This statutory narrow-based security index definition focuses on
indexes composed of equity securities and certain aspects of the
definition, in particular the evaluation of average daily trading
volume, are designed to take into account the trading patterns of
individual stocks.\196\ However, the Commissions, pursuant to authority
granted in the CEA and the Exchange Act, previously have extended the
definition to other categories of indexes but modified the definition
to take into account the characteristics of those other
categories.\197\ Specifically, the Commissions have provided guidance
regarding the application of the narrow-based security index definition
to futures contracts on volatility indexes \198\ and debt security
indexes.\199\ Today, then, there exists additional guidance for
determining what constitutes a narrow-based security index.
---------------------------------------------------------------------------

    \196\ See Joint Order Excluding Indexes Comprised of Certain
Index Options From the Definition of Narrow-Based Security Index, 69
FR 16900, Mar. 31, 2004 (``March 2004 Joint Order'').
    \197\ See CEA section 1a(35)(B)(vi), 7 U.S.C. 1a(35)(B)(vi), and
section 3(a)(55)(C)(vi) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(vi).
    \198\ See March 2004 Joint Order, supra note 196.
    \199\ See Joint Final Rules: Application of the Definition of
Narrow-Based Security Index to Debt Securities Indexes and Security
Futures on Debt Securities, 71 FR 39434, July 13, 2006 (``July 2006
Rules'').
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    Volatility indexes are indexes composed of index options. The
Commissions issued a joint order in 2004 to define when a volatility
index is not a narrow-based security index. Under this joint order, a
volatility index is not a narrow-based security index if the index
meets all of the following criteria:
     The index measures the magnitude of changes (as calculated
in accordance with the order) in the level of an underlying index that
is not a narrow-based security index pursuant to the statutory criteria
for equity indexes discussed above;
     The index has more than nine component securities, all of
which are options on the underlying index;
     No component security of the index comprises more than 30
percent of the index's weighting;
     The five highest weighted component securities of the
index in the aggregate do not comprise more than 60 percent of the
index's weighting;
     The average daily trading volume of the lowest weighted
component securities in the underlying index (those comprising, in the
aggregate, 25 percent of the underlying index's weighting) have a
dollar value of more than $50,000,000 (or $30,000,000 in the case of an
underlying index with 15 or more component securities), except if there
are 2 or more securities with equal weighting that could be included in
the calculation of the lowest weighted component securities comprising,
in the aggregate, 25 percent of the underlying index's weighting, such
securities shall be ranked from lowest to highest dollar value of
average daily trading volume and shall be included in the calculation
based on their ranking starting with the lowest ranked security;
     Options on the underlying index are listed and traded on
an NSE registered under section 6(a) of the Exchange Act; \200\ and
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    \200\ 15 U.S.C. 78f(a).
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     The aggregate average daily trading volume in options on
the underlying index is at least 10,000 contracts calculated as of the
preceding 6 full calendar months.\201\
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    \201\ See March 2004 Joint Order, supra note 196. In 2009, the
Commissions issued a joint order that provided that, instead of the
index options having to be listed on an NSE, the index options must
be listed on an exchange and pricing information for the index
options, and the underlying index, must be computed and disseminated
in real time through major market data vendors. See Joint Order To
Exclude Indexes Composed of Certain Index Options From the
Definition of Narrow-Based Security Index, 74 FR 61116, Nov. 23,
2009 (expanding the criteria necessary for exclusion under the March
2004 Joint Order to apply to volatility indexes for which pricing
information for the underlying broad-based security index, and the
options that compose such index, is current, accurate, and publicly
available).
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    With regard to debt security indexes, the Commissions issued joint
rules in 2006 (``July 2006 Rules'') to define when an index of debt
securities \202\ is not a narrow-based security index. The first three
criteria of that definition were similar to the statutory definition
for equities and the order regarding volatility indexes in that a debt
security index would not be narrow based if: (i) It had more than 9
debt securities issued by more than 9 non-affiliated issuers; (ii) the
securities of any issuer included in the index did not comprise more
than 30 percent of the index's weighting; and (iii) the securities of
any five non-affiliated issuers in the index did not comprise more than
60 percent of the index's weighting.
---------------------------------------------------------------------------

    \202\ Under the rules, debt securities include notes, bonds,
debentures or evidence of indebtedness. See CFTC rule
41.15(a)(1)(i), 17 CFR 41.15(a)(1)(i) and rule 3a55-4(a)(1)(i) under
the Exchange Act, 17 CFR 240.3a55-4(a)(1)(i).
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    In the July 2006 Rules, instead of the statutory average daily
trading volume test, however, the Commissions adopted a public
information availability requirement. Under this requirement, assuming
the aforementioned number and concentration limits were satisfied, a
debt security index would not be a narrow-based security index if the
debt securities or the issuers of debt securities in the index met any
one of the following criteria:
     The issuer of the debt security is required to file
reports pursuant to section 13 or section 15(d) of the Securities
Exchange Act of 1934; \203\
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    \203\ 15 U.S.C. 78m or 78o(d).
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     The issuer of the debt security has a worldwide market
value of its outstanding common equity held by non-affiliates of $700
million or more;
     The issuer of the debt security has outstanding securities
that are notes, bonds, debentures, or evidence of indebtedness having a
total remaining principal amount of at least $1 billion;

     The security is an exempted security as defined in section
3(a)(12) of the Securities Exchange Act of 1934 \204\ and the rules
promulgated thereunder; or
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    \204\ 15 U.S.C. 78c(a)(12).
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     The issuer of the security is a government of a foreign
country or a political subdivision of a foreign country.\205\
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    \205\ The July 2006 Rules also provided that debt securities in
the index must satisfy certain minimum outstanding principal balance
criteria, established certain exceptions to these criteria and the
public information availability requirement, and provided for the
treatment of indexes that include exempted securities (other than
municipal securities).
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    The statutory definition of the term ``narrow-based security
index'' for equities, and the Commissions' subsequent guidance as to
what constitutes a narrow-based security index with respect to
volatility and debt indexes, is applicable in the context of
distinguishing between futures contracts and security futures products.
In the Dodd-Frank Act, Congress included the term ``narrow-based
security index'' in the security-based swap definition, and thus the
statutory definition of the term ``narrow-based security index'' also
applies in distinguishing swaps (on security indexes that are not
narrow-based, also known as ``broad-based'') and security-based swaps
(on narrow-based security indexes). Further, the Commissions believe
that their prior guidance with respect to what constitutes a narrow-
based security index in the context of volatility and debt security
indexes should apply in determining whether a Title VII instrument is a
swap or a security-based swap.
    To clarify that the Commissions are applying the prior guidance and
rules to Title VII instruments, the Commissions are proposing rules to
further define the term ``narrow-based security index'' in the
security-based swap definition. Under paragraph (1) of proposed rule
1.3(yyy) under the CEA and paragraph (a) of proposed rule 3a68-3 under
the Exchange Act, for purposes of the security-based swap definition,
the term ``narrow-based security index'' would have the same meaning as
the statutory definition set forth in section 1a(35) of the CEA and
section 3(a)(55) of the Exchange Act,\206\ and the rules, regulations,
and orders issued by the Commissions relating to such definition. As a
result, except as the new rules the Commissions are proposing provide
for other treatment, market participants generally will be able to use
the Commissions' past guidance in determining whether certain Title VII
instruments based on a security index are swaps or security-based
swaps.
---------------------------------------------------------------------------

    \206\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).
---------------------------------------------------------------------------

    However, the Commissions are proposing interpretive guidance and
additional rules regarding Title VII instruments based on a security
index. The additional rules and interpretive guidance set forth new
narrow-based security index criteria with respect to indexes composed
of securities, loans, or issuers of securities referenced by an index
CDS. The proposed interpretive guidance and rules also address the
definition of an ``index'' and the treatment of broad-based security
indexes that become narrow-based and narrow-based indexes that become
broad-based, including rule provisions regarding tolerance and grace
periods for swaps on security indexes that are traded on CFTC-regulated
trading platforms and security-based swaps on security indexes that are
traded on SEC-regulated trading platforms. These rules and interpretive
guidance are discussed in turn below.
3. Narrow-Based Security Index Criteria for Index Credit Default Swaps
(a) In General
    A CDS is a Title VII instrument in which the ``protection buyer''
makes a series of payments to the ``protection seller'' and, in return,
the ``protection seller'' is obligated to make a payment to the
``protection buyer'' if an obligation or obligations (typically bonds,
but in some cases loans) of an entity or entities referenced in the
contract, or the entity or entities themselves, experience a ``credit
event.'' \207\ While the Commissions understand that the underlying
reference for most cleared CDS is a single entity or an index of
entities rather than a single security or an index of securities, the
underlying reference for CDS also could be a single security or an
index of securities.\208\ A CDS where the underlying reference is a
single entity (i.e., a single-name CDS), a single obligation of a
single entity (e.g., a CDS on a specific bond, loan, or asset-backed
security, or any tranche or series of any bond, loan, or asset-backed
security), or an index CDS where the underlying reference is a narrow-
based security index or the issuers of securities in a narrow-based
security index would be a security-based swap.\209\ An index CDS where
the underlying reference is not a narrow-based security index or the
issuers of securities in a narrow-based security index (i.e., a broad-
based index) would be a swap.\210\
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    \207\ See supra note 180 and accompanying text.
    \208\ See, e.g., Markit, ``Markit CDX'' (describing the Markit
CDX indexes and the number of ``names'' included in each index),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page?; Markit, ``Markit iTraxx Indices,''
(stating that the ``Markit iTraxx indices are comprised of the most
liquid names in the European and Asian markets'') (emphasis added),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/itraxx/itraxx.page?]. Examples of indexes based on
securities include the Markit ABX.HE and CMBX indexes. See Markit,
``Markit ABX.HE,'' (describing the Markit ABX.HE index as ``a
synthetic tradeable index referencing a basket of 20 subprime
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx.page;
Markit, ``Markit CMBX,'' (describing the Markit CMBX index as ``a
synthetic tradeable index referencing a basket of 25 commercial
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/cmbx/cmbx.page.
    \209\ Two commenters made suggestions relating to the effect of
the jurisdictional consequences of the definition of the term
``narrow-based security index,'' but neither commented on the
meaning of the term itself. One of the two commenters, recognizing
that a jurisdictional line would exist for CDS, stressed the need
for ``substantially identical'' regulations applicable to CDS. See
Deutsche Bank Letter. The other commenter also noted that a line for
CDS would exist and urged the Commissions to adopt a regulation
stating that a derivatives clearing organization (``DCO'') may be a
clearing agency and a clearing agency may be a DCO, in order to
facilitate portfolio margining and cross-margining. See White & Case
Letter. The Commissions are sensitive to the requirement in section
712(a)(7) of the Dodd-Frank Act to treat functionally or
economically similar products or entities in a similar manner.
    \210\ Similarly, an option to enter into a single-name CDS or a
CDS referencing a narrow-based security index as described above
would be a security-based swap, while an option to enter into a CDS
on a broad-based security index or the issuers of securities in a
broad-based security index would be a swap. Index CDS where the
underlying reference is a broad-based security index would be SBSAs.
The SEC has enforcement authority with respect to swaps that are
SBSAs, as discussed further in part V below.
---------------------------------------------------------------------------

