What is a Swap? Maybe (Almost) Everything? You Gotta Problem with That?April 12, 2012
This memorandum provides a brief, and critical, discussion of the term “swap” as it is defined (to use that word loosely) in Dodd-Frank. Readers interested in a fuller discussion of the term “swap” are referred to the much longer and more academic memorandum (75 pages with hundreds of citations)¸ “What is a Swap and Other Jurisdictional Questions,” that I will post through April on the “Cadwalader Cabinet.”
It has now been almost two years since Dodd-Frank was enacted in order to provide comprehensive regulation of those transactions the legislation calls “swaps.” In a world regulated by common sense, “what is a swap?” would have been the first question answered by the regulators—indeed, the term should have been clearly defined by the statute. After all, how can the regulators adopt rules that govern a group of transactions where the regulators themselves do not know the transactions to which the rules will apply? How can businesses comment as to whether the proposed rules are sensible, or even feasible, as applied to a set of transactions that is boundless?
In a world regulated by common sense, the next term to be defined would have been “dealer,” so that those entities most affected by the Dodd-Frank swaps regime would know who they were (and so that the regulators might know whom they were regulating and thus anticipate the consequences of regulation). The third “definition” would have been as to the geographic scope of Dodd-Frank: so that non-US persons could determine whether they would be subject to the statute, or so that they might limit their business to avoid the statute.
None of this is done. Instead, the regulators have proposed, and in some cases even adopted, rules dealing with recordkeeping (but concerning what transactions and by whom and where located?) and documentation (but concerning what transactions and by whom and where located?) and margin (but concerning what transactions and by whom and where located?). Meanwhile, the rules defining the term “swap” and “dealer” are postponed; and no date has been set for resolution of the geographic jurisdictional questions. The end result is that Dodd-Frank rules are proposed and adopted in a vacuum: they are to be applied to an undefined set of transactions, entered into by an undefined group of persons, located in undefined settings.
There are a few reasons for the regulatory delay of the definition of the term “swap”:
- The definition of “swap” in Dodd-Frank is impossibly, and I would guess unintentionally, over-broad. While it does not include the kitchen sink, it does include the contract to purchase and install the kitchen sink--if that contract has a price contingency relating to the timing of delivery and installation, the quality of work, or allowing the buyer to back-out of the deal for a fee, then the contract may be a “swap” within the meaning of Dodd-Frank.
- Congress amended the Commodity Exchange Act and the Securities Exchange Act to withdraw from the regulators the authority to provide exemptions from, or otherwise limit, the statutory definition of the term “swap.” This means that the regulators don’t actually have the legal authority to exclude the kitchen sink contingency contract, or insurance contracts for that matter, from the statutory definition of swap.
- The regulators themselves seem unsure of what they think should be, or what they want to regulate as, a swap. In the original proposal to define a regulated “swap,” as opposed to an unregulated “forward,” the CFTC, within the space of a few pages, (a) endorses cases that reach opposite results; (b) describes “intent to deliver” as (i) a “part of the analysis” for distinguishing swaps from forwards (but what are the other parts?) and (ii) an “essential part” of that analysis (are there any other parts?); and (c) then goes on to inquire as to the “primary purpose” of a swap or forward transaction (but does not explain what purposes are permissible or not). Ultimately, the regulators seem to give up on attempting an explanation of the swap/forward distinction, and the CFTC announces that it will determine what is a swap “in light of the totality of the circumstances” (but what circumstances? and what totality?) This “definition,” or absence of definition, does no good for the certainty of contract on which businesses depend, and are entitled to expect. It likewise does no good for the ability of commercial entities, financial entities, insurance companies and their state regulators, and consumers attempting to comply with the law, and to plan their business and consumer activities, if no one can define a swap except by its gestalt (and even that to be judged in retrospect).
II. What is a “Swap” As Actually “Defined” in Dodd-Frank?
Dodd-Frank provides a nine-pronged definition of the term “swap,” along with ten prongs of exclusion (and the regulators have created an eleventh “interpretative” prong). The nine inclusive prongs are, to be blunt, loosely drafted, ambiguous, and overlapping, with some of them entirely duplicative of others. That said, the key (over-inclusive) prongs are, in plain English, as follows:
- An agreement that provides for a payment based on the value of any commodity but that does not transfer ownership of the commodity, or an agreement that provides for payment based on an index or measure.
