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Credit Derivatives: Safe Harbors Under The CAE

This article was edited and reviewed by FindLaw Attorney Writers | Last reviewed March 26, 2008

This article has been written and reviewed for legal accuracy, clarity, and style by FindLaw’s team of legal writers and attorneys and in accordance with our editorial standards.

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

Michael S. Sackheim is Counsel at Brown & Wood LLPNew York City and a member of the Board of Editors of Futures 8c Derivatives Law Report.

To protect against risks associated with particular equities, sovereign debt or bonds, or other credit risks, dealers have devised bilateral derivative instruments that allow credit exposures to be transferred. Credit derivatives are packaged in a variety of instruments, including credit default swaps, total rate of return swaps, credit linked structured notes, and credit default options. Among the issues presented by derivative transactions that transfer credit risks, one crucial question is whether these instruments are legal and enforceable under the Commodity Exchange Act, as amended ("CEA"),(1) or are subject to regulation as commodity futures contracts that may only lawfully be traded on federally regulated exchanges. This article addresses the safe harbors that should be examined when structuring credit derivative transactions, in order to proceed with the certainty that the transaction will not be challenged by the Commodity Futures Trading Commission ("CFTC") or otherwise deemed unenforceable because of the CEA.

Introduction

Pursuant to CEA §§ 2(a)(1)(A)(i) and 4c(b), the CFTC has exclusive jurisdiction with respect to the trading of contracts of sale of commodities for future delivery ("futures contracts"), options on futures contracts, and options directly on commodities (collectively, "commodity contracts"). CEA § 2(a)(1)(B)(ii) excludes from the coverage of the CEA options directly on one or more securities, including any group or index of securities, or any interest therein or based on the value thereof. The term "commodity" is defined by CEA § la(3) to include all "goods and articles . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." CEA § 2(a)(1)(B)(v) prohibits futures contracts for the delivery of or based on the value of any nonexempt security (other than a municipal security). Futures contracts and options on futures contracts based on broad-based indices or groups of securities are permitted, although pursuant to CEA § 2(a)(1)(B)(iv) the Securities and Exchange Commission must concur in the CFTC's approval of a stock index futures contract, and the contract must be cash-settled and satisfy special antimanipulation and other criteria set forth in CEA § 2(a)(1)(B)(ii). A securities-based derivative instrument, if it is in fact a futures contract, cannot be the subject of a CFTC exemption from the requirements of CEA § 2(a)(1)(B) pertaining to either the ban on securities-based futures contracts or the special requirements for stock index futures contracts.

The CEA, at § 2(a)(1)(A)(ii), exempts from its coverage, among other transactions, "transactions in foreign currency, security warrants, security rights . . . government securities . . . unless such transactions involve the sale thereof for future delivery conducted on a board of trade." The CFTC and several federal courts have held that a "board of trade" does not have to be a formally organized legal entity but may exist by virtue of otherwise unregulated commodity transactions being engaged in between a broker and its general public customers, as opposed to sophisticated institutional customers.(2) The CEA, at § la(11), also excludes contracts for the sale of cash commodities for deferred shipment or delivery, traditionally referred to as forward contracts, from the coverage of the CEA.

Subject to certain exceptions, CEA § 4(a) requires that all trading in commodity contracts be conducted on or subject to the rules of a board of trade that has been designated as a contract market for such trading by the CFTC. This is customarily referred to as either the "exchange-trading requirement" or the "off-exchange prohibition." For example, the New York Mercantile Exchange ("NYMEX") is a board of trade that has been designated as a contract market for the trading of many energy-based futures contracts, and must be redesignated for each newly listed futures contract. The types of transactions traded on the NYMEX are unlawful if traded "off-exchange," i.e., they would be illegal futures contracts, unless done pursuant to an exemption or safe harbor as discussed later in this article.(3)

Although the term "futures contract" is not defined in the CEA, the CFTC and courts have characterized a futures contract as a bilateral contract for the purchase or sale of a commodity for future delivery that has elements including any or all of the following:

  • A standardized agreement with respect to material terms;

  • Participation by the general public;

  • Entered into for the purpose of transferring price risk rather than transferring the commodity;

  • Variation margin requirements; and

  • The transaction, even if it provides for delivery, is extinguishable by futures exchange-style offset rather than physical delivery.(4)

    Because the primary economic purpose of a futures contract is to shift the risk of price changes of a commodity without actually transferring the commodity, a hallmark of these transactions is their use by investors for speculative purposes.

    An option, also not defined in the CEA, has been found to have elements including:

  • A nonrefundable upfront charge, or premium;

  • The grant of the right, but not the obligation, to purchase or sell the underlying commodity; and

  • A profit potential based on the amount the value the underlying commodity exceeds the premium (and other charges) on the date the option is exercised.(5)

The CFTC has characterized various instruments as the economic equivalents of options, rather than as futures contracts, based, in part, on their exposures to loss being limited to the premium rather than dependent on the increase or decline in the price or value of the underlying commodity.(6) This economic analysis is particularly relevant when characterizing a credit derivative linked to the value of one or more underlying equities or debt securities (each, a "Referenced Security") as a securities option that falls outside of the jurisdiction of the CFTC pursuant to CEA § 2(a)(1)(B)(ii).