    The statutory definition of the term ``narrow-based security
index,'' as explained above, was designed with the U.S. equity markets
in mind. Thus, the statutory definition is not appropriate for
determining whether an index underlying an index CDS is broad or
narrow-based. Nor is the further guidance that the Commissions have
previously issued with respect to the narrow-based security index
definition discussed above necessarily appropriate, because that
guidance was designed to address and was uniquely tailored to the
characteristics of volatility indexes and debt security indexes in the
context of futures. Accordingly, the Commissions are proposing rules
that would adopt criteria for determining whether an index is a narrow-
based security index within the context of index CDS.\211\
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    \211\ Two commenters urged clarification of the definition of
the term ``narrow-based security index'' in the context of CDS to
ensure that it reflects ``the letter and the spirit'' of the
existing definition. See Letter from Thomas W. Jasper, Chief
Executive Officer, Primus Guaranty Ltd., and Gene Park, Chief
Executive Officer, Quadrant Structured Investment Advisers, LLC,
Sept. 20, 2010 (``Primus and Quadrant Letter'').

---------------------------------------------------------------------------

    The Commissions are further defining the term ``security-based
swap,'' and the use of the term ``narrow-based security index'' within
that definition to modify the criteria applied in the context of index
CDS in assessing whether the index is a narrow-based security index.
The third prong of the security-based swap definition includes a Title
VII instrument based on the occurrence of an event relating to the
``issuers of securities in a narrow-based security index,'' provided
that such event directly affects the ``financial statements, financial
condition, or financial obligations of the issuer.'' \212\ The first
prong of the security-based swap definition includes a Title VII
instrument that is based on a ``narrow-based security-index.'' \213\
Because the third prong of the security-based swap definition relates
to issuers of securities, while the first prong of such definition
relates to securities, the Commissions are proposing to further define
both the term ``narrow-based security index'' and the term ``issuers of
securities in a narrow-based security index'' in the context of the
definition of security-based swap as applied to index CDS. The
Commissions believe it is important to further define both terms in
order to ensure consistent analysis of index CDS.\214\ While the
wording of the two proposed definitions differs slightly, the
Commissions expect that they would yield the same substantive results
in distinguishing narrow-based and broad-based index CDS.
---------------------------------------------------------------------------

    \212\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
    \213\ Section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(I).
    \214\ Because it applies only with respect to index CDS, the
proposed definitions of ``issuers of securities in a narrow-based
security index'' and ``narrow-based security index'' would not apply
with respect to other types of event contracts, whether analyzed
under the first or third prong.
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(b) Proposed Rules Regarding the Definitions of ``Issuers of Securities
in a Narrow-Based Security Index'' and ``Narrow-Based Security Index''
for Index Credit Default Swaps
    The Commissions are considering how to further define the terms
``issuers of securities in a narrow-based security index'' and
``narrow-based security index'' in order to provide for appropriate
criteria for determining whether an index composed of issuers of
securities referenced by an index CDS and an index composed of
securities referenced by an index CDS are narrow-based security
indexes. In formulating these criteria, and consistent with the
guidance and rules the Commissions have previously issued and adopted
regarding narrow-based security indexes in the context of security
futures, the Commissions believe that there should be public
information available about a predominant percentage of the reference
entities underlying the index, or, in the case of an index CDS, on an
index of securities, about the issuers of the securities or the
securities underlying the index, in order to reduce the likelihood that
non-narrow-based indexes referenced in index CDS or the component
securities or issuers of securities in that index would be readily
susceptible to manipulation, as well as to help prevent the misuse of
material non-public information through the use of CDS based on such
indexes.
    To satisfy these objectives, the Commissions intend to use the
criteria developed for debt indexes discussed above \215\ but tailor
the criteria specifically to address index CDS.\216\ These criteria
would be used solely for the purpose of defining the terms ``narrow-
based security index'' and ``issuers of securities in a narrow-based
security index'' in the first and third prongs of the security-based
swap definition with respect to index CDS and would not be interpreted
to affect any other interpretation or use of the term ``narrow-based
security index'' or any other provision of the Dodd-Frank Act, CEA, or
Exchange Act.
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    \215\ See discussion of July 2006 Rules, supra note 199.
    \216\ The Commissions note that the language of the proposed
rules is intended, in general, to track the criteria developed for
debt indexes discussed above. Certain changes from the criteria
developed for debt indexes are necessary to address differences
between futures on debt indexes and index CDS. Certain other changes
are necessary because the rules for debt indexes define under what
conditions an index is not a narrow-based security index, whereas
the proposed rules define what is a narrow-based security index. For
example, an index is not a narrow-based security index under the
rule for debt indexes if it is not a narrow-based security index
under either subparagraph (a)(1) or paragraph (a)(2) of the rule.
Under the proposed rules for index CDS, however, an index is a
narrow-based security index if it meets the requirements of both of
the counterpart paragraphs in the proposed rules regarding index CDS
(paragraphs (1)(i) and (1)(ii) of proposed rules 1.3(xxx) and
1.3(aaaa) under the CEA and paragraphs (a)(1) and paragraph (a)(2)
of proposed rules 3a68-1a and 3a68-1b under the Exchange Act), even
though the criteria in the debt index rules and the proposed rules
for index CDS include generally the same criteria and structure.
---------------------------------------------------------------------------

(i) Number and Concentration Percentages of Reference Entities or
Securities
    The Commissions believe that the first three criteria of the debt
security index test discussed above (i.e., the number and concentration
weighting requirements) are appropriate to apply to index CDS, whether
CDS on indexes of securities or indexes of issuers of securities.
    Accordingly, proposed rules 1.3(zzz) under the CEA and proposed
rule 3a68-1a under the Exchange Act would provide that, for purposes of
determining whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(III) of the Exchange Act,\217\ the term ``issuers of
securities in a narrow-based security index'' would include issuers of
securities identified in an index in which:
---------------------------------------------------------------------------

    \217\ 15 U.S.C. 78c(a)(68)(A)(ii)(III).
---------------------------------------------------------------------------

     Number: There are 9 or fewer non-affiliated issuers of
securities that are reference entities \218\ in the index, provided
that an issuer of securities shall not be deemed a reference entity in
the index unless (i) a credit event with respect to such reference
entity would result in a payment by the credit protection seller to the
credit protection buyer under the CDS based on the related notional
amount allocated to such reference entity, or (ii) the fact of such
credit event or the calculation in accordance with clause (i) above of
the amount owed with respect to such credit event is taken into account
in determining whether to make any future payments under the CDS with
respect to any future credit events;
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    \218\ For purposes of proposed rules 1.3(zzz) and 3a68-1a: (i) A
reference entity would be affiliated with another entity if it
controls, is controlled by, or is under common control with, that
entity; (ii) control would mean ownership of 20 percent or more of
an entity's equity, or the ability to direct the voting of 20
percent or more of the entity's voting equity; and (iii) the term
``reference entity'' would include an issuer of securities, an
issuing entity of asset-backed securities, and a single reference
entity or group of affiliated entities; provided that an issuing
entity of an asset-backed security shall not be affiliated with any
other issuing entity or issuer under this proposed definition.
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     Single Component Concentration: The effective notional
amount allocated to any reference entity included in the index
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective
notional amount allocated to any 5 non-affiliated reference entities
included in the index comprises more than 60 percent of the index's
weighting.\219\
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    \219\ These proposed rules refer to the ``effective notional
amount'' allocated to reference entities or securities in order to
address potential situations in which the means of calculating
payout across the reference entities or securities is not uniform.
Thus, if one or more payouts is leveraged or enhanced by the
structure of the transaction (i.e., 2x recovery rate), that amount
would be the ``effective notional amount'' for purposes of the 30%
and 60% tests in paragraphs (1)(i)(B) and (1)(i)(C) of proposed
rules 1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) and
(a)(1)(iii) of proposed rules 3a68-1a and 3a68-1b. Similarly, if the
aggregate notional amount under a CDS is not uniformly allocated to
each reference entity or security, then the portion of the notional
amount allocated to each reference entity or security (which may be
by reference to the product of the aggregate notional amount and an
applicable percentage) would be the ``effective notional amount.''

