On June 14, 2011, the Commodity Futures Trading Commission (“CFTC”) issued a notice of proposed order and request for comment1 (the “Proposed CFTC Order”) with respect to the effective dates of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)2 relating to the regulation of the swaps markets. On June 16, 2011, the Securities and Exchange Commission (“SEC” and, with the CFTC, the “Agencies”) released an order3 (the “SEC Order” and, with the Proposed CFTC Order, the “Orders”) granting temporary exemptions and other temporary relief, and providing information on compliance dates, applicable to the regulation of the security-based swaps markets. The deadline for commenting on the Proposed CFTC order is July 1, 2011, and the deadline for commenting on the SEC order is July 6, 2011.
Dodd-Frank was enacted on July 21, 2010. Through enactment of Title VII of Dodd-Frank, Congress sought to create a comprehensive regulatory regime applicable to the over-the-counter derivatives markets. These markets have to date been largely unregulated. Title VII of Dodd-Frank adds extensive new provisions relating to OTC derivatives to the Commodity Exchange Act (“CEA”), the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”), while eliminating provisions of those statutes that were added by the Commodity Futures Modernization Act (“CFMA”) to provide legal certainty with respect to OTC derivatives through various “safe harbors.” Dodd-Frank generally eliminates those safe harbors.
The amendments to the CEA, Securities Act and Exchange Act made by Title VII of Dodd-Frank, including the elimination of certain safe harbors for OTC derivatives, are generally effective on July 16, 2011 or not less than 60 days after a rulemaking is finalized, to the extent that a provision of Title VII “requires a rulemaking.” Because the Agencies have, to date, finalized very few regulations implementing Title VII, there has been a great deal of uncertainty and concern about what will happen to the legal foundations for the OTC derivatives markets on and after July 16. The Agencies issued their respective Orders in an attempt to make July 16 a “non-event” for these markets. However, the Orders take entirely different approaches to providing regulatory relief and raise complex issues that market participants should discuss with counsel.
The Proposed CFTC Order
Title VII of Dodd-Frank grants the CFTC authority to regulate the “swaps” markets and certain participants in these markets. Absent relief, certain provisions of Dodd-Frank applicable to swaps are scheduled to automatically go into effect on July 16, 2011. Among these provisions are substantive requirements applicable to market participants, as well as the elimination of the existing safe harbors from the applicability of other laws for many forms of OTC derivative transaction.
The Proposed CFTC Order would grant temporary relief from the July 16 statutory effective date in two parts — first, the CFTC is proposing to temporarily exempt persons or entities with respect to CEA provisions added or amended by Title VII of Dodd-Frank if those provisions reference any term that is subject to “further definition” under Title VII, and second, the CFTC is proposing to grant temporary relief from the elimination of the CEA safe harbors for certain agreements, contracts or transactions in certain types of commodities.
The Proposed CFTC Order groups Title VII provisions affecting the CEA into four categories: (1) provisions that expressly require a rulemaking, (2) provisions that are, on their face, self-effectuating but that reference terms subject to further rulemaking, (3) self-effectuating provisions that do not reference terms subject to further rulemaking, but that repeal provisions of the CEA and (4) self-effectuating provisions for which the CFTC is not proposing to provide any relief under the Proposed CFTC Order. Provisions in Category 1 are beyond the scope of the Proposed CFTC Order because such provisions are, by their own terms, not effective until a minimum of 60 days after CFTC-mandated rulemaking is completed. Category 4 provisions do not reference terms subject to further rulemaking and do not repeal current provisions of the CEA.
Absent further CFTC action, the Proposed CFTC Order will expire on December 31, 2011.4
Category 1: Self-Effectuating Provisions that are Expressly Subject to Rulemaking
Certain provisions of the CEA added or amended by Title VII are expressly subject to CFTC rulemaking and will have no effect on July 16 unless the CFTC has put in place final rules by that date.5 Such provisions are outside the scope of the Proposed CFTC Order. Included among the Category 1 provisions are those defined terms in the CEA that are themselves subject to being “further defined,” as listed below. Note, however, that the expanded definitions of “futures commission merchant” and “introducing broker” are not on the Category 1 list. However, to the extent that these definitions reference terms subject to further definition, the definitions may fall within Category 2. Category 1 provisions will become effective on such dates as are determined by the CFTC in the exercise of its broad discretion under Title VII to determine the timing of implementation provisions of Title VII.
