Court Rules Against CFTC in Swap/SBS Classification Question
The U.S. District Court for the Southern District of New York determined that the CFTC does not have jurisdiction over swaps on ETF shares or certain "basket swaps" (i.e., that these products are "security-based swaps" subject to SEC's sole jurisdiction).
The CFTC brought the enforcement action against Archegos Capital Management LP and one of its former employees (see previous coverage). The Court (Judge J. Paul Oetken) granted the defendants motion to dismiss the CFTC complaint on the basis that the transactions at issue were within the exclusive jurisdiction of the SEC.
The Court reasoned that a swap on an ETF share is a "security-based swap," notwithstanding the CFTC argument that "there is no material economic difference between a swap based on a broad-based index of securities . . . and an ETF swap based on this very same index." The Court rejected the CFTC argument that the instruments were "mixed swaps," noting that the swaps incorporated only a single reference - the ETF shares.
Further, the Court determined that the "custom basket swaps" at issue in the case were "security-based swaps," citing a discussion in the SEC-CFTC adopting release which defined "swap" and "security-based swap." The Court highlighted (at p. 48262 of the release) that "[w]here the counterparties, either directly or indirectly . . . have [] discretionary authority to change the composition or weighting of securities in a security portfolio, that security portfolio will be treated as a narrow-based security index." Looking at the terms of the relevant swaps, the Court cited language that gave defendants the right to modify shares in the basket subject to the dealer's consent, not to be unreasonably withheld. The Court rejected the argument that consent must be unilateral, citing the joint release, and distinguished this discretion from instruments where the composition is determined by "predetermined criteria or predetermined self-executing formulas."
The Court also denied the CFTC's request to replead.
Commentary
The CFTC argument that a swap on ETF shares is a CFTC-regulated "swap" challenged the Court to take a leap of logic beyond clear statutory terms that establish SEC jurisdiction for a swap referencing a single security. (The SEC, in its amicus brief, was definitive in its view that these products are "security-based swaps.") (See also commentary regarding the CFTC complaint in the matter.)
Judge Oetken's analysis on "custom baskets" is more notable. The Court, largely adopting arguments made by the SEC in its amicus brief, focused on a particular section of the adopting release which was somewhat more definitive in interpreting swaps on numerous securities than the release is, as a whole. (The SEC, while taking a view on what is an SBS, did not take a view on whether the particular products in the action were SBS.) Unless appealed, this decision is now the legal standard for establishing whether a basket swap referencing numerous securities is a "swap" or a "security-based swap." This is not to say that the Court's decision - which relies on previous statements by the SEC and the CFTC - answers all questions. Like the guidance itself, the decision raises further questions, such as what is the difference between "discretion of both parties" and an amendment?
Setting aside what the right classification is, the case is an embarrassment for both the CFTC and the SEC. The agencies essentially engaged in a public dispute (through the CFTC Complaint and the SEC amicus brief) on product jurisdiction. This was an issue that should have been resolved either (1) in public through formal rulemaking or guidance or (2) in private through the agencies determining which one should handle what were effectively duplicative charges.