Background: The Statute, The Rule
Section 1a(49)(A) of the Commodity Exchange Act contains the statutory definition of the term "swap dealer" and excludes an insured depository institute ("IDI") "to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer."
CFTC Rule 1.3(ggg)(5) implements this statutory exclusion by providing that an IDI's swaps with a customer in connection with originating a loan to that customer are disregarded in determining if the IDI is a swap dealer.
Throughout the remainder of this posting, we will often refer to rule as the "loan origination rule". Structurally, the rule has three components:
1) The "In Connection With" Prong - The swap must relate to the loan itself or, in the technical language of the statute and rule, "be entered into in connection with originating a loan with that customer";
2) The "Loan Origination" Prong - The IDI must have originated the loan or, put slightly differently, have actually liability for the provision of the cash to the borrower; and
3) The "Anti-Evasion" Prong - The exclusion can not be used in a manner that evades the requirements of the swap dealer regulations generally.
This posting explores each of the components of the loan origination rule and related interpretive material from the related Adopting Release, which was published in the Federal Register on May 23, 2012 (77 Fed Reg 30596).
Before turning to each prong, we will answer three threshold questions of primary importance...
WHAT IS A LOAN? WHAT IS AN INSURED DEPOSITORY INSTITUTION? WHAT IS AN OFFER? & WHAT HAPPENS IF THE IDI TRANSFERS OR TERMINATES THE LOAN OR THE SWAP?
First, let's focus on the meaning of the term "loan" under the CFTC's loan origination rule. Rather than provide a specific definition in the rule, the CFTC opted to refer to the meaning of the term under common law, explaining:
This definition encompasses any contract by which one party transfers a defined quantity of money and the other party agrees to repay the sum transferred at a later date. 77 Fed Reg 30622
Second, let's focus on the meaning of insured depository institution. For purposes of the loan origination rule, the term "insured depository institution" has the meaning given to it in the Federal Deposit Insurance Act. Nothing more, nothing less.
Third, let's focus on the idea of an offer, since the loan origination rule excludes an IDI from the definition of a swap dealer if it "offers" to enter into a swap with a customer in connection with originating a loan with that customer." In the Adopting Release, the CFTC reiterated its view that "the word 'offer" in this exclusion includes scenarios where the IDI requires the customer to enter into a swap, or where the customer asks the IDI to enter into a swap, specifically in connection with a loan made by that IDI." 77 Fed Reg at 30623
So, knitting these together, we could say that:
A loan is a loan by any other name;
An IDI is only an IDI if it is one by name; and
An offer does not really even need to be an offer, regardless of what you call it.
With due respect and a nod to Sir William for the paraphrase.
Finally, let's focus on the effect of a transfer or a termination of the loan to which the swap relates, since this question has already come up several times over the past month from several FoTSRs (Friends of The Swap Report).. Here, the CFTC's words are better than anything that we could ever say:
Nor is it relevant to the exclusion if the IDI later transfers or terminates the loan in connection with which the swap was entered into, so long as the swap otherwise qualifies for the exclusion and the loan was originated in good faith and was not a sham. 77 Fed Reg at 30623
On the other hand, if the IDI were to transfer the swap (but not the loan) to another IDI, and the IDI that is the transferee of the swap is not a source of money to the borrower under the loan, then the transferee IDI would not be able to apply the exclusion to the swap. Footnote 335, 77 Fed Reg 30623.
THE "IN CONNECTION WITH" PRONG
Clause (i) of CFTC Rule 1.3(ggg) sets out the conditions that must be satisfied, in order for a swap to qualify as having been "entered into in connection with originating a loan with that customer". The table that follows summarizes each condition alongside any related interpretive guidance provided by the CFTC in the Adopting Release. At the outset please note that the first column of the table is a title for each requirement that we have assigned for purposes of presentation; no such title exists in the actual text of the rule.
