Securities-Based Hybrids: Can They Never Qualify Under Part 34?

Reproduced with permission of Glasser LegalWorks, 150 Clove Road, Little Falls, NJ 07424. (800) 308-1700."

Michael Sackeim is Counsel at Brown & Wood llp, New York, and a member of the Board of Editors of Futures & Derivatives Law Report.

This article addresses whether the Commodity Futures Trading Commission's ("Commission") Part 34 Hybrid Exemption Rule ("Hybrid Exemption") may be applied to a debt security, equity or deposit instrument, as to which potential payments and losses (two-way indexation) are based on or derived from the value of one or more nonexempt securities.⁽¹⁾

The Hybrid Exemption Criteria

Rule 34.3(a) sets forth the parameters of the Hybrid Exemption, including that a qualifying instrument will be exempt from all provisions of the Commodity Exchange Act ("CEA"), except Section 2(a)(1)(B). Section 2(a)(1)(B) is the provision that addresses securities-based futures contracts. Section 2(a)(1)(B)(ii) does not prohibit, but instead sets forth special requirements for the approval by both the Commission and the SEC of futures contracts based on a group or index of securities. Section 2(a)(1)(B)(v) prohibits futures contracts based on the value of one or more nonexempt securities, except as provided in Section (2)(a)(1)(B)(ii) for a group or index of securities (both of these provisions will be referred to as the "Securities-based Futures Provisions").

With respect to a transaction that satisfies all of the other substantive criteria of the Hybrid Exemption, if the transaction is a prohibited securities-based futures contract, the Securities-based Futures Provisions override the potential applicability of the Hybrid Exemption. In almost every situation that I have encountered involving a two-way indexed securities-based transaction, lawyers have advised their clients that the Hybrid Exemption cannot be applied, but that resort must be had to the Commission's 1989 Statutory Interpretation Concerning Certain Hybrid Instruments ("Interpretation")--an exclusion that only applies to debt securities, preferred equity and deposit instruments. If a two-way indexed securities-based instrument is a trust unit or equity (rather than preferred equity) and if the Hybrid Exemption is not applied to exempt the instrument from the provisions of the CEA, the Interpretation will not be applicable because the instrument is not one of the three classes of qualifying instruments.

Most lawyers will advise their clients that they cannot proceed with the legal certainty that the instrument is exempt, excluded or beyond the coverage of the CEA and many will advise their clients not to proceed. But, is it correct that a two-way indexed securities-based instrument simply can never qualify for the Hybrid Exemption? The answer, in my view, is that such a conclusion is incorrect and that certain securities-based instruments may be amenable to treatment under the Hybrid Exemption.

The Hybrid Exemption does not state that it is not applicable to securities-based transactions. The Hybrid Exemption, at subsection (a) of Rule 34.3, provides only that it cannot be applied to a transaction that is subject to the Securities-based Futures Provisions, i.e., disqualified transactions are limited to securities-based futures contracts. If you are not dealing with a securities-based futures contract, but instead with a securities-based transaction that does not constitute a futures contract, the Hybrid Exemption safe harbor can be applied to exempt the transaction from the provisions of the CEA because (a) the Securities based Futures Provisions are not applicable in the first instance and (b) the self-executing Hybrid Exemption is a safe harbor that does not require as a condition to its application a determination that the transaction is actually subject to the CFA. The Hybrid Exemption is not being applied to evade the Securities-based Futures Provisions but is instead utilized (a) so that the parties may proceed with the legal certainty that the transaction is outside of the jurisdiction of the CEA and (b) importantly, to invoke the CEA Section 12(e) preemption of state and local gaming and bucket shop laws--a preemption that applies to exchange-traded futures contracts and exempt transactions under CEA Section 4(c), e.g., the Hybrid Exemption, which was adopted under the authority of CEA Section 4(c).

