets that the person owns, produces, manufactures, processes or merchandises, or anticipates owning, producing, manufacturing, processing or merchandising; (ii) liabilities that the person owns or anticipates incurring; or (iii) services that the person provides, purchases or anticipates providing or purchasing;

(b) the swap represent a substitute for transactions made or to be made, or positions taken or to be taken, by the person at a later time in a physical marketing channel;

(c) the swap is "economically appropriate" to the reduction of the person's risks in the conduct and management of a commercial enterprise;

(d) the swap is entered into in accordance with sound commercial practices; and

(e) the person does not enter into the swap in connection with activity structured to evade designation as a swap dealer.

The Release notes that the exclusion draws upon the language in the CFTC's bona fide hedging provisions, without incorporating the provisions into the Interim Final Rule.

The Release also makes clear that the Interim Final Rule does not provide a per se exclusion for all swaps that hedge or mitigate commercial risk, nor does the existence of the Interim Final Rule mean that other types of hedging activity that are not included therein would necessarily be included in the SD determination. The Release also specifically notes that swaps used for dynamic hedging, i.e., modifying the hedging structure related to physical assets or positions based on changes to relevant pricing relationships applicable to that asset, could still qualify for the exclusion.

We note that because the SD definition in the Final Rules does not provide a per se exclusion for non-financial entities (i.e., commercial entities) and the Interim Final Rule only excludes physical swaps used to hedge risk, a commercial end user that uses non-physical swaps to hedge commercial risk could arguably be considered an SD if any of its swap activities could be deemed a dealer activity.

The CFTC has requested comments on a number of questions in the Interim Final Rule, including how swaps entered into for the purpose of hedging can be distinguished from other types of swaps, and whether the exclusion should be broadened beyond just hedges related to physical positions. Because the Interim Final Rule only addresses physical commodities, it is not applicable to security-based swaps or SSDs.

G. Limited Designations

The Final Rules, consistent with the proposed rules, retain the presumption that a person meeting the SD or SSD definition will be deemed an SD or SSD for all its swap activities, unless the Commissions limit the designation. The limitation, which the Release indicates will be considered upon application, may be based on a particular type, class, or category of swap and will be a fact and circumstance-based determination. For example, the Release notes that a person that enters into some swaps to hedge physical positions but enters into other swaps in connection with activities covered by the SD definition could be designated as an SD only for the latter activities. Any person applying for a limited designation will have to demonstrate that it can fully comply with the requirements applicable to dealers, such as recordkeeping, risk-management, registration, supervision and chief compliance officers.

III. Major Swap Participant and Major Security-Based Swap Participant Designation

Under the Final Rules, a major participant is a person that is not an SD or SSD and that:

(a) maintains a substantial position in swaps for any of the major swap categories, excluding both positions held for hedging or mitigating commercial risk, and positions maintained by any employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan;

(b) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the stability of the US banking system or financial markets; or

(c) is a financial entity that is highly leveraged relative to the amount of capital it holds (and is not subject to bank capital requirements), and maintains a substantial position in outstanding swaps in any major swap category.

The Guidance clarifies and expounds on several definitions and concepts in the MSP/MSSP definition. We summarize the most significant changes between the proposed rules and Final Rules.

A. Clarified Definitions and Concepts

1. "Highly Leveraged" and "Financial Entity"

In the proposed rules, the Commissions had proposed two possible definitions of "highly leveraged" for purposes of the major participant designations—either a ratio of total liabilities to equity, as determined in accordance with US GAAP, of 8 to 1 or of 15 to 1. In the Final Rules, however, the Commissions settled on an intermediate figure: a ratio of total liabilities to equity in excess of 12 to 1. The Final Rules also modify the definition of "financial entity" for purposes of the major participant definitions to exclude certain centralized hedging and treasury entities.

2. Major Categories of Swaps and Security-based Swaps

As to "major" categories of swaps and security-based swaps, the Guidance notes that the Commissions expect that mixed swaps would be placed in both the swap and security-based swap categories and that swaps or security-based swaps that are based on more than one item, instrument or risk should be placed in the category that most accurately describes the primary item, instrument or risk underlying the contract.