Typical Credit Swaps

Credit derivatives that are swap transactions are generally documented on master agreements, most frequently the master agreement published by the International Swaps and Derivatives Association, Inc. ("ISDA"). Two common forms of credit swaps that are used to transfer credit risks are the total return swap ("TRS") and the credit default swap ("CDS").(7) Each typically has a predetermined notional amount and seeks to transfer the credit risk concerning a Referenced Security, or the credit risk associated with the issuers of one or more Referenced Securities. ISDA has recently published a "Confirmation of OTC Credit Swap Transaction Single Reference Entity Non-Sovereign" ("Credit Confirmation") that is often customized and the "1999 ISDA Credit Derivatives Definitions."

A CDS provides protection against credit losses associated with a default on one or more Referenced Securities. The swap purchaser, i.e., the beneficiary of the credit protection ("Buyer"), exchanges the credit risk it originally had concerning the issuer of the Referenced Security for the credit risk of the provider of the swap, typically a highly-rated financial intermediary such as a derivatives dealer ("Seller"), without being required to divest itself of the underlying asset. In some cases, such as a CDS meant to protect against loans in an emerging market country, the Referenced Security may be the country's government bond or even a country or regional index. A CDS has been described as very similar to a standby letter of credit.(8) In a CDS, the Buyer agrees to pay to the Seller a periodic fee, typically amounting to a certain number of basis points on the par value of the Referenced Security. In return, the Seller agrees to pay the Buyer an agreed upon, market-based, post-default amount or a predetermined fixed percentage of the value of the Referenced Security contingent upon the occurrence of a credit default. The Seller makes no payment until there is a default, typically defined in the Credit Confirmation to include, for example, a bankruptcy, cross acceleration, downgrade, repudiation, restructuring or payment default. In some instances, the Seller is not required to make any payments to the Buyer until a pre-established loss threshold has been exceeded in conjunction with a default event. The CDS is terminated if there is a credit default concerning the Referenced Security prior to the maturity of the CDS. The amount owed by the Seller is the difference between the Referenced Security's initial principal (or notional) amount and the actual market value of the defaulted Reference Security. The Seller may have the option to purchase the defaulted Referenced Security from the Buyer at a set price. Alternatively, the CDS may call for a fixed payment in the event of a credit default.

In a typical TRS, the Buyer agrees to pay the Seller the total return on the Referenced Security, which consists of the dividend payments on equity or the interest payments on debt, as well as any appreciation in the market value of the Referenced Security from the origination date of the TRS to the date of the credit event or maturity. The Seller agrees to pay to the Buyer an interest rate plus any depreciation in the market value of the Referenced Security measured from the origination date of the TRS to the date of the credit event or maturity. At each periodic payment exchange date, or upon default, at which point the TRS may, but need not, terminate, any depreciation or appreciation in the amortized value of the Referenced Security is calculated as the difference between the notional principal balance of the reference asset and the dealer price, determined either by referring to a market quotation source or by polling a group of referenced dealers. The Buyer has transferred the risk of the Referenced Security but not the ownership of the Referenced Security.(9) As in a CDS, the TRS Seller may have the option of purchasing the underlying Referenced Security from the Buyer at a predetermined price or at the dealer price. Typically, a TRS may not terminate upon default of the Referenced Security. Instead, payments would continue to be made on subsequent payment dates based on the Referenced Security's post-default prices until the TRS's maturity.

CFTC Safe Harbors for Swaps

Some swap transactions may contain one or more elements of futures contracts. The exchange of future payments of income or interest on the underlying Referenced Security as a means to transfer price risk constitutes one element of "futurity," which may be sufficient to characterize a transaction as a futures contract. To date, no privately negotiated swap transaction has been found by a court or the CFTC to be a commodity contract.(10) Significantly, neither CDS or TRS swaps are known to have been offered or sold to the general public. These forms of swaps are typically privately negotiated and entered into by sophisticated financial and commercial institutions, although it is possible that a qualified natural person could utilize a CDS or TRS. In a CDS and TRS, each counterparty assumes the credit risk of the other based on diligent analysis and written representations and warranties. Because CDS and TRS swaps are the product of customization and negotiation, they are not the types of fungible or standardized transactions that are tradable on a futures exchange. For these reasons, it is improbable that a CDS or TRS swap could be characterized as a futures contract subject to regulation under the CEA. However, to the extent a CDS or TRS swap transaction may arguably possess elements of a futures contract, it may not be transacted with the legal certainty that it is free from the off-exchange prohibition of the CEA unless it qualifies for a CFTC safe harbor from regulation.(11) Such legal uncertainty may have a negative impact on the market for these transactions.