Whether a Two-Way Indexed Securities-Based Transaction Is a Futures Contract

Now for the hard part. If a lawyer is confronted with a two-way indexed securities-based transaction that is a deposit instrument, debt security or equity, and it is cash settled rather than settled by the physical delivery of the underlying security, is the transaction a futures contract--or is it a transaction that is not a futures contract and therefore eligible for the Hybrid Exemption. The answer depends on the factual circumstances. On one end of the spectrum, for example, may be a cash-settled standardized debt security to be sold to many retail public investors at $100 per unit, traded on a national securities exchange, and entered into for speculative (better to use the term "capital appreciation") reasons (the "Bad Example"). This transaction, the Bad Example, has many indicia of a futures contract and, most probably, avid readers of FDLR would take the view that the Hybrid Exemption could not be applied.

On the other end of the spectrum is the two-way indexed cash-settled securities-based debt security or equity that (a) has been negotiated as to its material economic terms and customized to meet the needs of a single institutional investor, (b) is subject to restrictions on transfers and resale, (c) is entered into for risk management or hedging purposes by the investor and (d) has been documented as containing these factors, such as through a representation letter or legend (the "Good Example"). Most lawyers would analyze the Good Example as having the economic indicia of a futures contract, but as not containing any of the other traditional elements of a futures contract, i.e., a lack of public participation, nonstandarized, nonfungible, not subject to liquidation by exchange-style offset and no margin or earnest money requirement.

There are no provisions of the CEA, Commission regulations, interpretations or court decisions that have characterized a transaction whose only resemblance to a futures contract is cash-settlement based on two-way indexing as actually being a futures contract, as opposed to performing economically like a futures contract. There are cases that have found a futures contract to exist in the absence of possessing every element of a futures contract, including the often-cited CFTC v. CoPetro Mgtg. Group, Inc.1 (speculative retail gas contracts) and Chicago Mercantile Exchange v. SEC's (SEC-approved exchange-traded stock index participations). But these cases involve participations by numerous investors and, in the case of CoPetro, violations of the CEA's antifraud provisions. With respect to the Good Example, given the case-by-case determinations of the nature of a futures contract, most lawyers would offer a reasoned but qualified opinion that it should or would not be characterized as a futures contract. Many lawyers might retain an economist to analyze the transaction to support the conclusion that it is not a futures contract. Therefore, in the case of the Good Example, the Hybrid Exemption is applicable if the characterization of the Good Example as not being a futures contract is correct. Why not consider applying the Hybrid Exemption to memorialize a possible safe harbor and benefit from the CEA preemption of state gaming and bucket shop laws?

Conclusion

Most lawyers simply will not even attempt to fit a securities-based transaction, even one such as the Good Example, into the Hybrid Exemption. It is important to note that few lawyers would categorically conclude that the Good Example actually is a futures contract as opposed to concluding that it merely possesses the economic indicia of a futures contract. In such a case, a lawyer might consider advising a client that (a) there is a strong argument that the Good Example is not a securities-based futures contract subject to the Securities-based Futures Provisions and therefore (b) if such conclusion is correct, the self-executing Hybrid Exemption could be applied and (c) to preserve in good faith the safe harbor and preemption argument, compliance with the Hybrid Exemption should be documented.

Clients need their lawyers to make prudent judgments, applying their knowledge of the CEA, cases, interpretations and the practices of the CFTC. The point I am making is that when we are confronted with a two-way indexed cash settled securities-based transaction, the potential applicability of the Hybrid Exemption should not be summarily dismissed. The Hybrid Exemption, along with other alternative analyses under the CEA, should always be considered. Depending on the unique factual circumstances, multiple characterizations, including that of an exempt transaction under the Hybrid Exemption, may be applied.

In my view, the position that a securities-based transaction is never eligible for the Hybrid Exemption is wrong. The first analysis should be whether the transaction is actually a futures contract, but is not subject to the Securities-based Futures Provisions, or whether it only economically resembles a futures contract, and therefore eligible for the Hybrid Exemption. If the transaction is eligible for the Hybrid Exemption, then you can proceed to determine whether the predominance test and the other criteria are satisfied.

1. FOOTNOTES:
   
   
2. 680 E2d 573 (9th Cirri. 1982).
3. 883 F.2d 537 (7th Cirri. 1989), cert. denied sub nom. Investment Company Institute v. SEC, 496 U.S. 936 (1990).