| REQUIREMENT | SUMMARY OF CFTC RULE | INTERPRETIVE GUIDANCE |
| Temporal Limitation |
The swap must be entered into no more than 90 days before or 180 days after the date of either: (A) the execution of the loan agreement; or (B) any transfer of principal to the borrower from the IDI (e.g., a draw of principal) pursuant to the loan. |
"We interpret the statutory phrase 'enter into a swap with a customer in connection with originating a loan with that customer' to mean that the swap is directly connected to the IDI's process of originating a loan to the customer...We do not believe, however, that the statutory term 'origination' can reasonably be stretched to cover the enter term of every loan that an IDI makes to its customers. At some point, the temporal distance renders the link to loan origination too attenuated, and the risk of evasion too greater, to support the exclusion." 77 Fed Reg at 30622 |
| Underlying Limitation |
The swap must be : (A) Connected to the financial terms of the loan, such as, for example, the loan's duration, interest rate, currency or principal amount; or (B) Required under the IDI's loan underwriting criteria to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business. |
"The first category of swaps generally serve to transform the financial terms of a loan for purposes of adjusting the borrower's exposure to certain risks directly related to the loan itself, such as risks arising from changes in interest rates or currency exchange rates. The second category of swaps mitigate risks faced by both the borrower and the lender, by reducing risks that the loan will not be repaid. Thus, both types of swaps are directly related to repayment of the loan." 77 Fed Reg 30622 "[Although,] there is no requirement that the loan agreement reference a swap in order for the swap to be excluded, if the swap otherwise qualifies for the exclusion." Footnote 324, 77 Fed Reg at 30622 |
| Duration Limitation | The duration of the swap must not extend beyond the termination of the loan. |
The Adopting Release did not contain any interpretive guidance on this requirement. |
| Participation Limitation |
Any one of the following conditions must be met: (A) The IDI is the sole source of funds under the loan; (B) The relevant loan agreements require the IDI to be the source of at least 10% of the maximum principal amount under the loan; or (C) If the IDI does not meet the 10% participation threshold, then the aggregate notional amount of all of the IDI's swaps with the customer related to (i.e., "in connection with") the financial terms of the loan does not exceed the amount lent by the IDI to the customer. |
"[S]ome commenters said that a borrower and the IDIs in a lending syndicate need flexibility to allocate responsibility for the swap(s) related to the loan as they may agree. We believe that, to allow for this flexibility, the exclusion may apply to a swap (which is otherwise covered by the exclusion) even if the notional amount of the swap is different from the amount of the loan tranche assigned to the IDI. However, we also agree with a commenter that the IDI should have a substantial participation would prevent an IDI from applying the exclusion where the IDI makes minimal lending commitments in multiple loan syndicates where it offers swaps, causing its swap activity to be far out of proportion to its loan activity." 77 Fed Reg at 30623, Footnotes omitted. |
| Notional Limitation | The aggregate notional amount of all swaps entered into by the borrower by the customer in connection with the financial terms of the loan at any time must not exceed the aggregate principal amount outstanding under the loan at that time. |
"The wording of this requirement refers to all swaps "in connection with the financial terms of the loan" in order to clarify that only such swaps are relevant in this regard. For example, if the IDI were to enter into a swap with the customer that is not in connection with the loan's financial terms, the swap would not be relevant because the exclusion would not apply to the swap." Footnote 334, 77 Fed Reg at 30623. |
| Reporting Requirement | The IDI must report the swap to a swap data repository ("SADR"). | "This requirement is consistent with the prevailing practice that ID Is handle the documentation of loans made to borrowers, and will provide for consistent reporting of swaps that are covered by the exclusion, thereby allowing the CFTC and other regulators to monitor the use of the exclusion." 77 Fed Reg at 30623 |
THE "LOAN ORIGINATION" PRONG
Clause (ii) of CFTC Rule 1.3(ggg) specifies when an IDI will satisfy the requirement that it originated a loan with the particular customer. In short, the exclusion is available to all IDIs that are a source of a transfer of money to a borrower pursuant to a loan. To this end, the loan origination rule provides that an IDI will satisfy the loan origination requirement if it:
1) Directly transfers the money to the borrower;
2) Is part of a lending syndicate that is the source of the funds transferred to the borrower;
3) Is an assignee of the loan, obtains a participation in the loan, or purchases the loan.
In the Adopting Release, the CFTC makes clear that, "[I]f an IDI were to transfer its participation in a loan to a non-IDI, then the non-IDI would not be able to claim this exclusion, regardless of the terms of the loan or the manner of the transfer. Similarly, a non-IDI that is part of a loan syndicate with IDIs would not be able to claim the exclusion." Footnote 328, 77 Fed Reg at 30623.
THE "ANTI-EVASION" PRONG
Finally, in order to prevent evasion of the swap dealer regulatory requirements generally, Clause (iii) of Rule 1.3(ggg)(5) provides that the statutory exclusion does not apply where:
1) The purpose of the swap is not linked to the financial terms of the loan;
2) The IDI enters into a "sham" loan; or
3) The purported "loan" is actually a synthetic loan such as a loan credit default swap or a loan total return swap (commonly called a loan CDS or a loan TRS, respectively).
In other words, these requirements amount to the "anti-evasion" prong of the loan origination exclusion under CEA §1a(49(A) and CFTC Rule 1.3(ggg)(5).
Good day. Good exclusion. TSR