- An option on any property or an option that is tied to any quantitative measurement or a financial or economic measure.
- Any contract as to which any payment or delivery term is associated with any event or contingency associated with a potential financial, economic, or commercial consequence.
- Any contract that has been structured to evade being a swap.
There are also various exclusions from the scope of these prongs. Among the significant ones are debt securities, floating rate bank loans and bank deposits.
III. Provide Some Examples.
Essentially, unless there is an exemption, every contract that has an uncertain payment amount, or that has an “out” for the obligation to make or take delivery, is potentially a swap. Here are a few simple, but important, examples.
- A home buyer obtains a floating rate mortgage from a credit union on which the mortgage payments are linked to LIBOR. Since the payments are tied to an interest index, the mortgage may be a “swap.” This has significant legal consequences, including that the mortgage is illegal unless, among other things, the buyer qualifies as an eligible contract participant.
- A developer is interested in building an apartment building and purchases an option on a potential development property. The option allows the developer to walk away from the purchase. The option may be a “swap.”
- A car owner purchases accident insurance for the vehicle. As car insurance is a contract that will pay off if the owner’s vehicle smashes into another vehicle (an event of economic consequence to the car owner), the insurance policy may be a swap.
IV. Is it Really That Bad? Some Examples of Uncertainty Cited By the Regulators.
Below is a list of the types of contracts that the regulators concede are subject to uncertain treatment under Dodd-Frank. (It is not a full list; it includes only those specifically cited by the regulators themselves.)
- Guarantees of loans;
- Letters of credit;
- Guarantees of swaps;
- Insurance contracts of the following types: variable universal life insurance and annuity contracts, private passenger or commercial automobile, homeowners, mortgage, commercial multiperil, general liability, professional liability, workers compensation, fire and allied lines, farm owners multiperil, aircraft, fidelity, surety, medical malpractice, ocean marine, inland marine, and boiler and machinery insurance;
- Contracts, consumer and commercial, of the following types: installment sales contracts, business financing arrangements such as receivables financings, pensions and other post-retirement benefits, contracts relating to the performance of a service, standby liquidity agreements, reimbursement agreements, affiliate guarantees;
- Purchases, sales, leases or transfers of equipment and inventory;
- Mortgage securitizations, buying and selling mortgages, and forward trading of government agency mortgage-backed securities, TBA contracts;
- Capacity contracts, reserve sharing agreements, tolling agreements, energy managements agreements;
- Forward sales of emissions allowances, carbon offsets/credits and renewable energy certificates;
- Debt with a variable rate of interest;
- Commercial contracts containing acceleration, escalation or indexation clauses;
- Agreements to acquire personal property, real property, mortgages, employment, leave and service agreements; all contracts that contain contingent payment arrangements;
- All contracts with caps (such as consumer mortgages and utility rates);
- Loan participations;
- Options that, by their terms and when exercised, call for delivery of a physical commodity;
- Options that allow the buyer not to exercise if the option is out of the money.
V. How Did We Get Such a Big, Bad Definition?
This definitional problem is not a new one. In fact, the definitional problem existed, albeit on a much much smaller scale, as to the definition of “futures” in the Commodity Exchange Act, prior to the adoption of the Commodity Futures Modernization Act in 2000.
When Congress adopted the Commodity Futures Modernization Act in 2000, for the purpose of exempting swaps from regulation, it created a very broad definition of a “swap agreement” (and “over-the-counter derivatives instrument”) for the purposes of providing exemptions from the CEA in light of the problems created by the uncertain definition of the term futures. This broad definition of swap made sense, in that context, because Congress was making it clear that a particular type of transaction was not intended to be regulated. Unfortunately, when a definition that is intended to provide an exemption from regulation is used instead as a basis for regulation, there are unintended consequences. An illustrative hypothetical follows:
Suppose that Congress had passed an exemptive statute providing that “restaurants in the United States are exempted from any requirement of local law to tell diners the calorie count of the foods that the restaurants serve” – and, just to be clear, Congress defined the term “restaurant” to include a “private citizen who invites a non-family member to dine in her house.” No harm is done by the broad definition of restaurant, even though no sensible person would believe that a private citizen could be thought a “restaurant.”