Although Part 35 of the CFTC's regulations, entitled "Exemption of Swap Agreements" ('Swap Exemption")(12) provides a potential exemption for certain swaps, the Swap Exemption's definition of a swap agreement only applies to various interest rate-based, commodity-based and currency-based swaps, and similar agreements including options. However, the definition does not specifically include a securities-based swap.(13) The Swap Exemption's criteria are: (a) the parties must be "eligible swap participants," e.g., financial and regulated entities satisfying certain criteria and high net worth individuals; (b) the swap must not have standardized material economic terms; (c) counterparty creditworthiness must be a material consideration in entering into the swap; and (d) the swap must not be entered into through a "multilateral transaction execution facility."(14) There is, however, an argument that because the Swap Exemption applies to "commodity swaps," to the extent the "commodity" in the CDS or TRS swap is considered not to be the price or value of a Referenced Security but to be the underlying credit default event, such as a corporate restructuring, which arguably could fit the CEA § la(3) definition of a "commodity," the Swap Exemption could apply.

By its own terms, the Swap Exemption may not be applied to securities-based swap agreements that are futures contracts to exempt them from CEA § 2(a)(1)(B)'s prohibition of futures contracts based on the value of, or directly on, one or more nonexempt securities or the special requirements for futures contracts based on a group or index of securities.(15) If the occurrence of a credit event such as a corporate restructuring is the trigger for the payments on the CDS or TRS prior to maturity, rather than the depreciation in the market value of the Referenced Security, the CDS or TRS may possibly be characterized as a swap not based on the value of, or directly on, the Referenced Security, but instead on some other "commodity" that is not a security. In such a case, there may be an argument that the Swap Exemption is applicable because it is not being used to exempt a transaction from the requirements of CEA § 2(a)(1)(B)(ii) concerning securities-based futures contracts. Furthermore, the "commodity" underlying some credit derivatives may not be a security at all, such as a portfolio of commercial or consumer loans, in which case the Swap Exemption may more clearly be applied to the transaction. Importantly, pursuant to CEA § 12(e)(2), transactions that qualify for the Swap Exemption benefit from a preemption from the applicability of state and local gaming and bucket shop laws.(16)

If a CDS or TRS is arguably a futures contract, and if the Swap Exemption is either inapplicable or cannot be relied upon with a high level of comfort, reliance may be placed on the CFTC's 1989 "Policy Statement Concerning Swap Transactions" ("Swaps Safe Harbor"),(17) an alternative nonexclusive safe harbor from regulation by the CFTC for qualifying credit swap agreements. The CFTC has advised that the Swaps Safe Harbor applies to securities-based swaps.(18) Under the Swaps Safe Harbor, a swap is characterized as "an agreement between two parties to exchange a series of cash flows measured by different interest rates, exchange rates or prices with payments calculated by reference to a principal base (notional amount)." The Swaps Safe Harbor applies only to swap agreements settled in cash and options on such cash-settled swap agreements, with foreign currencies considered to be cash. Therefore, to the extent a credit swap provides for physical delivery of the Referenced Security, the transaction will not qualify for the Swaps Safe Harbor.

The Swaps Safe Harbor requires that qualifying swap agreements have the following elements:

  • Individually tailored terms;

  • Absence of exchange-style offset;

  • Absence of a clearing organization or margin system;

  • The transaction is undertaken in conjunction with each party's line of business (there is not a requirement that the parties be "eligible swap participants" as in the Swap Exemption); this requirement does not preclude a counterparty to the swap being a financial intermediary; and

  • A prohibition against marketing the swap to the public.

If a cash-settled CDS or TRS satisfies the criteria of the Swaps Safe Harbor, it may be transacted with the legal certainty that is it not subject to any enforcement action by the CFTC based on its being recharacterized as an unlawful commodity contract. The Swaps Safe Harbor, as an interpretation and statement of prosecutorial discretion by an expert agency, would also be persuasive authority in a court proceeding concerning enforceability in the event of litigation between the swap counterparties or third parties with respect to the swap. However, compliance with the Swaps Safe Harbor will not estop private parties from litigating and a court from adjudicating the status of the transaction under the CEA.