---------------------------------------------------------------------------

    Similarly, proposed rules 1.3(aaaa) under the CEA and proposed rule
3a68-1b under the Exchange Act would provide that, for purposes of
determining whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(I) of the Exchange Act,\220\ the term ``narrow-based
security index'' would include an index in which essentially the same
criteria apply, substituting securities for issuers. Under these
proposed criteria, the term ``narrow-based security index'' would mean
an index in which:
---------------------------------------------------------------------------

    \220\ 15 U.S.C. 78c(a)(68)(A)(ii)(I).
---------------------------------------------------------------------------

     Number: There are 9 or fewer securities, or securities
that are issued by 9 or fewer non-affiliated issuers,\221\ in the
index, provided that a security shall not be deemed a component of the
index unless (i) a credit event with respect to the issuer of such
security or a credit event with respect to such security would result
in a payment by the credit protection seller to the credit protection
buyer under the CDS based on the related notional amount allocated to
such security, or (ii) the fact of such credit event or the calculation
in accordance with clause (i) above of the amount owed with respect to
such credit event is taken into account in determining whether to make
any future payments under the CDS with respect to any future credit
events;
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    \221\ This language is intended to be consistent with the
language in the rule for debt indexes but the specific language is
different to deal with the differences in structure between the rule
for debt indexes and proposed rules 1.3(aaaa) and 3a68-1b. See
discussion supra note 216.
    For purposes of proposed rules 1.3(aaaa) and 3a68-1b: (i) An
issuer would be affiliated with another issuer if it controls, is
controlled by, or is under common control with, that issuer; (ii)
control would mean ownership of 20 percent or more of an issuer's
equity, or the ability to direct the voting of 20 percent or more of
the issuer's voting equity; and (iii) the term ``issuer'' would
include an issuer of securities, an issuing entity of asset-backed
securities, and a single issuer or group of affiliated issuers;
provided that an issuing entity of an asset-backed security shall
not be deemed affiliated with any other issuing entity or issuer
under this proposed definition.
---------------------------------------------------------------------------

     Single Component Concentration: The effective notional
amount allocated to the securities of any issuer included in the index
comprises more than 30 percent of the index's weighting; or
     Largest Five Component Concentration: The effective
notional amount allocated to the securities of any 5 non-affiliated
issuers included in the index comprises more than 60 percent of the
index's weighting.
    Thus, the applicability of the proposed rules would depend on
conditions relating to the number of non-affiliated reference entities,
issuers of securities, or securities, as applicable, included in an
index and the weighting of notional amounts allocated to the reference
entities or securities in the index, as applicable. These first three
criteria of the proposed rules would evaluate the number and
concentration of the issuers or securities in the index, as applicable,
and ensure that an index with a small number of issuers or securities
or concentrated in only a few issuers or securities would be narrow-
based, and thus where such index is the underlying reference of an
index CDS, the index CDS would be a security-based swap.
    Specifically, the proposed rules would provide that an index
meeting any one of certain identified conditions would be a narrow-
based security index. The first condition in paragraph (1)(i)(A) of
proposed rule 1.3(zzz) under the CEA and paragraph (a)(1)(i) of
proposed rule 3a68-1a under the Exchange Act is that there are 9 or
fewer non-affiliated issuers of securities that are reference entities
in the index. An issuer of securities would count toward this total
only if a credit event with respect to such entity would result in a
payment by the credit protection seller to the credit protection buyer
under the CDS based on the notional amount allocated to such entity, or
if the fact of such a credit event or the calculation of the payment
with respect to such credit event is taken into account when
determining whether to make any future payments under the CDS with
respect to any future credit events.
    Similarly, the first condition in paragraph (1)(i)(A) of proposed
rules 1.3(aaaa) under the CEA and paragraph (a)(1)(i) of proposed rule
3a68-1b under the Exchange Act would provide that a security would
count toward the total number of securities in the index only if a
credit event with respect to such security, or the issuer of such
security, would result in a payment by the credit protection seller to
the credit protection buyer under the CDS based on the notional amount
allocated to such security, or if the fact of such a credit event or
the calculation of the payment with respect to such credit event is
taken into account when determining whether to make any future payments
under the CDS with respect to any future credit events. These
provisions are intended to ensure that an index concentrated in a few
reference entities or securities, or a few reference entities that are
affiliated or a few securities issued by a few issuers that are
affiliated, are within the ``narrow-based'' definition and that an
entity is not counted as a reference entity in the index, and a
security is not counted as a security in the index, unless a credit
event with respect to the entity, issuer, or security affects payout
under a CDS on the index.\222\
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    \222\ This requirement is generally consistent with the
definition of ``narrow-based security index'' in CEA section
1a(35)(A), 7 U.S.C. 1a(35)(A), and section 3(a)(55)(B) of the
Exchange Act, 15 U.S.C. 78c(a)(55)(B), and the July 2006 Rules,
supra note 199.
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    In addition, the proposed rules would provide that a reference
entity or issuer of a security in an index and any of that reference
entity's or issuer's affiliated entities are deemed to be a single
reference entity or issuer in the index.\223\ For purposes of the
narrow-based security index definition for index CDS under the third
prong and first prong, a reference entity or issuer would be affiliated
with another entity if it controls, is controlled by, or is under
common control with, that other entity or issuer. The proposed rules
would define control, solely for purposes of this provision, to mean
ownership of 20% or more of an entity's or issuer's equity or the
ability to direct the voting of 20% or more of an entity's or issuer's
voting equity.\224\ This definition of control is designed to provide a
clear standard for determining affiliation for purposes of the narrow-
based security index criteria with respect to index CDS. Determining
whether a reference entity or issuer is affiliated with another entity
or issuer is important in assessing whether an index meets the criteria
in the proposed rules because the notional amounts allocated to all
affiliated reference entities, or all securities issued by affiliated
issuers, included in an index must be aggregated in order to prevent a
concentration of the index in reference entities or securities issued
by issuers that are affiliated and because a reference entity's and
issuer's affiliates must be considered when determining whether the
reference entity or security meets the public information availability
test discussed below. In addition, in order to ensure application of
the criteria regarding index CDS to indexes of

reference entities that have issued asset-backed securities as defined
in section 3(a)(77) of the Exchange Act,\225\ as well as indexes of
such asset-backed securities, the term reference entity and the term
issuer under the proposed rules includes issuing entities of asset-
backed securities. The proposed rules also would provide that each
issuing entity of an asset-backed security is considered a separate
reference entity or issuer, as applicable.
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    \223\ See proposed rule 1.3(zzz)(4) under the CEA and proposed
rule 3a68-1a(d) under the Exchange Act.
    \224\ The affiliate issue under the Federal securities laws is
generally a facts and circumstances determination based on the
definition of the term ``affiliate'' contained in such laws. See,
e.g., rule 405 under the Securities Act, 17 CFR 230.405; rule 12b-2
under the Exchange Act, 17 CFR 240.12b-2.
    \225\ 15 U.S.C. 78c(a)(77). The Commissions note that section
941 of the Dodd-Frank Act added the definition of the term ``asset-
backed security'' as section 3(a)(77) of the Exchange Act, 15 U.S.C.
78c(a)(77). However, section 761(a)(6) of the Dodd-Frank Act also
added the definition of the term ``security-based swap execution
facility'' as section 3(a)(77) of the Exchange Act, 15 U.S.C.
78c(a)(77). References to the definition of the term ``asset-backed
security'' in this release are to the definition added by section
941 of the Dodd-Frank Act.
---------------------------------------------------------------------------

    The second condition, in paragraphs (1)(i)(B) of proposed rules
1.3(zzz) and 1.3(aaaa) under the CEA and paragraphs (a)(1)(ii) of
proposed rules 3a68-1a and 3a68-1b under the Exchange Act, is that the
effective notional amount allocated to any reference entity or security
included in the index comprises more than 30 percent of the index's
weighting.
    The third condition, in paragraphs (1)(i)(C) of proposed rules
1.3(zzz) and 1.3(aaaa) under the CEA and paragraphs (a)(1)(iii) of
proposed rules 3a68-1a and 3a68-1b under the Exchange Act, is that the
effective notional amount allocated to any 5 non-affiliated reference
entities, or to the securities of any 5 non-affiliated issuers,
included in the index that are the underlying reference entities or
securities, respectively, comprises more than 60 percent of the index's
weighting.
    Given that Congress determined that these concentration percentages
are appropriate to characterize an index as a narrow-based security
index, and the Commissions have determined they are appropriate for
debt security indexes in the security futures context, the Commissions
believe that these concentration percentages are appropriate to apply
to the notional amount allocated to reference entities and securities
in order to apply similar standards to indexes that are the underlying
references of index CDS. Moreover, with respect to both the numerical
and concentration percentage criteria, the markets have had experience
with these criteria with respect to futures on equity indexes,
volatility indexes, and debt security indexes.
(ii) Public Information Availability Regarding Reference Entities and
Securities
    In addition to the numerical and concentration percentage criteria,
the debt security index test also included, as discussed above, a
public information availability test. This test was designed to reduce
the likelihood that broad-based debt security indexes or the component
securities or issuers of securities in that index would be readily
susceptible to manipulation. The fourth condition in the proposed rules
includes a similar public information availability test that is
intended solely for purposes of determining whether an index underlying
a CDS is narrow-based. Except as discussed below, under the proposed
rules, an index CDS would be considered narrow-based if a reference
entity or security included in the index does not meet any one of the
following criteria:
     The reference entity or the issuer of the security is
required to file reports pursuant to the Exchange Act or the
regulations thereunder;
     The reference entity or the issuer of the security is
eligible to rely on the exemption provided in rule 12g3-2(b) under the
Exchange Act; \226\
---------------------------------------------------------------------------

    \226\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------

     The reference entity or the issuer of the security has a
worldwide market value of its outstanding common equity held by non-
affiliates of $700 million or more; \227\
---------------------------------------------------------------------------

    \227\ See July 2006 Rules, supra note 199, at 39537 (noting that
issuers having worldwide equity market capitalization of $700
million are likely to have public information available about them).
---------------------------------------------------------------------------

     The reference entity or the issuer of the security (other
than an issuing entity of an asset-backed security as defined in
section 3(a)(77) of the Exchange Act \228\) has outstanding securities
that are notes, bonds, debentures, or evidences of indebtedness having
a total remaining principal amount of at least $1 billion;
---------------------------------------------------------------------------

    \228\ 15 U.S.C. 78c(a)(77).
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     The reference entity is an issuer of an exempted security,
or the security is an exempted security, each as defined in section
3(a)(12) of the Exchange Act \229\ and the rules promulgated thereunder
(except a municipal security);
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    \229\ 15 U.S.C. 78c(a)12.
---------------------------------------------------------------------------

     The reference entity or the issuer of the security is a
government of a foreign country or a political subdivision of a foreign
country; or
     If the reference entity or the issuer of the security is
an issuing entity of asset-backed securities as defined in section
3(a)(77) of the Exchange Act,\230\ such asset-backed securities were
issued in a transaction registered under the Securities Act and have
publicly available distribution reports.
---------------------------------------------------------------------------

    \230\ 15 U.S.C. 78c(a)(77).
---------------------------------------------------------------------------