3. Uncollateralized Current Exposure

Further, in regard to the measure of uncollateralized current exposure in the presence of netting arrangements, the Final Rules note that an entity may calculate its exposure on a net basis by applying the terms of one or more master netting agreements with a counterparty. The Final Rules also state that the entity may account for offsetting positions entered into with that counterparty involving swaps or security-based swaps, as well as securities financing transactions, and other financial instruments and agreements that are subject to netting offsets for purposes of applicable bankruptcy law, to the extent consistent with the offsets provided by those master netting agreements.

The Final Rules also codify the method discussed in the proposing release related to the allocation of any uncollateralized exposure that remains following netting and the posting of collateral. The Final Rules provide that, for purposes of the substantial position analysis, the amount of net uncollateralized exposure that is attributable to a particular major category of swaps or security-based swaps would be allocated pro rata in a manner that compares the amount of the entity's out-of-the-money positions in that major category to its total out-of-the-money positions in all categories that are subject to the netting arrangements with that counterparty.

4. "Economically Appropriate Standard"

To qualify for the hedging or commercial risk mitigation major participant exemption, the relevant swap must be "economically appropriate" to the reduction of risks, a determination that will be based on the facts and circumstances applicable to the swap at the time such swap is entered into. While the "economically appropriate" standard has been adopted largely as proposed, the Guidance provides examples in the context of security-based swap positions that, depending on the applicable facts and circumstances, may satisfy that standard, including: (a) positions established to manage the default risk posed by a financial counterparty in connection with a separate transaction; (b) positions established to manage equity or market risk associated with certain employee compensation plans; and (c) positions established by a bank to manage counterparty risks in connection with loans the bank has made. The security-based swap position cannot materially over-hedge the underlying risk such that it could reasonably have a speculative effect. In addition, the position cannot introduce any new basis or other type of risk more than is reasonably necessary to manage the identified risks.

B. Safe Harbor

The Final Rules provide important safe harbors from the designation as a major participant. The Final Rules state that a person will not be deemed to be a major participant in any of the following four scenarios:

(a) Scenario 1: (i) The express terms of the person's arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $100 million to all such counterparties; and (ii) the person does not maintain notional positions of more than $2 billion in any major category of swaps or security-based swaps, or more than $4 billion in aggregate;

(b) Scenario 2: (i) The express terms of the person's arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $200 million to all such counterparties; and (ii) the person performs the major participant calculations, as of the end of every month, and the results of each of those monthly calculations indicate that the person's swap or security-based swap positions lead to no more than one-half of the level of current exposure, plus potential future exposure that would cause the person to be a major participant;

(c) Scenario 3: (i) The person's current uncollateralized exposure is in connection with a major category of swaps or security-based swaps is less than $500 million (or less than $1.5 billion with regard to the rate swap category); and (ii) the person performs certain modified major participant calculations, as of the end of every month, and the results of each of those monthly calculations indicate that the person's swap or security-based swap positions in each major category of swaps or security-based swaps are less than one-half of the substantial position threshold; and

(d) Scenario 4: The person's monthly calculations indicate that the person's positions across all major categories of swaps or security-based swaps are significantly less than the substantial counterparty exposure threshold.

The rules further provide that even if a person does not meet the conditions required to take advantage of the safe harbor, that fact by itself will not lead to a presumption that a person must perform the calculations required to determine if it is a major participant.

C. Ownership-related Exclusions and Other Exclusions

As with the SD/SSD designation, the Final Rules mandate that the major participant definitions should not encompass a person's swaps for which the counterparty is a majority-owned affiliate. Further, in contrast to the proposed rules, the Guidance states that an entity's swap positions, in general, would only be attributed to a parent, other affiliate, or guarantor for purposes of the major participant analysis, to the extent that the counterparties to those positions would have recourse to that other entity in connection with the position.