Category 2: Self-Effectuating Provisions that Reference Terms Subject to “Further Definition”
Many provisions of the CEA added or amended by Title VII do not themselves expressly require further CFTC rulemaking in order to become effective on July 16. Certain of these provisions, however, rely upon or reference terms that are expressly required by Dodd-Frank to be “further defined.”
The terms subject to further definition are:
- “security-based swap”;
- “swap dealer”;
- “security-based swap dealer”;
- “major swap participant”;
- “major security-based swap participant”;
- “eligible contract participant”; and
- “security-based swap agreement.”
The Agencies have issued proposed rules to further define each of the terms listed above.6 However, those proposed rules will not be in effect by the July 16 statutory effective date. As these terms are central to the implementation of the regulatory framework established by Title VII, allowing self-effectuating provisions referencing these terms to go into effect without final definitions in place could lead to large-scale disruption of the swaps markets. The CFTC is therefore proposing to exempt persons and entities from virtually all Category 2 provisions of the CEA with respect to “those requirements or portions of such provisions that specifically relate to [the terms listed above].”7
For example, the new definitions of “commodity pool operator” (“CPO”) and “commodity trading advisor (“CTA”) require registration (subject to applicable exemptions) due to activities relating to “swaps” (e.g., currency swaps, interest rate swaps or broad-based stock index swaps), even if such persons do not engage in traditional exchange-traded futures activities. But because the term “swap” is subject to further definitional rulemaking, the CFTC is proposing exemptive relief to delay the effective date of the new CPO and CTA definitions pursuant to the CFTC’s general exemptive authority. Pursuant to the Proposed CFTC Order, persons who would be required to register as CPOs or CTAs based solely on their “swaps” activities will benefit from the proposed exemption and, if the exemption is finalized, will not need to become registered by July 16 as would otherwise be required under Dodd-Frank. However, the exemption will be temporary, so potential CPOs and CTAs should start familiarizing themselves with the registration process (and potentially applicable exemptions) and beginning the process of registering if necessary.
In addition, the Proposed CFTC Order would not affect the applicability of any provision of the CEA to transactions with retail customers in foreign currency. Note, however, that the addition of a “look-though” to the commodity pool prong of the definition of an “eligible contract participant” is listed by the CFTC as a Category 1 amendment, and therefore not effective on July 16, which would prevent commodity pools in which non-eligible contract participants are invested from becoming retail customers with respect to OTC foreign currency transactions.
The Proposed CFTC Order would not limit the CFTC’s anti-fraud or anti-manipulation authority (including new authorities created by Dodd-Frank with respect to swaps), nor would it affect the applicability of any provision of the CEA to futures contracts or options on futures contracts. This temporary exemptive relief would expire upon the earlier of (a) the date on which the CFTC issues final rules further defining the applicable term and (b) December 31, 2011.
Category 3: Self-Effectuating Provisions that Repeal CEA Provisions
The CEA includes provisions that exempt or exclude, to varying degrees, certain transactions from CFTC oversight. Among these provisions are “safe harbors” for off-exchange transactions in excluded commodities (including currencies, interest rates and exchange rates), exempt commodities (including energy and metal commodities), and other underlying interests. Dodd-Frank will eliminate virtually all of these safe harbors, effective July 16, 2011.
In 1993, years before the statutory safe harbors were added to the CEA, the CFTC adopted its Part 35 regulations, which provide a broad-based exemption from the CEA for “swap agreements,” irrespective of the nature of the underlying commodity. Although the enactment of the CFMA in 2000 rendered Part 35 moot with respect to many transactions, OTC transactions in agricultural commodities (for which no statutory safe harbor exists) have been conducted under Part 35 since 2000 and the CFTC has never repealed Part 35. In addition, in 1989, the CFTC issued its "Swaps Policy Statement" which set forth the criteria necessary for the CFTC to conclude that a "swap" is not an unlawful off-exchange futures contract. That document will take an increased relevance once the statutory safe harbors for OTC derivatives are eliminated from the CEA.