    However, so long as the effective notional amounts allocated to
reference entities or securities that satisfy the public information
availability test comprise at least 80 percent of the index's
weighting, failure by a reference entity or security included in the
index to satisfy the public information availability test would be
disregarded if the effective notional amounts allocated to that
reference entity or security comprise less than 5 percent of the
index's weighting.
    These issuer eligibility criteria are intended to condition the
characterization of an index as ``narrow-based'' on the likelihood that
information about a predominant percentage of the reference entities or
securities included in the index is publicly available.\231\ For
example, a reference entity or issuer of securities that is required to
file reports pursuant to the Exchange Act or the regulations thereunder
makes regular and public disclosure through those filings. Moreover,
reference entities and issuers of securities that do not file reports
with the SEC but that are eligible to rely on the exemption in rule
12g3-2(b) under the Exchange Act (i.e., foreign private issuers) are
required to make certain types of financial information publicly
available in English on their Web sites or through an electronic
information delivery system generally available to the public in their
primary trading markets.\232\ The Commissions believe that other
reference entities or issuers of securities that do not file reports
with the SEC, but that have worldwide equity market capitalization of
$700 million, have $1 billion in outstanding debt (other than in the
case of issuing entities of asset-backed securities), issue exempted
securities (other than municipal securities), or are foreign

sovereign entities either are required to or are otherwise sufficiently
likely, solely for purposes of the proposed ``narrow-based security-
index'' and ``issuers of securities in a narrow-based security index''
definitions, to have public information available about them.\233\
---------------------------------------------------------------------------

    \231\ See discussion supra part III.G.3(b). Most of the
thresholds in the public information availability test are similar
to those the Commissions adopted in their joint rules regarding the
application of the definition of the term ``narrow-based security
index'' to debt security indexes and security futures on debt
securities. See July 2006 Rules, supra note 199. The July 2006 Rules
also included an additional requirement regarding the minimum
principal amount outstanding for each security in the index. The
Commissions have not included this requirement in proposed rule
1.3(zzz) under the CEA and proposed rule 3a68-1a under the Exchange
Act. The numerical thresholds also are similar to those the SEC
adopted in its securities offering reform rules, which were based on
data analysis conducted by the SEC's Office of Economic Analysis.
See Securities Offering Reform, 70 FR 44722, Aug. 3, 2005.
    \232\ 17 CFR 240.12g3-2(b).
    \233\ It is important to note that the public information
availability test is designed solely for purposes of distinguishing
between index CDS that are swaps and index CDS that are security-
based swaps. The proposed criteria are not intended to provide any
assurance that there is any particular level of information actually
available regarding a particular reference entity or issuer of
securities. Meeting one or more of the proposed criteria for the
limited purpose here--defining the terms ``narrow-based security
index'' and ``issuers of securities in a narrow-based security
index'' in the first and third prongs of the security-based swap
definition with respect to index CDS--would not substitute for or
satisfy any other requirement for public disclosure of information
or public availability of information for purposes of the Federal
securities laws.
---------------------------------------------------------------------------

    In the case of indexes including asset-backed securities, or
reference entities that are issuing entities of asset-backed
securities, information about the reference entity or issuing entity of
the asset-backed security would not alone be sufficient and,
consequently, the proposed rules provide that the public information
availability test would be satisfied only if certain information also
is available about the asset-backed securities. An issuing entity
(whether or not a reference entity) of asset-backed securities may meet
the public information availability test if such asset-backed
securities were issued in a transaction registered under the Securities
Act and distribution reports about such asset-backed securities are
publicly available. In addition, because of the lack of public
information regarding many asset-backed securities, despite the size of
the outstanding amount of securities,\234\ the proposed rules would not
permit such reference entities and issuers to satisfy the public
information availability test by having $1 billion in outstanding debt.
Characterizing an index with reference entities or securities for which
public information is not likely to be available as ``narrow-based,''
and thus index CDS where the underlying references or securities are
such indexes as security-based swaps, should help to ensure the
transparency of the index components.
---------------------------------------------------------------------------

    \234\ See generally Asset-Backed Securities, 75 FR 23328, May 3,
2010.
---------------------------------------------------------------------------

    In sum, an index that is not narrow-based under the number and
weighting requirements would be characterized as broad-based (and thus
an index CDS, where the underlying reference is that index, would be
characterized as a swap and not a security-based swap) unless one of
the reference entities or securities in the index fails to meet one of
the criteria in the public information availability test set forth in
the proposed rules. Yet, even if one or more of the reference entities
or securities included in the index fail the public information
availability test, the proposed rules would provide that the terms
``issuers of securities in a narrow-based security index'' and
``narrow-based security index'' would not include such an index, so
long as the applicable reference entity or security that failed the
test represents less than 5 percent of the index's weighting, and so
long as reference entities or securities comprising at least 80 percent
of the index's weighting do satisfy the public information availability
test.
    An index that includes a very small proportion of reference
entities or securities that do not satisfy this public information
availability test should nevertheless be treated as a broad-based
security index. This would be achieved where the index satisfies both
of the requirements at the time the parties enter into the index CDS.
The 5-percent weighting threshold is designed to provide that reference
entities or securities not satisfying the public information
availability test comprise only a very small portion of the index, and
the 80-percent weighting threshold is designed to provide that a
predominant percentage of the reference entities or securities in the
index satisfy the public information availability test. As a result,
these thresholds would provide market participants with flexibility in
constructing an index. The Commissions believe that this provision is
appropriate and that providing such flexibility is not likely to
increase the likelihood that an index that satisfies these provisions
would be readily susceptible to manipulation or the likelihood that the
component securities or issuers of securities in that index also would
be subject to manipulation or that there would be misuse of material
non-public information about them through the use of CDS based on such
indexes.
    The Commissions also are proposing that, for index CDS entered into
solely between ECPs, the public information availability test may
instead be satisfied other than in the manner discussed above.
Accordingly, solely for index CDS entered into between ECPs, an index
would be considered narrow-based if a reference entity or security
included in the index does not meet any one of the criteria enumerated
above or any one of the following criteria:
     The reference entity or the issuer of the security (other
than issuing entities of asset-backed securities) provides to the
public or to such eligible contract participant information about such
reference entity or issuer pursuant to rule 144A(d)(4) under the
Securities Act; \235\
---------------------------------------------------------------------------

    \235\ 17 CFR 230.144A(d)(4).
---------------------------------------------------------------------------

     Financial information about the reference entity (other
than an issuing entity of asset-backed securities) is otherwise
publicly available; or
     In the case of an asset-backed security, or a reference
entity that is an issuing entity of asset-backed securities,
information of the type and level included in public distribution
reports for similar asset-backed securities is publicly available about
both the reference entity or issuing entity as well as such asset-
backed securities.
    Reference entities or reference securities that meet alternative
public information criteria currently may underlie CDS that are entered
into by ECPs and that are cleared by central counterparties operating
pursuant to exemptive orders granted by the SEC.\236\ In addition,
solely with respect to index CDS entered into by ECPs, so long as the
effective notional amounts allocated to reference entities or
securities that satisfy this expanded public information availability
test comprise at least 80 percent of the index's weighting, a reference
entity or security included in the index that fails to satisfy this
expanded public information availability test would be disregarded if
the effective notional amounts allocated to that reference entity or
security comprise less than 5 percent of the index's weighting.
---------------------------------------------------------------------------

    \236\ See, e.g., Order Granting Temporary Exemptions Under the
Securities Exchange Act of 1934 in Connection With Request of
Chicago Mercantile Exchange Inc. and Citadel Investment Group,
L.L.C. Related to Central Clearing of Credit Default Swaps, and
Request for Comments, Exchange Act Release No. 34-59578 (Mar. 13,
2009). This order has been extended a number of times, most recently
on November 29, 2010. See Order Extending Temporary Conditional
Exemptions Under the Securities Exchange Act of 1934 in Connection
With Request of Chicago Mercantile Exchange Inc. Related to Central
Clearing of Credit Default Swaps and Request for Comment, Exchange
Act Release No. 34-63388 (Nov. 29, 2010).
---------------------------------------------------------------------------

    The Commissions are also seeking comment as to whether the public
information availability test should apply to the extent that an index
is compiled by an index provider that is not a party to an index CDS
(``third-party index provider'') and makes publicly available general
information about the construction of the index, index rules, identity
of components, and predetermined adjustments, and which index is
referenced by an index CDS that is offered on or subject to the rules
of a DCM or SEF, or by direct access in

the U.S. from an FBOT that is registered with the CFTC.
    The CFTC believes that the requirement that the index be compiled
by a third-party index provider may help to ensure that information is
publicly available because such index providers generally employ a
variety of selection criteria for inclusion of reference entities or
securities in the indexes for index CDS, including liquidity
thresholds. The CFTC believes that requiring that such index providers
make publicly available general information about the construction of
the index, index rules, components, and predetermined adjustments may
help ensure transparency regarding the index and its components. In
addition, the CFTC believes that the requirement that the index be the
underlying reference of an index CDS that is offered for trading on or
subject to the rules of a DCM or SEF, or by direct access in the U.S.
from a registered FBOT, helps to ensure that information about the
index is publicly available and that the index is not readily
susceptible to manipulation. The CEA prohibits DCMs and SEFs from
offering for trading contracts that are readily susceptible to
manipulation.\237\ Similarly, under rules recently proposed by the
CFTC, FBOTs only may offer contracts by direct access from the U.S.
that are not readily susceptible to manipulation.\238\ The CFTC
believes that CFTC oversight of DCMs, SEFs and registered FBOTs for
compliance with these requirements \239\ will help ensure that
information about an index that is the underlying reference of an index
CDS traded on these platforms is publicly available and is not readily
susceptible to manipulation.\240\
---------------------------------------------------------------------------

    \237\ See CEA sections 5(d)(3), 7 U.S.C. 7(d)(3) (a DCM ``shall
list on the contract market only contracts that are not readily
susceptible to manipulation.''); 5h(f)(3), 7 U.S.C. 7b-3(f)(3) (same
requirement for SEFs).
    \238\ See Registration of Foreign Boards of Trade, 75 FR 70973,
Nov. 19, 2010.
    \239\ CFTC oversight in evaluating compliance with the
requirement that a swap not be readily susceptible to manipulation
for cash settled contracts includes consideration of whether cash
settlement is at a price reflecting the underlying cash market, will
not be subject to manipulation or distortion, and is based on a cash
price series that is reliable, acceptable, publicly available, and
timely. See 17 CFR Part 40, Appendix A--Guideline No. 1.
    \240\ Such indexes also would be SBSAs, providing the SEC with
antifraud and anti-manipulation authority.
---------------------------------------------------------------------------

