Don't Call it a Swap: The CFTC Asserts Jurisdiction Where it Shouldn't
The Situation: In a federal district court complaint against Archegos Capital Management, LP ("Archegos"), the Commodity Futures Trading Commission ("CFTC") has asserted jurisdiction over what many view as security-based swaps ("SBSs") by effectively ignoring the presence of exchange-traded fund ("ETF") shares between a total return swap ("TRS") and the broad-based security indexes constituting the source of the ETFs' returns.
The Result: If the CFTC broadly adopts the characterization of TRSs on shares of ETFs that track broad-based security indexes ("Broad-based Index ETF TRSs") as CFTC-regulated swaps, many market participants would need to adjust the way they report such swaps and otherwise comply with applicable rules.
Looking Ahead: Archegos filed a motion to dismiss the CFTC's complaint and a related memorandum in support in which Archegos concedes that the Broad-based Index ETF TRSs are swaps. Affected parties should take note of the CFTC's view.
On April 27, 2022, the CFTC took the position in a complaint alleging fraud filed against Archegos, and in related settlements with Archegos executives, that certain derivatives with returns based on shares of ETFs that track broad-based security indexes, such as the S&P 500, are swaps rather than SBSs. In settlements with two senior Archegos employees, the CFTC stated in a footnote that "because certain swaps in connection with the fraud . . . are based on a broad-based securities index, this matter falls within the [CFTC's] jurisdiction" (and there is substantively similar language in the Archegos complaint). For this, the CFTC cited only the swap definition generally and a general interpretive principle from the 2012 Further Definition of "Swap" and SBS rulemaking adopting release ("Adopting Release") published jointly with the Securities and Exchange Commission ("SEC" and, together with the CFTC, the "Commissions"). That principle holds that "a Title VII instrument [(i.e., an over-the-counter derivative that potentially is a swap or an SBS or both)] in which the underlying reference of the instrument is a . . . broad-based [security index] is a swap subject to regulation by the CFTC."
What the CFTC Didn't Say
In claiming jurisdiction over the TRSs at issue in the foregoing manner, however, the CFTC neglected to mention that: (i) the direct underlying references of the TRSs were ETF shares, not broad-based security indexes; (ii) the Dodd-Frank Act ("Dodd-Frank") SBS definition states that a Title VII instrument based on a single security (ETF shares are single securities) is an SBS; (iii) in the Adopting Release, the Commissions declined to address a request from a commenter on the proposed rules leading to the Adopting Release for an interpretation (as a swap or SBS) of exactly this situation (i.e., a Title VII instrument on shares of an ETF that tracks a broad-based security index), noting that interested parties could request a joint interpretation from the Commissions; and (iv) Dodd-Frank Section 712(d)(4) provides that any interpretation or guidance by either Commission regarding a provision of Title VII of Dodd-Frank that required joint Commission rulemaking to implement, such as further defining "swap" and SBS, shall be effective only if issued jointly by both Commissions after consulting with the Federal Reserve Board.
Why the CFTC Arguably Should not Have Looked Through the ETF Shares
A TRS on an ETF that is designed to track a broad-based security index is not the same as a TRS on a broad-based security index. The return on a TRS on the ETF will be different from a TRS on the broad-based security index, as ETFs do not perfectly track the index due to tracking error, embedded management fees, etc. And TRSs on ETFs generally reference the NAV of the ETF itself, shares of which are securities, rather than the published index level.
Although the Commissions did determine that it is appropriate to look through futures contracts to their underliers to determine the nature of a Title VII instrument on a futures contract, that does not mean that it is appropriate to take the same approach with securities. The two situations are not parallel in that the statutory SBS definition states that a Title VII instrument on a security is an SBS, but the statutory swap definition contains no parallel element stating that a Title VII instrument on a futures contract is a swap.
We note that the CFTC's complaint and settlements also discussed TRSs on custom indices, which we do not discuss here. It is unclear from the record whether those TRSs should be treated as swaps, which will depend on the composition of the custom index and whether either party had the discretion to adjust that composition.
Two Key Takeaways
- The CFTC's assertions in its recent Archegos actions have upset the long-settled understanding of many market participants that Broad-based Index ETF TRSs are SBSs.
- Although the jurisdictional question has not been squarely presented, and district court decisions are not binding on other courts, interested parties should take note of the CFTC's view and may wish to share their views with the CFTC and SEC or seek a CFTC Rule 1.8 interpretation.
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