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Financial Services Alert
CFTC and SEC Approve Entity Definition Rules

The CFTC and SEC approved, in simultaneous meetings, the final so called “entity definition rules” defining the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.”  The rules were prepared jointly by the two agencies.  The final rules and related explanatory releases are not yet available.  The final rules will become effective 60 days after publication in the Federal Register.

Swap Dealer/Security-Based Swap Dealer.  The Commissions announced that the new rules follow the text of the Dodd-Frank Act in defining “swap dealer” and “security-based swap dealer” as any person who (i) holds itself out as a dealer in swaps or security-based swaps, (ii) makes a market in swaps or security-based swaps, (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account or security-based swaps, or (iv) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.  However, swaps or security-based swaps entered for a person’ own account and not as part of a regular business are excluded. 

Both the CFTC and SEC rules contain a de minimis exemption from “swap dealer” and “security-based swap dealer” status.  The respective exemptions will be available to persons that, over the prior 12 months, entered into not more than $3 billion in notional of swaps (or $3 billion in notional of credit default swaps or $150 million of other types of security-based swaps).  During the initial phase-in period, however, the threshold amount will be $8 billion in notional of swaps (or $8 billion in notional of credit default swaps or $400 million of other types of security-based swaps). 

Major Swap Participant/Major Security-Based Swap Participant.  The new CFTC and SEC rules defining “major swap participant”  and “major security-based swap participant” also track those Dodd-Frank Act definitions, which capture (i) a person that maintains a “substantial position” in any of the major swap (or security-based swap) categories, subject to certain exclusions; (ii) a person whose outstanding swaps (or security-based swaps) create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; or (iii) any “financial entity” that is highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency and that maintains a ‘substantial position’ in any of the major swap categories.  (An entity that meets the definition of swap dealer or security-based swap dealer is excluded from the definition of major swap participant or major security-based swap dealer, respectively.)  The rules elaborate on many of the terms included in the definition and offer, for example, specific, numerical tests to determine whether a person holds a “substantial position” in various swap categories, as well as definitions of terms such as “substantial counterparty exposure” and “highly leveraged.”  The approach taken by the SEC to the definition of “major security-based swap participant” corresponds to the CFTC’s.

Hedging Transactions.  The rules exclude certain hedging transactions from the calculations used to determine whether an entity qualifies as a “swap dealer,” “security-based swap dealer,” “major swap participant,” or “major security-based swap participant,” respectively.  These exclusions are based on the Commissions’ position that bona fide hedging is inconsistent with swap dealing.   Additionally, positions held for hedging or mitigating commercial risk or employee benefit plan operational risks will be excluded from the determination of whether an entity is a “major swap participant” or “major security-based swap participant.”  It is important to note that the Commissions are not excluding all transactions that hedge or mitigate risk, but will exclude swaps entered into for the specific hedging purposes identified in the rules.  The rules will clarify the definition of “hedging,” using a narrow interpretation that will exclude swaps entered into for the purpose of portfolio hedging or anticipatory hedging.

© 2014 Goodwin Procter LLP. All rights reserved. This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP, Goodwin Procter (UK) LLP or their attorneys. Prior results do not guarantee similar outcome.

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