In addition, the Guidance notes that the major participant analysis that applies to the beneficial owners of managed swaps positions should focus on where the risk associated with those positions ultimately resides. For example, the Guidance notes that if the counterparties to a swap position within a managed account have recourse only to the assets of that account in the event of default, it would not be appropriate to attribute that position to its beneficial owner. However, to the extent that the counterparty to that position also has recourse to the beneficial owner, it would be appropriate to attribute the positions to the beneficial owner for purposes of the major participant analysis.

Despite the requests from commenters, the Final Rules do not provide for categorical exclusions for specific types of entities from the major participant definition, such as entities that maintain legacy portfolios, investment companies, ERISA plans, registered broker-dealers and/or registered futures commission merchants, sovereign wealth funds, banks, state-regulated insurers, private and state pension plans and registered DCOs or clearing agencies.

Further, while not granting a per se exclusion for foreign entities from the CEA's MSP or SD definition, the Release does make clear that foreign governments, foreign central banks and international financial institutions should not be required to register either as MSPs or SDs.

IV. Eligible Contract Participants (ECP)

Title VII of the Dodd-Frank Act makes it unlawful for any person that is not an ECP to enter into a swap except on and subject to the rules of a registered exchange or DCM. In addition, it is unlawful to offer, purchase, or sell a security-based swap to any non-ECP unless the security-based swap is first registered under the Securities Act of 1933. The Final Rules make explicit that SDs, SSDs and major participants are ECPs. We describe below some additional significant elements of the Final Rules as they relate to the further definition of the term ECP.

A. Retail Forex Pools

Rule 1.3(m)(5)(i) under the CEA further defines ECP by generally prohibiting a Forex Pool from qualifying as an ECP, if such Forex Pool directly enters into retail Forex transactions, and has one or more direct participants that are not ECPs.

B. Retail Forex Look Through

The Final Rules include a revision of Rule 1.3(m)(5)(ii) to provide that, in determining whether a commodity pool that is a direct participant in a transaction-level Forex Pool is an ECP, the indirect participants in the transaction-level Forex Pool will not be considered unless such Forex Pool, a commodity pool holding a direct or indirect interest in such Forex Pool, or any commodity pool in which such Forex Pool holds a direct or indirect interest, has been structured to evade Subtitle A of Title VII by permitting persons that are not ECPs to participate in agreements, contracts or transactions described in Section 2(c)(2)(B)(i) or Section 2(c)(2)(C)(i) of the CEA.7

The Guidance notes that one example of a scheme to evade is if a commodity pool tier has been included in the structure of the Forex Pool primarily to provide non-ECP participants exposure to retail Forex transactions, rather than to achieve any other legitimate business purpose.

The Guidance also provides examples of a "legitimate business purpose," including a fund of funds (FOF) operated primarily for the purpose of investing in underlying funds and using retail Forex transactions solely to hedge the currency risk posed by an unfavorable change in the exchange rate between the currency in which the underlying funds accept investments and the currency in which the FOF investors pay for their investments in the FOF.

Importantly, for purposes of Rule 1.3(m)(5), the Final Rules allow commodity pool operators (CPOs) and retail Forex transaction counterparties to rely on written representations from pool participants or potential pool participants that the person making the representation is an ECP, or from Forex Pools that the Forex Pool is an ECP, provided that the CPO or retail Forex transaction counterparty has a reasonable basis to rely on the representations.

Significantly, Rules 1.3(m)(5)&(6), which limit the commodity pools that can be defined as ECPs, will not be effective until the end of 2012. The Commissions intend to monitor developments in this area closely and to revisit the less stringent "Look Through" standard should they detect a pattern of misconduct.

C. Non-US Persons

The adopting Release notes that Forex Pools whose participants are limited solely to non-US persons and which are operated by CPOs located outside the US should not be subject to a US retail Forex regime. Thus, these persons will be considered ECPs for purposes of Rule 1.3(m)(5). The Final Rules provide, however, that if a participant is an entity organized principally for passive investment, it will be considered to be a non-US person for purposes of Rule 1.3(m)(5) only if all units of participation in the passive investment vehicle participant are held by non-US persons.