Forward Contract Exclusion

A CDS or TRS that is intended to be settled by physical delivery of the Referenced Security or, in some cases, by the delivery of a substitute obligation or equity of the issuer of the Referenced Security, rather than by cash-settlement, is not eligible for the Swaps Safe Harbor. To the extent the parties are concerned than a physically-settled credit swap may be subject to being recharacterized as a commodity contract subject to the CEA's prohibition, it is prudent to seek to fit such a physically-settled swap within the CEA § la(11) forward contract exclusion. Swap transactions that are not intended to be physically settled and are ultimately cash-settled would not fit within the forward contract exclusion. Many financial transactions are either settled by book-entry, netted against other similar transactions, or ultimately cash-settled between the participants. The CFTC should address the issue of whether the forward contract exclusion could be applied to financial transactions, such as swaps, involving underlying equity and debt instruments that are entered into for business-related purposes and may conveniently and economically be settled by means other than physical delivery.(19)

The questions of what forms of transactions should be covered by the CEA's forward contract exclusion and whether characterization as a forward contract turns on the issue of the types of participants to the transaction must be addressed by the CFTC and Congress. A May 1999 report issued by the U.S. General Accounting Office entitled "The Commodity Exchange Act, Issues Related to the Commodity Futures Trading Commission's Reauthorization" ("GAO Report")(20) found that forward contracts were excluded from the regulatory coverage of the CEA to facilitate the movement of commodities through the merchandising chain. Consistent with the CEA reference to forward contracts involving the sale of cash commodities for deferred delivery, forward contracts have been distinguished from futures contracts on the basis of whether the contract served primarily as a vehicle for physical delivery of a commodity or for financial risk shifting based on the fluctuating value of the commodity. Because forward contracts primarily serve as a merchandizing tool, they are expected to result in delivery of the commodity at a later date. In contrast, futures contracts primarily serve a financial risk-transferring function and actual delivery is not generally expected to occur, e.g., cash-settlements and exchange-style offset settlements distinguish futures contracts from forward contracts.

In its 1990 "Statutory Interpretation on Forward Transactions,"(21) the CFTC concluded that so-called Brent oil contracts were forward contracts that need not be traded only on, or subject to, the rules of regulated futures exchanges, notwithstanding that their delivery obligations could be, and were, routinely offset.(22) This forward contract analysis was based on the Brent oil contracts" requirement that the commercial parties intended and agreed to make and take delivery of oil, even though they routinely did not do so. The CFTC found that the initial Brent oil contracts did not include any provisions that enabled the parties to settle their contractual obligations through means other than physical delivery. The CFTC's application of the forward contract exclusion was premised upon the commercial parties' initial binding delivery obligations, which imposed substantial economic risks to the parties, even though physical delivery was routinely extinguished by separate, individually negotiated, new agreements that provided for cash payment-of-differences between parties.

The GAO Report found that the CFTC's Statutory Interpretation did not provide a clear basis for distinguishing forward contracts from futures contracts because it did not preclude forward contracts being settled routinely without delivery and being used primarily for risk-shifting or speculative purposes instead of merchandising purposes. Indeed, one CFTC Commissioner dissented from the Statutory Interpretation, arguing that it made the forward contract exclusion potentially applicable to standardized, offsetable noncommercial transactions. The evolution of certain forms of transactions in which delivery may not routinely occur has made it difficult to distinguish unregulated forward contracts from regulated futures contracts and can result in enforceability risk, e.g., they may be unenforceable between private parties if the transactions are found to be unlawful futures contracts.

In 1995, the CFTC settled an enforcement action against MG Refining and Marketing Inc. for selling illegal, off-exchange futures to commercial counterparties.(23) The transactions purportedly required the delivery of energy products in the future at a price established by the parties at the initiation of the agreement. These contracts provided counterparties with a contractual right to settle the contracts in cash without delivery of the underlying commodity, which right could be invoked if the price of the underlying commodity reached a pre-established level. Without any adjudication on the merits, a CFTC settlement order found these contracts to be illegal off-exchange futures contracts, based largely on the CFTC's finding that the contractual right to offset is a critical element distinguishing a futures contract from an unregulated forward contract.(24) The GAO Report found that market participants believe that the MG settlement broadened the definition of a futures contract and resulted in "greater legal risk for forwards and securities-based swaps."

In a footnote to its 1990 Statutory Interpretation, the CFTC stated that it would address at a later time the applicability of the forward contract exclusion to "commercial transactions which are only settled in cash."(25) The CFTC has yet to address this issue, but it may be that a credit derivative whose Referenced Security is settled by book-entry may not be disqualified from the forward contract exclusion. Therefore, for a credit derivative possibly to qualify for the CEA's forward contract exclusion, its elements should include:

  • A commercial counterparty whose business involves the Referenced Security or other obligations of the issuer of the Referenced Security;

  • A binding delivery obligation with respect to the Referenced Security or a substitute obligation, although a reasoned argument may be made that book-entry of a financial instrument, as distinguished from physical delivery of a hard commodity such as gold or wheat, constitutes valid delivery for a forward contract; and

  • The absence of an exchange-style offset mechanism agreed upon at the initiation of the transaction. If the CDS or TRS is a deliverable forward contract, it would be excluded from the CEA's regulatory prohibitions and would not need to qualify for the CFTC's Swaps Safe Harbor, which, in any event, only applies to cash-settled transactions.