    The SEC believes that a third-party index provider that simply
provides general information about the construction of an index, index
rules, components, and predetermined adjustments is not a substitute
for the public availability of information about the issuers of the
securities or the securities in the index; nor does such a third-party
index provider indicate a likelihood that such public information is
available, which the SEC believes, for purposes of index CDS, is
important to market integrity and to investors in engaging in
transactions based on such indexes. If a third-party index provider
does not require, as a condition of inclusion in an index it compiles,
that information likely is publicly available regarding the component
issuers or securities in the index, the SEC does not believe investors
will have adequate information regarding such component issuers or
securities. In addition, the SEC notes that, absent specified standards
regarding what persons constitute a third-party index provider for
purposes of the proposed rules, any person that compiles an index at
the behest of another person could constitute a ``third-party index
provider.'' Moreover, the SEC does not believe that requiring an index
CDS to be offered on or subject to the rules of a DCM or SEF, or by an
FBOT, addresses whether public information likely is available about
the issuers of securities or securities in an index compiled by a
third-party index provider. As a result, the SEC does not believe that
an index compiled by a third-party index provider that makes publicly
available general information about the construction of the index,
index rules, components, and index adjustments, and that is referenced
by an index CDS that is offered for trading on or subject to the rules
of a DCM or SEF, or by direct access in the U.S. from a registered
FBOT, should substitute for the public information availability test
under the proposed rules for index CDS.
    Accordingly, the Commissions seek comment as to whether the public
information availability test should apply to indexes compiled by a
third-party index provider that makes publicly available general
information about the construction of the index, index rules, identity
of components, and predetermined adjustments, and which index is
referenced by an index CDS that is offered on or subject to the rules
of a DCM or SEF, or by direct access in the U.S. from an FBOT that is
registered with the CFTC.
(iii) Treatment of Indexes Including Reference Entities That Are
Issuers of Exempted Securities or Including Exempted Securities
    In addition, the proposed rules provide for alternative treatment
of indexes that include exempted securities or reference entities that
are issuers of exempted securities.\241\ The Commissions believe such
treatment is consistent with the objective and intent of the definition
of the term ``security-based swap,'' as well as the approach taken in
the context of security futures.\242\ Accordingly, paragraph (1)(ii) of
proposed rules 1.3(zzz) and 1.3(aaaa) under the CEA and paragraph
(a)(2) of proposed rules 3a68-1a and 3a68-1b under the Exchange Act
would provide that, in the case of an index that includes exempted
securities, or reference entities that are issuers of exempted
securities, in each case as defined as of the date of enactment of the
Futures Trading Act of 1982 (other than municipal securities), such
securities or reference entities are excluded from the index when
determining whether the securities or reference entities in the index
constitute a ``narrow-based security index'' or ``issuers of securities
in a narrow-based security index'' under the proposed rules.
---------------------------------------------------------------------------

    \241\ See proposed rules 1.3(zzz)(1)(i) and 1.3(aaaa)(1)(i)
under the CEA and proposed rules 3a68-1a(a)(2) and 3a68-1b(a)(2)
under the Exchange Act; July 2006 Rules, supra note 199.
    \242\ See section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.
78c(a)(68)(C) (providing that ``[t]he term `security-based swap'
does not include any agreement, contract, or transaction that meets
the definition of a security-based swap only because such agreement,
contract, or transaction references, is based upon, or settles
through the transfer, delivery, or receipt of an exempted security
under paragraph (12) [of the Exchange Act], as in effect on the date
of enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in paragraph (29) [of the Exchange
Act] as in effect on the date of enactment of the Futures Trading
Act of 1982), unless such agreement, contract, or transaction is of
the character of, or is commonly known in the trade as, a put, call,
or other option'').
---------------------------------------------------------------------------

    Under paragraph (1)(ii) of proposed rules 1.3(zzz) and 1.3(aaaa)
under the CEA and paragraph (a)(2) of proposed rules 3a68-1a and 3a68-
1b under the Exchange Act, an index composed solely of securities that
are, or reference entities that are issuers of, exempted securities
(other than municipal securities) would not be a ``narrow-based
security index'' or an index composed of ``issuers of securities in a
narrow-based security index.'' In the case of an index where some, but
not all, of the securities or reference entities are exempted
securities (other than municipal securities) or issuers of exempted
securities (other than municipal securities), the index would be a
``narrow-based security index'' or an index composed of ``issuers of
securities in a narrow-based security index'' only if the index is
narrow-based when the securities that are, or reference entities that
are issuers of, exempted securities (other than municipal securities)
are

disregarded. The Commissions believe this approach would result in
consistent treatment for indexes regardless of whether they include
securities that are, or issuers of securities that are, exempted
securities (other than municipal securities) while ensuring that
exempted securities (other than municipal securities) and issuers of
exempted securities (other than municipal securities) are not included
in an index merely to make the index either broad-based or narrow-based
under the proposed rules.

Request for Comment

    The Commissions request comment on all aspects of proposed rules
1.3(zzz) and 1.3(aaaa) under the CEA and proposed rules 3a68-1a and
3a68-1b under the Exchange Act, as applied to CDS, including the
following:
    85. Do the proposed criteria for identifying when an index of
reference entities constitutes ``issuers of securities in a narrow-
based security index'' and when an index of securities constitutes a
``narrow-based security index'' effectively encompass the key elements
of a narrow-based security index as it pertains to paragraph
(A)(ii)(III) (i.e., the third prong) and paragraph (A)(ii)(I) (i.e.,
the first prong) of the security-based swap definition? Why or why not?
    86. Should an index with 9 or fewer non-affiliated issuers of
securities or 9 or fewer securities be ``narrow-based?'' Why or why
not?
    87. Should an index in which the effective notional amounts
allocated to any reference entity or security included in the index
comprise more than 30 percent of the index's weighting be ``narrow-
based''? Why or why not?
    88. Should an index in which the effective notional amounts
allocated to any 5 non-affiliated reference entities or securities
included in the index comprise more than 60 percent of the index's
weighting be ``narrow-based''? Why or why not?
    89. Should an index in which publicly available information is not
available for a predominant percentage of reference entities or
securities included in the index be ``narrow-based'' for purposes of
index CDS? Why or why not? The Commissions note that the criteria for
the public information availability test do not necessarily ensure that
there is in fact public information available regarding the relevant
entities or securities, or that the criteria act in any way as a
substitute for the actual availability of public information; instead,
the criteria, taken as a whole, are intended to capture, for purposes
of the definition of the term ``narrow-based security index'' for index
CDS, those entities or securities, that on average, are likely to have
public information available, and that the relevant index would
therefore not be treated as ``narrow-based.'' Do the proposed criteria
appropriately achieve this objective? Are the criteria for the public
information availability test under the proposed rules appropriate to
result in a sufficient likelihood that public information about the
component securities or issuers of securities in an index CDS would be
available to properly address the regulatory interests of the Federal
securities laws? Are the $700 million and $1 billion thresholds
discussed above appropriate tests for the likelihood of publicly
available information in this context? These thresholds are similar to
those in the SEC securities offering reform rules used to determine, in
part, whether a particular issuer was a ``well-known seasoned issuer,''
in order to streamline registration requirements under the Securities
Act.\243\ Are there companies that have less than $700 million in
worldwide equity capitalization, or less than $1 billion in outstanding
debt (other than asset-backed securities), and that do not otherwise
satisfy the public information availability test, that have public
information available about them for purposes of determining whether an
index CDS that includes such a company as a reference entity or such a
security is broad or narrow-based? The Commissions request comment on
the appropriate thresholds for determining whether there likely is
public information available for purposes of the proposed definition of
narrow-based security index and issuers of securities in a narrow-based
security index for purposes of index CDS, in particular whether these
thresholds should be modified higher or lower, and request empirical
data to support the response.
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    \243\ See supra note 231.
---------------------------------------------------------------------------

    90. Is it appropriate to treat an issuer eligible to rely on rule
12g3-2(b) under the Exchange Act as meeting the public information
availability test under the proposed rules? Why or why not? Would such
a provision include issuers that otherwise would not satisfy the
information condition in the proposed rules? Why or why not? Please
provide a detailed explanation and include empirical data to support
any suggested modification.
    91. With respect to asset-backed securities, is the proposed
criterion for meeting the public information availability test, that
the asset-backed securities were issued in a transaction registered
under the Securities Act and have publicly available distribution
reports, the correct approach? Why or why not? Should such a provision
explicitly also apply to include asset-backed securities issued by
Fannie Mae and Freddie Mac? Why or why not? Please provide a detailed
explanation of whether and why such a condition is necessary and
include empirical data to support any suggested modification.
    92. Should the proposed rules exclude a reference entity or
security in the index from the public information availability test, so
long as the reference entity or security included in the index
represents less than five percent of the index's weighting? Why or why
not?
    93. Should the proposed rules exclude a reference entity or
security in the index from the public information availability test, so
long as the reference entities or securities comprising at least 80
percent of the index's weighting satisfy the provisions of those
paragraphs? Why or why not?
    94. The Commissions are considering whether the public information
availability test in proposed rules 1.3(zzz) and 1.3(aaaa) under the
CEA and proposed rules 3a68-1a and 3a68-1b under the Exchange Act
should apply to an index of issuers of securities or securities that is
created and published by a third-party index provider that is not a
party to an index CDS and makes publicly available general information
about the construction of the index, index rules, components, and
predetermined adjustments, and which index is referenced by an index
CDS that is offered on or subject to the rules of a DCM or SEF, or by
direct access in the U.S. from an FBOT that is registered with the
CFTC. How are indexes created by such a third-party index provider and
what type of compensation do they receive? What role do parties to a
swap or security-based swap play in determining the constituents or
index criteria? What type of information does a third-party index
provider ensure is publicly available on an ongoing basis about each of
the constituent issuers of securities or securities identified in the
index and what actions does the third-party index provider take to
ensure the accuracy of information about the issuers of securities or
securities in any index compiled by such third-party index provider?
How would a third-party index provider take steps to ensure that the
indexes it creates are composed of issuers of securities or securities
for which there likely is public information available? Please provide
detailed examples.
    95. If the Commissions determine to use, as an alternative to the
public