Congress later decides that restaurants should disclose their calorie counts. Therefore, Congress requires that “each restaurant tell its diners how many calories are in the restaurant’s food, and, for the avoidance of doubt, the term “restaurant” includes a private citizen who invites a family member to dine in her house.”
Now that broad definition of restaurant has become a problem. And it gets worse.
- In adopting Dodd-Frank, Congress actually further expanded the existing definition of what had been a “swap” for exemptive purposes— (e.g., the definition now applies not only to transactions in “commodities,” but also to transactions in all “property” or “events”) (to stick with my “restaurant” analogy, not just to private citizens, but also to social clubs, colleges and street vendors).
- Congress denied the regulators the power to provide exemptions from the definition of “swap” (no carve-outs for private citizens, social clubs, colleges and street vendors).
- Congress provided that any attempt to evade the Dodd-Frank’s regulation of a “swap” was a crime (if the private citizen packs a picnic lunch to be eaten with third-parties outside her home, is that an “evasion”?).
VI. Can This Definitional Problem Be Solved?
Bluntly, the swap definition problem cannot really be fixed without corrective legislation. At a minimum, Congress should (i) deliberate as to how to define, by statute, the term “swap” and (ii) provide the regulators with exemptive authority to be used “in the public interest” (to use the common phraseology).
Failing corrective legislation, the regulators should (i) make a far more aggressive effort to limit the scope of the term “swap,” and (ii) hope that no one challenges their exemptive authority (or lack thereof). To some extent, the regulators have moved in this direction, although somewhat half-heartedly, by, for example, asserting that “insurance” is carved out from the definition of swap.
Nonetheless, I think it incumbent upon the regulators to be far more aggressive. After all, if the regulators can “interpret” some insurance contracts out of regulation as a swap, there is no reason why this power of interpretation should not be used more broadly. At a minimum, the regulators should interpret out of the definition of swap transactions the following:
- any loan on which the interest amounts are linked on a direct 1-1 basis to a common interest rate measure, such as LIBOR or Fed Funds;
- any option on a specific, non‑fungible physical asset, such as a particular parcel of real estate;
- any instrument commonly known as insurance that is sold by a regulated insurance company in the United States;
- any loan participation sold between banking institutions; and
- any merger or purchase agreement that provides for termination based on a “material adverse change” in the business or condition of the merged or acquired asset.
However the regulators elect to define a swap, I do believe it is their responsibility to the commercial, financial, insurance and consumer markets to define the word in a way that we can all understand what is intended. An economy can only thrive where it operates subject to rules that provide a high degree of legal certainty.1 For the regulators to say that they will judge whether a trade is a “swap” in light of the “totality of the circumstances” seems unsatisfactory to me as a guide to participants in the economy. If the regulators do not believe that they can provide more definitive advice in light of the expansiveness of Dodd-Frank, then it is incumbent on the regulators to go back to Congress and ask for a narrower definition and for exemptive authority.
1 See, e.g., "The Rule of Law Influences Sovereign Yields" on the Center for Financial Stability webpage. The report demonstrates a very close correlation between a high degree of legal certainty in a jurisdiction and low borrowing rates by the government. (The Center for Financial Stability is an independent, nonpartisan, and nonprofit think tank dedicated to financial markets for the benefit of investors, officials, and the public. Steven Lofchie also serves as a Legal Studies Senior Fellow at the Center.)
"I recognize that some readers of this memorandum believe that I will have pointed out these problems with the statutory definition of the term “swap,” because I do not like Dodd-Frank. It is absolutely true that I do not like Dodd-Frank, and that I do not believe that the statute is good legal policy and that I have written previously (and intend to write more) as to what I perceive as its flaws. (In fact, I wrote my first piece criticizing “Dodd-Frank” more than a year before the statute was even proposed. See “Meet the New Regulators; Same as the Old Regulators”.) I hope that admission is not disqualifying. In fact, I would even hope that those who are better able to perceive the good in Dodd-Frank than I would seek to correct what I think are some fairly serious problems that create genuine uncertainty of a type that cannot be good for commerce in the United States." Steven Lofchie