Typical Credit Securities

The two most common forms of credit derivatives that are also securities are credit default options ("CDO") and credit linked structured notes ("CLSN"). The CDO permits the Buyer of the protection to hedge against credit default events with respect to a Referenced Security. A CDO is typically a negotiated and customized option entered into between a financial intermediary--the Seller, and the purchaser of the credit protection--the Buyer. In a callable CDO, the Buyer has the right, but not the obligation, to purchase the Referenced Security at a predetermined price for either a defined period of time or on a specific exercise date. A puttable CDO gives the Buyer the right, but not the obligation, to sell the Referenced Security to the Seller under the above exercise terms. Like other credit derivatives, the CDO can be based on more than one or a basket of Referenced Securities, or a spread between Referenced Securities and a marker such as the Prime Rate or another interest rate, or it can be linked to other obligations or assets. The CDO is typically settled by physical delivery by the Buyer to the Seller of the Referenced Security. The CLSN is a debt security issued by an investment grade entity or a bankruptcy-remote special purpose vehicle that has a fixed or floating rate coupon and a highly structured maturity payment provision. At maturity, the principal is repaid in full unless there is a defined credit default event with respect to a Referenced Security, in which case either a predetermined fixed amount or the then current value of the Referenced Security is paid to the Buyer.

Securities Option Analysis

Regardless of the form of the credit derivative instrument, if it is based on the price or value of a security or index or group of securities, and it can be characterized as the economic equivalent of a securities option, CEA § 2(a)(1)(B)(ii) may be applicable to exclude the transaction from the jurisdiction of the CFTC.(26) In CFTC Interpretative Letter No. 94-32 (Off-Exchange Task Force, 1994),(27) the CFTC staff examined three financial instruments indexed to the values of individual securities. Two of the financial products were described as having payout characteristics similar to stock options, i.e., (a) the payout of a call option becomes positive and rises as the price of the stock rises above the strike price specified in the option and (b) the payout of a put option becomes positive and rises as the price of the stock falls below the strike price specified in the option. The CFTC staff found that "in the vicinity of the strike price, an option effectively exhibits one-way price indexing. However, as an option goes deeper in-the-money, it takes on more of the characteristics of a futures contract as the option's payout becomes increasingly two-way indexed." (Emphasis added.)

The CFTC has frequently used this one-way versus two-way indexation analysis to characterize a transaction as the economic equivalent of an option. To put it another way, in a one-way indexed instrument that may be characterized as an option, the investor's exposure to profit is limited to the fluctuating value of the commodity, or security, either above or below the strike price, but the investor is not fully exposed to profits resulting from price fluctuations both above and below the strike price. This economic equivalent analysis is important with respect to credit derivatives based on the value of a Referenced Security. If the transaction has a one-way payout characteristic, it may reasonably be characterized as having elements of a security option excluded from the coverage of CEA. One appellate court wrote that "[o]ptions are written out of the money, limited in time and establish a careful balance among premium, strike price, and duration."(28) The CFTC staff, in Letter No. 94-32, considered the court's out-of-the-money analysis as referring to the one-way indexation attribute of an option. However, if based on the price of a commodity (the Referenced Security), the credit derivative has a two-way indexed payout, or two-way exposure to loss, it may be subject to challenge as a futures contract, in which case it would be prudent to seek to qualify the transaction under one or more CEA safe harbors or exemptions.

A CDO is not only termed and marketed as an option, it possesses the economic equivalent characteristic that the CFTC frequently relies upon in characterizing a transaction as an option. Typically, the defined credit default event affects the value of the Referenced Security. The CDO economically functions as a put or call option in that the Buyer can only exercise the option if the Referenced Security's value or price drops below (for a put) or above (for a call) the strike price based upon the occurrence of a credit event. If it is properly characterized as a securities option, the CDO is excluded from the jurisdictional coverage of the CEA and need not satisfy any special CFTC safe harbor exemption or exclusion. If the Referenced Security is deliverable, the CDO may also be eligible for the forward contract exclusion.

The Office of the Comptroller of the Currency, in describing CDS swaps, wrote that the risk hedger, i.e., the Buyer of credit protection "pays a fee, which effectively represents an option premium, in return for the right to receive a conditional payment" upon a credit event.(29) In this regard, a CDS may also be viewed as a form of option and, if on a Referenced Security, it may also be a securities option excluded from the coverage of the CEA.

Arguably, a CLSN may also be viewed as an option directly on, or based on the value of or an interest in the Referenced Security, which would constitute a securities option outside of the coverage of the CEA. Generally, the plain vanilla CLSN has a coupon and requires the full repayment of the principal investment unless a credit default event occurs, in which event, a lower predetermined amount is paid or the market value of the Referenced Security is paid. In such a case, the CLSN functions as a contingent debt security with an embedded credit default event option linked to the Referenced Security. To the extent the exposure to loss is limited to the principal investment or any portion thereof, and the exposure to profit is limited to the fluctuating value of the Referenced Security either above or below the strike price, but not above and below the strike price (such as an option struck deep-in-the-money), the CLSN exhibits the one-way indexation factor that the CFTC views as the important economic equivalent of an option. Under such an analysis, the CLSN should be characterized as a securities option outside of the jurisdiction of the CFTC. However, for legal certainty purposes, it may be prudent to also seek to qualify the CLSN under one additional CFTC safe harbor, discussed below.