information availability test in the proposed rules relating to index
CDS, the existence of a third-party index provider that is not a party
to an index CDS and makes publicly available general information about
the construction of the index, index rules, components, and
predetermined adjustments, and which index is referenced by an index
CDS that is offered on or subject to the rules of a DCM or SEF, or by
direct access in the U.S. from an FBOT that is registered with the
CFTC, what requirements, if any, should the Commissions impose on the
DCM, SEF, or FBOT to ensure that public information likely will be
available in this context regarding the issuers of securities or
securities in the index? What specified standards, if any, should the
Commissions require the DCM, SEF, or FBOT to meet for purposes of the
proposed rules?
    96. Should index CDS based on an index compiled by a third-party
index provider as described in this section be considered a ``mixed
swap'' rather than a swap in order to ensure that the protections of
the Federal securities laws apply with respect to index constituents
about which public information about the constituent issuers of
securities or securities in the index (subject to the de minimis
provisions of the proposed rules) may not be available?
    97. Are there other criteria that the Commissions should adopt as
alternative means of satisfying the public information availability
test in the proposed rules? If so, please explain what they are and
what requirements the Commissions should impose to ensure the public
availability of information regarding issuers of securities or
securities in index CDS.
    98. Should the proposed rules provide, solely with respect to CDS
that may be entered into only between eligible contract participants,
that the information availability test could be satisfied if the
reference entity or the issuer of the security (i) except in the case
of issuing entities of asset-backed securities, provides information to
the public or to such eligible contract participant pursuant to rule
144A(d)(4) of the Securities Act; (ii) except in the case of issuing
entities of asset-backed securities, financial information is otherwise
publicly available about the reference entity or the issuer of the
security; or (iii) in the case of asset-backed securities and issuing
entities of asset-backed securities, financial information of the type
and level included in public distribution reports for similar asset-
backed securities about both the issuing entity and such asset-backed
securities is publicly available? Why or why not? Please provide a
detailed explanation and empirical data, to the extent feasible.
    99. Should the proposed rules include additional or other criteria
to determine whether an index is ``narrow-based'' with respect to index
CDS? If so, what criteria should be included, and why?
    100. Does the proposed treatment of index CDS whereby a payment is
contemplated based on the default of a particular entity in the index
rather than solely on the value of the index adequately address the
Federal regulatory interests under the Federal securities laws and the
Commodity Exchange Act?
    101. Does the definition of ``control'' for purposes of identifying
whether a reference entity or issuer is affiliated with another entity
(ownership of 20 percent or more of an entity's or issuer's equity, or
the ability to direct the voting of 20 percent or more of the entity's
or issuer's voting equity) appropriately identify when affiliates are
in a control relationship for these purposes? Why or why not? Should
these thresholds be higher or lower? Please provide supporting data
and/or analysis. Should issuing entities of asset-backed securities be
considered separate reference entities or issuers for purposes of the
proposed criteria? If not, why not? Are there circumstances under which
issuing entities of asset-backed securities should not be considered
separate reference entities or issuers for purposes of the proposed
criteria? Why or why not?
    102. Are there other categories or types of CDS that proposed rules
1.3(zzz) and (aaaa) and proposed rules 3a68-1a and 3a68-1b do not
address or that require additional clarification regarding their
treatment under the Dodd-Frank Act? If so, please provide a detailed
description of any such categories or types of CDS, as well as any
analysis, supported by empirical data to the extent feasible, of what
clarification is necessary.
    103. Are there other categories of event-type contracts relating to
issuers of securities that require additional clarification regarding
their treatment under the Dodd-Frank Act? If so, please provide a
detailed explanation of the types of contracts and why the proposed
rules should apply to such other event-type contracts.
4. Security Indexes
    The Dodd-Frank Act defines the term ``index'' as ``an index or
group of securities, including any interest therein or based on the
value thereof.'' \244\ The Commissions are proposing guidance as to how
to determine when a portfolio of securities is a narrow-based or broad-
based security index and the circumstances in which changes to the
composition of a security index (including a portfolio of securities)
\245\ underlying a Title VII instrument would affect the
characterization of such Title VII instrument.\246\
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    \244\ See section 3(a)(68)(E) of the Exchange Act, 15 U.S.C.
78c(a)(68)(E).
    \245\ A ``portfolio'' of securities could be a group of
securities and therefore an ``index'' for purposes of the Dodd-Frank
Act. To the extent that changes are made to the securities
underlying the Title VII instrument and each such change is
individually confirmed, then those substituted securities would not
be part of a security index as defined in the Dodd-Frank Act, and
therefore a Title VII instrument on each of those substituted
securities would be a security-based swap.
    \246\ Solely for purposes of the discussion in this section, the
terms ``security index'' and ``security portfolio'' are intended to
include either securities or the issuers of securities.
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    In most cases, a security index is designed to reflect the
performance of a market or sector by reference to representative
securities or interests in securities. There are a number of well-known
security indexes established and maintained by recognized index
providers currently in the market.\247\ The Commissions understand,
however, that instead of using these established indexes, market
participants may enter into a Title VII instrument where the underlying
reference of the Title VII instrument is a portfolio of securities
selected by the counterparties or created by a third-party index
provider at the behest of one or both counterparties. In some cases,
the Title VII instrument may give one or both of the counterparties,
either directly or indirectly (e.g., through an investment adviser or
through the third-party index provider), discretionary authority to
change the composition of the security portfolio, including, for
example, by adding or removing securities in the security portfolio on
an ``at-will'' basis during the term of the Title VII instrument.\248\
The Commissions believe that where the counterparties, either directly
or indirectly (e.g., through an investment adviser or through the
third-party index provider), have this discretionary authority to
change the

composition or weighting of securities in a security portfolio, that
security portfolio should be treated as a narrow-based security index,
and that therefore a Title VII instrument on that security portfolio
would be a security-based swap.\249\
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    \247\ For instance, the S&P 500[reg] is an index that gauges the
large cap U.S. equities market.
    \248\ Alternatively, counterparties may enter into Title VII
instruments where a third-party investment manager selects an
initial portfolio of securities and has discretionary authority to
change the composition of the security portfolio in accordance with
guidelines agreed upon with the counterparties. Such security
portfolios would be treated as narrow-based security indexes with
Title VII instruments on those security portfolios being security-
based swaps.
    \249\ The Commissions understand that a security portfolio could
be labeled as such or could just be an aggregate of individual Title
VII instruments documented, for example, under a master agreement or
by amending an annex of securities attached to a master trade
confirmation. If the security portfolio were created by aggregating
individual Title VII instruments, each Title VII instrument would
need to be evaluated in accordance with the proposed guidance to
determine whether it is a swap or a security-based swap. For the
avoidance of doubt, if the counterparties to a Title VII instrument
exchanged payments under that Title VII instrument based on a
security index that was itself created by aggregating individual
security-based swaps, such Title VII instrument would be a security-
based swap. See discussion supra part III.D.
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    The Commissions believe, however, that not all changes that occur
to the composition or weighting of a security index underlying a Title
VII instrument will always result in that security index being treated
as a narrow-based security index. Many security indexes are constructed
and maintained by an index provider pursuant to a published
methodology.\250\ For instance, the various Standard & Poor's security
indexes are reconstituted and rebalanced as needed and on a periodic
basis pursuant to published index criteria.\251\
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    \250\ See, e.g., NASDAQ, ``NASDAQ-100 Index'' (``The NASDAQ-100
Index is calculated under a modified capitalization-weighted
methodology. The methodology is expected to retain in general the
economic attributes of capitalization-weighting while providing
enhanced diversification. To accomplish this, NASDAQ will review the
composition of the NASDAQ-100 Index on a quarterly basis and adjust
the weightings of Index components using a proprietary algorithm, if
certain pre-established weight distribution requirements are not
met.''), available at http://dynamic.nasdaq.com/dynamic/nasdaq100_activity.stm
    \251\ Information regarding security indexes and their related
methodologies may be widely available to the general public or
restricted to licensees in the case of proprietary or ``private
label'' security indexes. Both public and private label security
indexes are frequently subject to intellectual property protection.
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    In addition, counterparties to a Title VII instrument frequently
agree to use as the underlying reference of a Title VII instrument a
security index based on predetermined criteria where the security index
composition or weighting may change as a result of the occurrence of
certain events specified in the Title VII instrument at execution, such
as ``succession events.'' Counterparties to a Title VII instrument also
may use a predetermined self-executing formula to make other changes to
the composition or weighting of a security index underlying a Title VII
instrument. In either of these situations, the composition of a
security index may change pursuant to predetermined criteria or
predetermined self-executing formulas without the Title VII instrument
counterparties, their agents, or third-party index providers having any
direct or indirect discretionary authority to change the security
index.
    In general, and by contrast to Title VII instruments in which the
counterparties, either directly or indirectly (e.g., through an
investment adviser or through the third-party index provider), have the
discretion to change the composition or weighting of the referenced
security index, where there is an underlying security index for which
there are predetermined criteria or a predetermined self-executing
formula for adjusting the security index that are not subject to change
or modification through the life of the Title VII instrument and that
are set forth in the Title VII instrument at execution (regardless of
who establishes the criteria or formula), a Title VII instrument on
such underlying security index would be on a broad-based or narrow-
based security index, depending on the composition and weighting of the
underlying security index. Subject to the interpretation discussed
below regarding security indexes that may shift from being a narrow-
based security index or broad-based security index during the life of
an existing Title VII instrument,\252\ the characterization of a Title
VII instrument based on a security index as either a swap or a
security-based swap would depend on the characterization of the
security index using the above interpretation.\253\
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    \252\ As discussed further below, the Commissions are concerned
about the potential use of security indexes to game the narrow-based
security index definition.
    \253\ See supra note 249 regarding the aggregation of separate
trades.
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Request for Comment