D. Safe Harbor for Pools with Assets Over $10 Million

The Release does provide some certainty to commodity pools that enter into retail Forex transactions that are well-capitalized and were not formed with fraudulent intent. Rule 1.3(m)(8) under the CEA provides that a commodity pool that enters a retail Forex transaction is an ECP, regardless of whether each participant in the pool is an ECP, if all of the following conditions are met: (a) the pool was not formed to evade Sections 2(c)(2)(B) or (C) of the CEA; (b) the pool has total assets greater than $10 million; and (c) the pool was formed and operated by a registered CPO or an adviser exempt under CEA Rule 4.13(a)(3).

Further, because many advisers of these pools had previously been exempt from registration under Rule 4.13(a)(4) (which has been rescinded), or under Rule 4.5 (which has been modified), and, therefore, would not have registered as CPOs, the Final Rules provide that the requirement that a pool be formed by a registered CPO is waived for pools formed before the end of 2012.

E. Line of Business Exclusion

The Final Rules also provide a "line of business" exclusion. Rule 1.3(m)(7) under the CEA permits an entity, in determining its net worth for purposes of the ECP definition, to include the net worth of its owners, solely for purposes of determining its ECP status for swaps used to hedge or mitigate commercial risk, provided that all of its owners are themselves ECPs (disregarding shell companies).

Further, the Final Rules specify that an individual may rely on the proprietorship provision of clause (A)(v) of the statutory definition for purposes of determining his or her status as an ECP owner of an entity, only if the proprietorship status arises independently of the business conducted by such entity and the individual proprietor acquires his or her interest in such entity either (a) in connection with the conduct of the individual's proprietorship, or (b) to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the proprietorship.

While the SEC had previously provided limited exemptive relief in connection with Exchange Act § 6(l), which prohibits any person from effecting a security-based swap transaction with a person that is not an ECP, unless effected on a national securities exchange, that relief expires as of the effective date of the Final Rules further defining ECP.

VI. Conclusion

While the Final Rules retain many of the provisions of the proposed rules, there are some significant differences. As discussed above, the Final Rules carve out a greater number of entities as a result of the substantially increased de minimis threshold. In addition, the Final Rules provide important exemptions or exclusions from designation as an SD, SSD, MSP, MSSP and ECP, while also targeting fraudulent activities surrounding retail Forex transactions.



1Securities Exchange Act Release No. 66,868, Further Definition of "Swap Dealer," "Security Based Swap Dealer," "Major Swap Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant" (April 27, 2012), available at

2Section 712(d)(1) of the Dodd-Frank Act directs the CFTC and the SEC, in consultation with the Federal Reserve, jointly to further define these terms. Section 712(d)(2)(A) provides that the Commissions shall jointly adopt such other rules regarding the definitions set forth in Section 712(d)(1) as they "determine are necessary and appropriate, in the public interest, and for the protection of investors." Also, Section 721(c) requires the CFTC to adopt a rule to further define the terms "swap dealer," "major swap participant," and "eligible contract participant" for the purpose of including transactions and entities that have been structured to evade Title VII. Finally, Section 761(b) permits the SEC to adopt a rule to further define the terms "security-based swap dealer," "major security-based swap participant," and "eligible contract participant," with regard to security-based swaps, for the purpose of including transactions and entities that have been structured to evade Title VII.

3Joint Proposing Release, Further Definition of "Swap Dealer," "Security Based Swap Dealer," "Major Swap Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant," 75 Fed. Reg. 80174 (December 21, 2010).

4"The SEC and CFTC Issue Joint Rules Defining Swap Dealers and Major Swap Participants," Paul M. Architzel, Jeannette K. Boot, Bruce H. Newman, Gail C. Bernstein, Elena Schwieger (December 10, 2010), available at

5Unless otherwise noted, references in this alert to "swaps" also include references to security-based swaps.

6Release at n.293.

7Sections 2(c)(2)(B)(i) and 2(c)(2)(C)(i) generally address retail foreign exchange.