CFTC Hybrid Instrument Safe Harbors

In 1989, the CFTC recognized that certain instruments combined characteristics of securities or bank deposits with characteristics of commodity contracts and sought to exclude from the exchange-trading requirement and other CEA provisions those instruments whose commodity-dependent value was less than their commodity-independent value. The CFTC issued a 'statutory Interpretation Concerning Certain Hybrid Instruments" ("Hybrid Interpretation"),(30) that excludes from regulation under the CEA preferred equity and debt securities within the meaning of Section 2(1) of the Securities Act of 1933 and specified time deposits that have the following characteristics:

  • Indexation to a commodity on no more than a one-to-one basis, i.e., no leverage;

  • A limited maximum loss, i.e., the issuer must receive full payment for the instrument upon its issuance and the investor cannot be required to pay additional out-of-pocket consideration during the life of the investment or its maturity related to the commodity-dependent component;

  • Inclusion of a significant commodity-independent component;

  • Lack of a severable commodity component;

  • No required delivery of a commodity by means of an instrument specified in the rules of a designated contract market; and

  • No marketing of the instrument as a commodity contract.

Unlike the Hybrid Exemption (an alternative safe harbor discussed below), the Hybrid Interpretation is applicable to a securities-based instrument even if it possesses elements of a futures contract.(31)

The typical CLSN carries a fixed coupon. A fixed-rate coupon represents a component the Hybrid Interpretation refers to as a commodity-independent yield ("CIY"). The Hybrid Interpretation provides that if the CIY is at least 50%, but no more than 150%, of the estimated annual yield at the time of issuance for a comparable non-hybrid instrument (the "Computation Test"), e.g., the interest rate of a debt instrument having similar risk characteristics to the CIY portion of the CLSN, issued by the same or a similar issuer for a similar maturity, the CLSN will be deemed to have a significant commodity-independent component. If the CIY coupon on the CLSN satisfies the Computation Test and the CLSN satisfies the remaining factors in the Hybrid Interpretation, such an instrument is excluded from regulation by the CFTC. In 1993, the CFTC adopted Part 34 of its regulations entitled "Regulation of Hybrid Instruments" ("Hybrid Exemption").(32) The Hybrid Exemption provides an exemption from CEA provisions for equity or debt securities within the definition of Section 2(1) of the Securities Act of 1933. To qualify for the self-executing Hybrid Exemption, the sum of the instrument's commodity-dependent values of its commodity-dependent components must be less than the commodity-independent value of its commodity-independent components (the "Predominance Test"),(33) and the instrument must satisfy the various other marketing, settlement and maximum loss criteria set forth in CFTC Rule 34.3. Similar to the CFTC Swap Exemption, the Hybrid Exemption cannot be used to exempt an instrument from the provisions of CEA § 2(a)(1)(B), i.e., the prohibition on futures contracts based on, or for the delivery of, nonexempt securities arid the special provisions for stock index futures contracts.(34)

The "commodity-dependent component" is defined under CFTC Rule 34.2 as "the payment of which results from indexing to, or calculation by reference to, the price of a commodity." It is possible that for certain CLSNs, the commodity-dependent component may not be the price decline of the Referenced Security but instead is the credit event, such as a corporate restructuring, and that the payment of the value of the Reference Security is merely the payment amount resulting from the referencing to the credit event. Assuming that (a) the commodity is the credit event that is not itself a security and (b) the CLSN is not appropriately characterized as a futures contract for the delivery of the Referenced Security or based on the value of the Referenced Security, the CLSN could qualify for the Hybrid Exemption. This argument would also apply if the underlying credit risk (the commodity) is a consumer or commercial loan that is not a security. Since, in many instances, the coupons on a CLSN are significant, it is possible that the payments based on the coupons could be greater than the contingent principal repayments based on the commodity-dependent component, in which case the CLSN may satisfy the Predominance Test. Assuming that the CLSN also satisfies the remaining criteria of the self-executing Hybrid Exemption, CEA § 12(e)(2) preempts the applicability of state and local gaming and bucket shop laws to the CLSN.