    104. The Commissions request comment on whether there are
additional or other criteria that would be appropriate in determining
whether a security index or security portfolio would constitute a
narrow-based security index for purposes of the definitions of the
terms ``swap'' and ``security-based swap.'' Please discuss any criteria
in detail and provide any supporting data where relevant.
    105. What are the ways in which Title VII instruments involving
security portfolios are structured, including changes in security
portfolio composition?
    106. Should ``discretionary authority to change'' by the
counterparties, either directly or indirectly (e.g., through an
investment adviser or through the third-party index provider), be a
determinative factor for whether a security portfolio should be treated
as a narrow-based security index? Why or why not? Are there Title VII
instruments where the underlying reference is a security portfolio
where counterparties may directly or indirectly (e.g., through an
investment manager or the third-party provider) exercise discretionary
authority to change the composition of the security portfolio that
should not be considered security-based swaps? Why or why not? Please
provide a detailed explanation of such Title VII instruments, the means
by which, and why, the composition of the underlying security portfolio
are established and subsequently changed, and for what purpose such
Title VII instruments are used.
    107. Should a security index, where changes to the composition are
not subject to discretionary authority but instead may be made pursuant
to predetermined criteria or a predetermined self-executing formula set
forth in the Title VII instrument at execution, be considered either a
broad-based security index or a narrow-based security index, depending
on its constitution? Why or why not? Are changes pursuant to such
predetermined criteria or formulas common? How frequently do such
changes occur? What sorts of events trigger such changes? Please
provide a detailed explanation and empirical data, to the extent
feasible.
    108. Are the terms ``predetermined criteria'' and ``predetermined
self-executing formula'' clear? Why or why not? If not, what
alternative or additional guidance should be provided to clarify under
what circumstances changes to the composition of a security index
underlying a Title VII instrument may be made without being considered
``at will'' or discretionary changes by the counterparties, either
directly or indirectly (e.g., through an investment adviser or through
the third-party index provider), that would result in the security
index being treated as a narrow-based security index and the Title VII
instrument being a security-based swap? Are there specific additional
criteria, restrictions, or parameters that should be considered? If so,
please provide a detailed explanation regarding such criteria,
restrictions, or parameters, including the types of changes that should
or should not be permitted.
    109. Are there specific methodologies or criteria, agreed to at or
prior to the

execution of a Title VII instrument, for changing the composition of an
underlying security index, that should be explicitly addressed by the
Commissions in providing the proposed guidance regarding security
indexes? If so, please provide a detailed explanation of those
methodologies or criteria and what additional guidance is necessary.
    110. Would restrictions on the frequency of changes to the
composition of a security index underlying a Title VII instrument be
useful in determining whether the underlying security index should be
treated as a narrow-based security index? If so, please provide a
detailed explanation of what restrictions should apply and why, as well
as empirical data to the extent feasible.
5. Evaluation of Title VII Instruments on Security Indexes That Move
From Broad-Based to Narrow-Based or Narrow-Based to Broad-Based
(a) In General
    As discussed above, the determination of whether a Title VII
instrument is a swap, a security-based swap, or both (i.e., a mixed
swap), is made at the execution of the Title VII instrument.\254\ If
the security index underlying a Title VII instrument migrates from
being broad-based to being narrow-based, or vice versa, during the life
of a Title VII instrument, the characterization of that Title VII
instrument would not change from its initial characterization
regardless of whether the Title VII instrument was entered into
bilaterally or was executed through a trade on or subject to the rules
of a DCM, SEF, FBOT, security-based SEF, or NSE. For example, if two
counterparties enter into a swap based on a broad-based security index,
and three months into the life of the swap the security index
underlying that Title VII instrument migrates from being broad-based to
being narrow-based, the Title VII instrument would remain a swap for
the duration of its life and would not be recharacterized as a
security-based swap.
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    \254\ See discussion supra part III.A.
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    If the material terms of a Title VII instrument are amended or
modified during its life, the Commissions would view the amended or
modified Title VII instrument as a new Title VII instrument.\255\ As a
result, the characteristics of the underlying security index must be
reassessed at the time of such an amendment or modification to
determine whether the security index has migrated from broad-based to
narrow-based or vice versa. If the security index has migrated, then
the characterization of the amended or modified Title VII instrument
would be determined by evaluating the characterization of the
underlying security index at the time the Title VII instrument is
amended or modified. Similarly, if a security index has migrated from
broad-based to narrow-based or vice versa, any new Title VII instrument
based on that security index would be characterized pursuant to an
evaluation of the underlying security index at the execution of that
new Title VII instrument.
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    \255\ For example, if, on its effective date, a Title VII
instrument tracks the performance of an index of 12 securities but
is amended during its term to track the performance of only 8 of
those 12 securities, the Commissions would view the amended or
modified Title VII instrument as a new Title VII instrument.
Conversely, if, on its effective date, a Title VII instrument tracks
the performance of an index of 12 securities but is amended during
its term to reflect the replacement of a departing ``key person'' of
a hedge fund that is a counterparty to the Title VII instrument with
a new ``key person,'' the Commissions would not view the amended or
modified Title VII instrument as a new Title VII instrument because
the amendment or modification is not to a material term of the Title
VII instrument. Because it would be a new Title VII instrument, any
regulatory requirements regarding new Title VII instruments would
apply.
---------------------------------------------------------------------------

    The Commissions are proposing guidance regarding circumstances in
which the character of a security index on which a Title VII instrument
is based changes according to predetermined criteria or a predetermined
self-executing formula set forth in the Title VII instrument (or in a
related or other agreement entered into by the counterparties or a
third-party index provider to the Title VII instrument) at execution.
Where at the time of execution such criteria or such formula would
cause the underlying broad-based security index to become or assume the
characteristics of a narrow-based security index or vice versa during
the duration of the instrument,\256\ then the characterization of the
Title VII instrument based on such security index would be a mixed swap
during the entire life of the Title VII instrument.\257\ Although at
certain points during the life of the Title VII instrument the
underlying security index would be broad-based and at other points the
underlying security index would be narrow-based, the Commissions
believe that regulating such a Title VII instrument as a mixed swap
from the execution of the Title VII instrument and throughout its life
reflects the appropriate characterization of a Title VII instrument
based on a security index that migrates pursuant to predetermined
criteria or a predetermined self-executing formula.
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    \256\ Thus, for example, if a predetermined self-executing
formula agreed to by the counterparties of a Title VII instrument at
or prior to the execution of the Title VII instrument provided that
the security index underlying the Title VII instrument would
decrease from 20 to 5 securities after six months, such that the
security index would become narrow-based as a result of the reduced
number of securities, then the Title VII instrument would be a mixed
swap at its execution. The characterization of the Title VII
instrument as a mixed swap would not change during the life of the
Title VII instrument.
    \257\ As discussed above in part III.G.4, to the extent a Title
VII instrument permits ``at will'' substitution of an underlying
security index, however, as opposed to the use of predetermined
criteria or a predetermined self-executing formula, the Title VII
instrument would be a security-based swap at its execution and
throughout its life regardless of whether the underlying security
index was narrow-based at the execution of the Title VII instrument.
---------------------------------------------------------------------------

    The Commissions believe that this guidance regarding the use of
predetermined criteria or a predetermined self-executing formula would
prevent potential gaming of the Commissions' guidance regarding
security indexes and prevent potential regulatory arbitrage based on
the migration of a security index from broad-based to narrow-based or
vice versa. In particular, the Commissions note that predetermined
criteria and predetermined self-executing formulas can be constructed
in ways that take into account the characteristics of a narrow-based
security index and prevent a narrow-based security index from becoming
broad-based and vice versa.

(b) Title VII Instruments on Security Indexes Traded on Designated
Contract Markets, Swap Execution Facilities, Foreign Boards of Trade,
Security-Based Swap Execution Facilities, and National Securities
Exchanges

    The Commissions recognize that security indexes underlying Title
VII instruments that are traded on DCMs, SEFs, FBOTs, security-based
SEFs, or NSEs raise particular issues if an underlying security index
migrates from broad-based to narrow-based or vice versa. The
characterization of an exchange-traded Title VII instrument at its
execution, as explained above, would not change through the life of the
Title VII instrument, regardless of whether the underlying security
index migrates from broad-based to narrow-based or vice versa.
Accordingly, a market participant who enters into a swap on a broad-
based security index traded on or subject to the rules of a DCM, SEF or
FBOT that migrates from broad-based to narrow-based may hold that
position until the swap's expiration without any change in regulatory
responsibilities, requirements, or obligations, and

