In a decisive rebuke to the Commodity Futures Trading Commission (CFTC), the District Court for the U.S. Southern District of New York (Court) ruled the agency lacked jurisdiction over certain Title VII instruments it determined were security-based swaps (SBS). In granting Archegos Capital Management's (Archegos) motion to dismiss (Order), the Court's ruling will lead to the Securities Exchange Commission's (SEC) exclusive pursuit of claims the firm defrauded counterparties in connection with derivatives activities. The SEC submitted an amicus brief claiming jurisdiction over the trades and activity at issue.
While firms have grown accustomed to scouring CFTC administrative settlements for informal guidance on product classification (e.g., FX products), the Archegos Order reminds us that a federal case can also clarify ambiguous product distinctions. Notwithstanding the CFTC's stance that the Title VII instruments, total return swaps (TRS) based on (i) exchange-traded fund (ETF Swaps) shares, and (ii) an adjustable custom basket (Basket Swaps), were swaps under the CEA, the Court was persuaded by the SEC's amicus filing asserting that it held exclusive jurisdiction over the SBS, and ultimately served as a check on the CFTC's jurisdictional assertion.
Title VII Product Background
The Commodity Exchange Act (CEA), Securities Exchange Act ('34 Act) and a joint-agency (CFTC, SEC) swap product rule (Swap Product Rule) distinguish between swaps, regulated by the CFTC, and SBS, regulated by the SEC. A third category, "mixed swap," has characteristics of both swaps and SBS, and subjects market participants to oversight by both the CFTC and SEC. Importantly, the '34 Act defines an SBS as a swap transaction based on, in relevant part, a narrow-based security index or a single security or loan. As a result, Title VII transactions based on a broad-based security index, or a portfolio of securities, are swaps – and thus not SBS. The Swap Product Rule specifies that a TRS based on a single security, loan, or narrow-based security index would also qualify as an SBS. A narrow-based security index is generally defined as being comprised of nine or fewer non-affiliated security issuers.
Swaps Referencing ETF Shares and Custom Baskets (With Discretion) Are SBS
Archegos entered into short ETF and Basket Swaps, both TRS, to hedge its net long TRS strategy. The ETF Swaps referred to underlying ETF shares, meaning that the transaction tracked one or more shares of the ETF and not the referential index. The CFTC argued there was "no material economic difference" between a swap based on a broad-based index of securities and an ETF-referencing swap. In effect, the CFTC argument aimed to "look-through" the ETF-component of the contract to the underlying index or broad grouping of securities from which the ETF share derived its value.
Conversely, the SEC argued that the transaction was based on the value of the ETF shares and not the underlying securities or index tracked by the ETF. In siding with the SEC's position, the Court quoted the agency's amicus brief, finding that "[a]n ETF share represents an interest in the ETF, not an interest in the securities or the index of securities that the ETF is intended to track."
The CFTC argued further that, if the trades were found to be based on a single-name security (i.e., the ETF shares), then the trades should be mixed swaps, on the basis that they are simultaneously based on a broad-based security index. Mixed swaps are subject to joint CFTC and SEC examination authority. But the Court was not persuaded, referring to the Swap Product Rule and finding that a mixed swap "must be based on multiple underlying references — one that is subject to SEC authority and one that is subject to CFTC authority," and that the ETF Swaps refer only to one such underlying reference, i.e., the ETF share.
Separately, the Basket Swaps were based on an underlying basket of securities, and a "basket modification" provision in the trading agreement gave Archegos the ability to remove one or more shares from the basket, "subject to the counterparty's prior consent" which could not be unreasonably withheld. The Swap Product Rule treats Title VII instruments that "give one or both" counterparties discretionary authority to alter an underlying security portfolio as narrow-based indices and SBS. The CFTC asserted that Archegos lacked discretion to alter the basket because its counterparty's consent was required, arguing that neither party had unilateral discretion to alter the composition of the basket. In rejecting the CFTC's argument and finding the trades to be SBS, the Court applied the Swap Product Rule in holding that Archegos did possess discretionary authority given its contractual ability to alter the composition of the underlying basket. The court found that Archegos held such discretionary authority despite its counterparty's consent being required to ultimately effect a compositional change.
The Court also found that there was no basis to permit the CFTC to replead its allegations (permission for which is regularly granted), finding that "leave to replead is therefore denied on the basis of futility."
Takeaways
The Order interprets the Swap Product Rule by further distinguishing between and within Title VII instruments and what had been the understood definitions of swap, mixed swap and SBS. The finding rejects, albeit on the facts at issue, the presence of a mixed swap, as well as the dueling jurisdictional complexities that result from that determination. For example, mixed swaps entered into by a dually-registered swap dealer and security-based swap dealer remain subject to both CFTC and SEC trade reporting requirements.
In rejecting the CFTC's mixed swap argument, the Order reinforces the Swap Product Rule's guidance that limits joint-agency jurisdiction over Title VII products, and also could provide footing to firms seeking to establish single-regulator jurisdiction (or jurisdictional assurances) over similar transaction types.
Practically speaking, the Order is most impactful to (1) firms dealing in Title VII instruments closely monitoring swap dealer, security-based swap dealer and related registration thresholds, and (2) reporting counterparties that may need to revise legacy and outstanding trade reports and consider any related disclosure or notification obligations in recognition of the Order's holdings.
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