Conclusion

Innovative credit derivatives of the type addressed in this article present issues under a variety of regulatory schemes, including the CEA.(35) Establishing that any transaction is a futures contract or another form of commodity contract subject to the off-exchange prohibition and other requirements enforced by the CFTC is a challenging exercise, especially in situations where there is no general public participation and the instrument has been customized to meet the risk-management objectives of an institutional participant. The question of whether a particular credit event is a "commodity," as such term is defined in CEA § la(3) requires an analysis as to whether the credit event is a good, article, service, right or interest capable of being dealt in as a futures contract. However, for legal and regulatory certainty, it is prudent to seek to fit a credit derivative into one or more CFTC safe harbors from regulation under the CEA. A determination need not first be made that the credit derivative is in fact subject to the CEA. The safe harbors discussed in this article may be applied even to instruments that may not fall within the coverage of the CEA. It is also preferable to qualify a credit derivative for either the Swap Exemption or the Hybrid Exemption, rather than, or in addition to, the Swaps Safe Harbor or the Hybrid Interpretation, because (a) the Swaps Safe Harbor and the Hybrid Interpretation only bind the CFTC from regulating the transaction but do not necessarily preclude a counterparty from seeking to invalidate a transaction based on a claim of illegality under the CEA, and (b) state and local gaming and bucket shop laws will be preempted.