In the Proposed CFTC Order, the CFTC notes that, notwithstanding the elimination of the CEA statutory safe harbors for many OTC derivatives, parties may continue to rely on Part 35 to the extent they fully meet the requirements thereof. The CFTC is also proposing to extend Part 35 to parties and transactions that did not previously meet certain requirements of Part 35, provided that the relevant transaction (and the persons offering or entering into the transaction) would fall within the CEA statutory safe harbors, as in effect prior to July 16, 2011. Once again, this proposal would not in any way limit the CFTC anti-fraud or anti-manipulation authority with respect to the transactions in question. Under the Proposed CFTC Order, this temporary exemptive relief would expire on the earlier of (a) December 31, 2011 or (b) the repeal or replacement of Part 35 of the CFTC’s regulations. The CFTC is also proposing similar treatment for “commodity options” pursuant to Part 32 of the CFTC’s regulations.
Category 4: Provisions of Title VII that will go into Effect on July 16
Provisions of the CEA added or amended by Title VII that are not expressly subject to CFTC rulemaking and that do not rely on or reference any of the terms required to be “further defined” will become effective on July 16, 2011.8
Section 737 of Dodd-Frank requires the CFTC to establish speculative position limits for swaps that are economically equivalent to futures contracts traded on designated contract markets. This section became effective on the enactment date of Dodd-Frank on July 21, 2010. The Proposed CFTC Order advises that the exemptions proposed by the CFTC do not affect the effective date of section 737 position limits provisions (which already occurred in 2010). However, although the statutory provision is already effective, to the extent section 737 references "swaps," a term subject to further definition by the Agencies, it is reasonable to anticipate that final position limits rules in respect of economically equivalent swaps will not be implemented until the further definition of the term "swap" is finalized.
The SEC Order
Title VII of Dodd-Frank grants the SEC authority to regulate the “security-based swaps” markets and certain participants in these markets. Absent relief, certain provisions of Dodd-Frank applicable to the security-based swaps markets automatically go into effect on July 16, 2011. Among these provisions are substantive requirements applicable to market participants, as well as amendments to prior law that would cause security-based swaps to fall within the definition of a “security” for purposes of the Securities Act and Exchange Act. The impact of security-based swaps being treated as “securities” will be far-reaching and will require considerable time to evaluate. The SEC Order grants open-ended exemptive relief from the July 16 statutory deadline with respect to many (though not all) Securities Act and Exchange Act provisions added or amended by Title VII of Dodd-Frank relating to security-based swaps. This relief, while temporary, will not expire on a specific date that is independent of further SEC rulemaking. The SEC Order does not address the fact that security-based swaps will become securities effective July 16. The SEC has indicated that it will address that issue separately.9
As noted above, the CFTC took a broad and general approach to its proposed exemptive relief, leaving the applicability of that relief to specific CEA provisions open to further analysis and interpretation. The SEC, on the other hand, elected to address each Title VII requirement applicable to security-based swaps on a provision-by-provision basis, categorizing each such provision in one of three groups: (a) provisions for which compliance will (absent relief) be required as of July 16, 2011, (b) provisions for which compliance will be required upon registration, publication of final rules, or other SEC action, and (c) provisions that authorize or direct the SEC to take certain actions. The SEC Order then, where so determined by the SEC, affords relief from the July 16 effective date.
Provisions in the second group either apply only to certain registered persons for which the relevant registration processes have not yet been established or expressly require an SEC rulemaking. Neither type of provision will become effective automatically on July 16 and therefore no exemptive relief is being provided with respect to such provisions. Provisions in the third group similarly impose no obligation on market participants on July 16, except to the extent that the SEC has already taken the relevant action. Provisions in the first group, however, would impose compliance obligations on market participants as of July 16 absent SEC exemptive relief. The SEC is providing exemptive relief with respect to the majority of these provisions.
Although the SEC Order is open to comment through July 6, the order itself will be effective upon publication in the Federal Register, which should occur within several days of its initial release. There is no expiration date attached to the SEC Order.
Although the Agencies have signaled their intention that July 16 be a “non-event” for the OTC derivatives markets, and have attempted to craft their respective Orders accordingly, the Agencies’ approaches to implementing relief from the July 16 effective date with respect to the provisions of Title VII of Dodd-Frank differ substantially. In addition, certain substantive provisions of Dodd-Frank impacting the OTC derivatives markets will nevertheless go into effect, either partly or entirely, on July 16 notwithstanding the Orders. Each market participant should carefully review the Orders and discuss with counsel the impact of the Orders on its own business in light of its particular circumstances.