  1. FOOTNOTES:

  2. 7 U.S.C. §§ 1 et seq. (1994). Rules adopted under the CEA are found at 17 C.F.R. Ch. I (1998).
  3. See, e.g., In the Matter of Global Link Miami Corporation, CFTC Docket No. 98-1 (CFTC, May 24, 1999); and Rosner v. Peregine Finance Ltd., No. 95 Civ. 10904 (KTD), 1998 WL 249197 (S.D.N.Y., May 18, 1998); but see CFTC v. Franklin Bullion Limited, 99 F.3d 299 (9th Cir. 1996) ("board of trade" means "on-exchange").
  4. The CFTC has brought numerous enforcement actions seeking monetary and other penalties against persons engaged in unlawful off-exchange commodity contracts. See, e.g., CFTC v. Noble Metals International, Inc., 67 F.3d 766 (9th Cir. 1995), cert. denied sub nom., Schultz v. CFTC, 117 S.Ct. 64 (1996); and CFTC v. Morgan, Harris & Scott Ltd., 484 F.Supp. 168 (S.D.N.Y. 1979).
  5. See, e.g., CFTC v. CoPetro Marketing Group, Inc. 680 F.2d 573, 579-81 (9th Cir. 1982) ("the transaction must be viewed as a whole with a critical eye towards its underlying purpose"); and CFTC v. American Metal Exchange Corp., 693 F.Supp. 168, 192 (D.N.J. 1988).
  6. U.S. v. Bein, 728 F.2d 107, 111-12 (2d Cir. 1984).
  7. See. e.g., CFTC Interpretative Letter No. 94-32 (Off-Exchange Task Force, February 4, 1994), reprinted at Comm. Fut. L. Rep. (CCH) 626,042.
  8. Various federal banking regulators have described in great detail the forms of credit derivatives addressed in this article. See, e.g., Office of the Comptroller of the Currency, Bulletin 96-43 (August 12, 1996) ("OCC Bulletin"); and Federal Reserve Board, Supervisory Release 96-17 (August 12, 1996), each reprinted at Fed. Banking L. Rep. (CCH) 662-157. A good article describing these and other credit derivatives is Nierenberg and Kopp, Credit Derivatives: Tax Treatment of Total Return Swaps, Default Swaps, and Credit Linked Notes, 87 J. Taxation 82 (August 1997).
  9. See OCC Bulletin, id. at 71,747
  10. One U.S. bank regulator has advised that credit derivatives, such as CDS and TRS swaps, "can assist banks in arranging internal limits, while avoiding customer relationship problems that can arise if the bank sells the asset." OCC Bulletin, id. at 71,747.
  11. But see In re BT Securities Corp., CFTC Docket No. 95-3, 1994 CFTC LEXIS 340 (Dec. 22, 1994) (advice concerning an interest rate swap found to be commodity trading advice subject to a CEA antifraud provision).
  12. The then Chairman of the CFTC has testified that one concern in respect of swaps is "the legal uncertainty that may result from trading in instruments that do not comply with the terms and conditions of the current swaps exemption. To the extent that such instruments are futures and options and are not subject to another exemption in the Act, they violate the CEA." Testimony Concerning The Over-The-Counter Derivatives Market Before the House Committee on Agriculture Subcommittee on Risk Management and Specialty Crops (June 10, 1998) (testimony of Brooksley H. Born, Chairman of the CFTC), reprinted at Comm. Fut. L. Rep. (CCH) 627,317 at 46,416.
  13. 17 C.F.R. Part 35 (1998). The Swap Exemption was adopted in 1993 under the authority of CEA § 4(c). 58 Fed. Reg. 5587 (CFTC, January 22. 1993).
  14. The definition of "swap agreement" in the Swap Exemption is the same as the definition set forth in CEA § 4(c)(5)(B).
  15. CFTC Rule 35.2.
  16. The opening paragraph of CFTC Rule 35.2, which sets forth the limitation on the scope of the Swap Exemption, is based on the limitation contained in CEA § 4(c)(1), its enabling statutory provision.
  17. Exchange-traded commodity contracts and transactions that qualify for CFTC exemptions adopted under CEA § 4(c), e.g., the Swap Exemption and the Hybrid Exemption (discussed later in this article), are covered by the CEA § 12(e)(2) preemption. Bucket shops are places "where contracts for the purchase and sale of stocks or commodities are made which are entirely fictitious". Words and Phrases, "Bucket Shop" (West 1968) at 468. See, e.g., New York General Business Law § 351 (McKinney's 1988), a bucket shop statute, that prohibits contracts for the purchase or delivery, on credit or margin, of any "securities or commodities ... intending that such contract shall be ... settled ... upon the basis of the public market quotations of or prices made on any board of trade or exchange or market ... without intending a bona fide purchase or sale of the same"; and New York General Obligations Law §§ 5-401 et seq. (McKinney's 1988), an antigaming statute, that prohibits bets on "any unknown or contingent event". An argument can be made that these statutes are not intended to apply to transactions entered into by commercial participants in connection with their lawful business activities. See, e.g., Liss v. Manuel, 296 N.Y.S. 2d 627 (N.Y. Cty. Civ. Ct., 1968).
  18. 54 Fed. Reg. 30694 (CFTC, 1989).
  19. 58 Fed. Reg. 5587, at ftn. 11 (CFTC, January 22, 1993).
  20. The CFTC has recognized that certain swap transactions may he forward contracts or tit within the CFTC's exemption for trade options for certain commodities entered into for commercial purposes. 58 Fed.Reg. 5587, at ftn. 9 (CFTC, January 22. 1993).
  21. Report Number GAO/GGD-99-74, reprinted at Comm. Fut. L. Rep. (CCH) 627,610.
  22. 55 Fed. Reg. 39188 (CFTC, 1990).
  23. Immediately prior to the CFTC's issuance of its "Statutory Interpretation on Forward Contracts," Brent oil contracts were found by one court to be unlawful off-exchange futures contracts. Transnor (Bermuda) v. B.P. N. Am. Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990) ("This Court concludes that even where there is no 'right' of offset, the 'opportunity' to offset and a tacit expectation and common practice of offsetting suffices to deem the transaction a futures contract." id. at 1492).
  24. In re MG Relining & Marketing, Inc. and MG Futures. Inc., CFTC Docket No. 95-14, 1995 CFTC LEXIS 190 (CFTC July 27, 1995).
  25. In private litigation involving the same transactions that were the subject of the CFTC enforcement action against MG, a court refused to estop the customers from arguing that the transactions were not unlawful futures contracts, finding that the CFTC settlement order is "a consent judgment between a federal agency and a private corporation which is not the result of an actual adjudication of any of the issues." In re MG Refining & Marketing, Inc. Litigation, 94 Civ. 2512 (S.D.N.Y. January 22, 1997), reprinted at Comm. Fut. L. Rep. (CCH) 626,956, at 44,637.
  26. 55 Fed. Reg. 39188, at ftn. 2 (CFTC, Sept. 25, 1990).
  27. In In re BT Securities Corp., Exchange Act Release No. 35,136, Fed. Sec. L. Rep. (CCH) 685,477 (Dec. 22, 1994), the SEC found that an interest rate swap was a security because it contained an embedded option based on a government security. The CFTC found that advice furnished with respect to the same transaction constituted commodity trading advice requiring compliance with the CEA's antifraud rule for commodity trading advisors, CEA § 4o. In re BT Securities Corp., CFTC Docket No. 95-3, 194 CFTC LEXIS 340 (Dec. 22, 1994). Each of these enforcement actions was settled without an adjudication of the merits of the charges.
  28. Reprinted at Comm. Fut. L. Rep. (CCH) 626,042.
  29. Chicago Mercantile Exchange v. SEC, 883 F.2d 537 (7th Cir. 1986).
  30. See OCC Bulletin, supra note 7, at 71,747.
  31. 55 Fed. Reg. 13582 (CFTC, April 11, 1990).
  32. See Letter dated September 22, 1993, from Sheila C. Barr, Acting Chairman, CFTC, to Arthur Levitt, Chairman, SEC.
  33. 58 Fed. Reg. 5585 (CFTC, January 22, 1993).
  34. The CFTC's suggested methodology for calculating the Predominance Test is set forth in the Hybrid Exemption proposal, 57 Fed. Reg. 53618 (CFTC, November 12. 1992).
  35. The opening paragraph of CFTC Rule 34.3, which sets forth the limitation on the scope of the Hybrid Exemption, is based on the limitation set forth in CEA § 4(c)(1), its enabling statutory provision. This is the same limitation as in the Swap Exemption discussed earlier.
  36. The CFTC has raised questions concerning the scope of its regulatory oversight of swap transactions, hybrid instruments and other over-the-counter transactions. CFTC, Over-the-Counter Derivatives Concept Release, 63 Fed. Reg. 26114 (CFTC, May 12, 1998).


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