similarly a market participant who enters into a security-based swap on
a narrow-based security index traded on a security-based SEF or NSE may
hold that position until the security-based swap's expiration without
any change in regulatory responsibilities, requirements, or
obligations.
    However, in the absence of any action by the Commissions, if the
market participant wants to offset the swap or enter into a new swap on
the DCM, SEF or FBOT where the underlying security index has migrated
from broad-based to narrow-based, or to offset the security-based swap
or enter into a new security-based swap on a security-based SEF or NSE
where the underlying security index has migrated from narrow-based to
broad-based, the participant would be prohibited from doing so. That is
because swaps may trade only on DCMs, SEFs, and FBOTs, and security-
based swaps may trade only on registered NSEs and security-based
SEFs.\258\ The Commissions believe it is important to address how to
treat Title VII instruments traded on trading platforms where the
underlying security index migrates from broad-based to narrow-based or
narrow-based to broad-based so that market participants will know where
such Title VII instruments may be traded and can avoid potential
disruption of their ability to offset or enter into new Title VII
instruments on trading platforms when such migration occurs. The
Commissions are proposing rules accordingly.\259\
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    \258\ If a swap were based on a security index that migrated
from broad-based to narrow-based, a DCM, SEF, or FBOT could no
longer offer the Title VII instrument because it would be a
security-based swap. Similarly, if a security-based swap were based
on a security index that migrated from narrow-based to broad-based,
a security-based SEF or NSE could no longer offer the Title VII
instrument because it would be a swap.
    \259\ The proposed rules apply only to the particular Title VII
instrument that is traded on or subject to the rules of a DCM, SEF,
FBOT, security-based SEF, or NSE. To the extent that a particular
Title VII instrument is not traded on such a trading platform (even
if another Title VII instrument of the same class or type is traded
on such a trading platform) the proposed rules would not apply to
that particular Title VII instrument.
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    Congress and the Commissions addressed a similar issue in the
context of security futures, where the security index on which a future
is based may migrate from broad-based to narrow-based or vice versa.
Congress provided in the definition of ``narrow-based security index''
in both the CEA and the Exchange Act \260\ for a tolerance period
ensuring that, under certain conditions, a futures contract on a broad-
based security index traded on a DCM may continue to trade, even when
the index temporarily assumes characteristics that would render it a
narrow-based security index under the statutory definition.\261\ In
general, an index is subject to this tolerance period, and therefore is
not a narrow-based security index, if: (i) a futures contract on the
index traded on a DCM for at least 30 days as a futures contract on a
broad-based security index before the index assumed the characteristics
of a narrow-based security index and (ii) the index does not retain the
characteristics of a narrow-based security index for more than 45
business days over 3 consecutive calendar months. Pursuant to these
statutory provisions, if the index becomes narrow-based for more than
45 business days over 3 consecutive calendar months, the index is
excluded from the definition of the term ``narrow-based security
index'' for the following 3 calendar months as a grace period.
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    \260\ CEA section 1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii);
section 3(a)(55)(C)(iii) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii).
    \261\ By joint rules, the Commissions have provided that
``[w]hen a contract of sale for future delivery on a security index
is traded on or subject to the rules of a foreign board of trade,
such index shall not be a narrow-based security index if it would
not be a narrow-based security index if a futures contract on such
index were traded on a designated contract market * * * .'' See CFTC
rule 41.13, 17 CFR 41.13, and rule 3a55-3 under the Exchange Act, 17
CFR 240.3a55-3. Accordingly, the statutory tolerance period rules
applicable to futures on security indexes traded on DCMs apply to
futures traded on FBOTs as well.
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    The Commissions believe a similar tolerance period should apply to
swaps traded on DCMs, SEFs, and FBOTs and security-based swaps traded
on security-based SEFs and NSEs. Accordingly, the Commissions are
proposing rules providing for tolerance periods for swaps that are
traded on DCMs, SEFs, or FBOTs and for security-based swaps traded on
security-based SEFs and NSEs.
    Under paragraph (2)(i)(A) of proposed rule 1.3(yyy) under the CEA
and paragraph (b)(1)(i) of proposed rule 3a68-3 under the Exchange Act,
to be subject to the tolerance period, a security index underlying a
swap executed on or subject to the rules of a DCM, SEF, or FBOT must
not have been a narrow-based security index \262\ during the first 30
days of trading.\263\ If the index becomes narrow-based during the
first 30 days of trading, paragraph (2)(i)(B) of proposed rule 1.3(yyy)
under the CEA and paragraph (b)(1)(ii) of proposed rule 3a68-3 under
the Exchange Act provide that the index must not have been a narrow-
based security index during every trading day of the 6 full calendar
months preceding a date no earlier than 30 days prior to the
commencement of trading of a swap on such index.\264\ If either of
these alternatives are met, paragraph (2)(ii) of proposed rule 1.3(yyy)
under the CEA and paragraph (b)(2) of proposed rule 3a68-3 under the
Exchange Act provide that the index will not be a narrow-based security
index if it has been a narrow-based security index for no more than 45
business days over 3 consecutive calendar months. Paragraph (2) of
proposed rule 1.3(yyy) under the CEA and paragraph (b) of proposed rule
3a68-3 under the Exchange Act apply solely for purposes of swaps traded
on or subject to the rules of a DCM, SEF, or FBOT.
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    \262\ For purposes of the proposed rules, the term ``narrow-
based security index'' shall also mean ``issuers of securities in a
narrow-based security index.'' See supra part III.G.3(b) (discussing
the proposed rules defining ``issuers of securities in a narrow-
based security index'').
    \263\ This provision is consistent with the provisions of the
CEA and the Exchange Act applicable to futures contracts on security
indexes. CEA section 1a(35)(B)(iii)(I), 7 U.S.C. 1a(35)(B)(iii)(I);
section 3(a)(55)(C)(iii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii)(I).
    \264\ This alternative test is the same as the alternative test
applicable to futures contracts in CEA rule 41.12, 17 CFR 41.12 and
rule 3a55-2 under the Exchange Act, 17 CFR 240.3a55-2.
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    Similarly, paragraph (3) of proposed rule 1.3(yyy) under the CEA
and paragraph (c) of proposed rule 3a68-3 under the Exchange Act
provide a tolerance period for security-based swaps traded on security-
based SEFs or NSEs. Under paragraph (3)(i)(A) of proposed rule 1.3(yyy)
under the CEA and paragraph (c)(1)(i) of proposed rule 3a68-3 under the
Exchange Act, to be subject to the tolerance period, a security index
underlying a security-based swap executed on a security-based SEF or
NSE must have been a narrow-based security index during the first 30
days of trading. If the index becomes broad-based during the first 30
days of trading, paragraph (3)(i)(B) of proposed rule 1.3(yyy) under
the CEA and paragraph (c)(1)(ii) of proposed rule 3a68-3 under the
Exchange Act provide that the index must have been a non-narrow-based
security index during every trading day of the 6 full calendar months
preceding a date no earlier than 30 days prior to the commencement of
trading of a security-based swap on such index. If either of these
alternatives are met, paragraph (3)(ii) of proposed rule 1.3(yyy) under
the CEA and paragraph (c)(2) of proposed rule 3a68-3 under the Exchange
Act provide that the index will be a narrow-based security index if it
has been a security index that is not narrow-based for no more than 45
business days over 3 consecutive

calendar months.\265\ Paragraph (3) of proposed rule 1.3(yyy) under the
CEA and paragraph (c) of proposed rule 3a68-3 under the Exchange Act
apply solely for purposes of security-based swaps traded on security-
based SEFs or NSEs.
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    \265\ These provisions are consistent with the parallel
provisions in the CEA and the Exchange Act applicable to futures
contracts on security indexes traded on DCMs. CEA section
1a(35)(B)(iii)(II), 7 U.S.C. 1a(35)(B)(iii)(II); section
3(a)(55)(C)(iii)(II) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii)(II).
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    The Commissions are proposing that, once the tolerance period under
the proposed rules has ended, there would be a grace period during
which a Title VII instrument based on a security index that has
migrated from broad-based to narrow-based or vice versa would be able
to trade on the platform on which Title VII instruments based on such
security index were trading before the security index migrated and can
also, during such period, be cleared. Paragraph (4)(i) of proposed rule
1.3(yyy) under the CEA and paragraph (d)(1) of proposed rule3a68-3
under the Exchange Act would provide for an additional 3-month grace
period applicable to a security index that becomes narrow-based for
more than 45 business days over 3 consecutive calendar months, solely
with respect to swaps that are traded on or subject to the rules of
DCMs, SEFs, or FBOTs. During the grace period, such an index would not
be considered a narrow-based security index. Paragraph (4)(ii) of
proposed rule 1.3(yyy) under the CEA and paragraph (d)(2) of proposed
rule3a68-3 under the Exchange Act would apply the same grace period to
a security-based swap on a security index that becomes broad-based for
more than 45 business days over 3 consecutive calendar months, solely
with respect to security-based swaps that are traded on a security-
based SEF or NSE. During the grace period, such an index would not be
considered a broad-based security index.\266\ As a result, this
proposed rule would provide sufficient time for the migrated Title VII
instrument to satisfy listing and clearing requirements applicable to
swaps or security-based swaps, as appropriate.
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    \266\ These provisions are consistent with the parallel
provisions in the CEA and the Exchange Act applicable to futures
contracts on security indexes traded on DCMs. See CEA section
1a(35)(D), 7 U.S.C. 1a(35)(D); section 3(a)(55)(E) of the Exchange
Act, 15 U.S.C. 78c(a)(55)(E).
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    There would be no overlap between the tolerance and the grace
periods under the proposed rules and no ``re-triggering'' of the
tolerance period. For example, if a security index becomes narrow-based
for more than 45 business days over 3 consecutive calendar months,
solely with respect to swaps that are traded on or subject to the rules
of DCMs, SEFs, or FBOTs, but as a result of the proposed rules is not
considered a narrow-based security index during the grace period, the
tolerance period provisions would not apply, even if the security-index
migrated temporarily during the grace period. After the grace period
has ended, a security index would need to satisfy anew the requirements
under the proposed rules regarding the tolerance period in order to
trigger a new tolerance period.
    The Commissions note that the proposed rules would not result in
the recharacterization of any outstanding Title VII instruments. In
addition, the proposed tolerance and grace periods would apply only to
Title VII instruments that are traded on or subject to the rules of
DCMs, SEFs, FBOTs, security-based SEFs, and NSEs.

Request for Comment

    The Commissions request comment on all aspects of proposed rules
1.3(yyy) under the CEA and proposed rule 3a68-3 under the Exchange Act,
including the following:
    111. The Commissions request comment regarding whether the term
``narrow-based security index'' as defined in the CEA and the Exchange
Act \267\ requires further definition solely in the context of Title
VII instruments.
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    \267\ CEA sections 1a(35)(A) and (B), 7 U.S.C. 1a(35)(A) and
(B); section 3(a)(55)(B) and (C) of the Exchange Act, 15 U.S.C.
78c(a)(55)(B) and (C).
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    112. Are there particular types of Title VII instruments that
require additional guidance as to how the narrow-based security index
definition applies? If so, which types of Title VII instruments? How
should the definition apply to them? Please provide a detailed
explanation of such Title VII instruments and the additional guidance
that would be appropriate.
    113. Does the proposed guidance effectively address security
indexes that migrate from broad-based to narrow-based and vice versa?
Why or why not? If not, what additional or alternative requirements
would be appropriate, and why?
    114. Will the proposed limitations regarding the use of
predetermined criteria or predetermined self-executing formulas for
Title VII instruments effectively prevent gaming of the proposed rules
and potential regulatory arbitrage based on the migration of a security
index or security portfolio from broad-based to narrow-based or vice
versa? Why or why not? If not, please provide a detailed explanation of
why not, and what additional or alternative limitations would do so.
    115. Should the standard pursuant to which a Title VII instrument
would be a mixed swap during the entire life of the Title VII
instrument require instead that the predetermined criteria or
predetermined self-executing formula be constructed in such a manner
that a broad-based security index or security portfolio would be
reasonably likely to become or assume the characteristics of a narrow-
based security index or security portfolio, or vice versa? Why or why
not? Are there additional or alternative standards that should be used
in determining when a Title VII instrument would be a mixed swap during
the entire life of the Title VII instrument? If so, please provide a
detailed explanation of such standards and why they would be effective.
    116. Do the proposed tolerance period rules appropriately address
security indexes that temporarily change from broad-based to narrow-
based, and from narrow-based to broad-based, in the context of Title
VII instruments that are executed on or subject to the rules of a DCM,
SEF, FBOT, security-based SEF, or NSE? Why or why not? If not, how
should the proposed tolerance period rules be modified?
    117. Should the ``grace period'' applicable to Title VII
instruments executed on or subject to the rules of a DCM, SEF, FBOT,
security-based SEF, or NSE regarding a security index that becomes
narrow-based or broad-based, respectively, for more than 45 business
days over 3 consecutive calendar months be modified? Why or why not? If
so, what modifications should be made?
    118. What would be the impact of the proposed rules on market
participants with open swap or security-based swap positions if the
security index underlying a swap were to become narrow-based or if the
security index underlying a security-based swap were to become broad-
based? Should market participants be allowed to liquidate their swaps
or security-based swaps prior to expiration but after the grace period?
If so, how would the listing market restrict trading for liquidation
only?

H. Method of Settlement of Index CDS

    The method that the parties have chosen or use to settle an index
CDS following the occurrence of a credit event under such index CDS
also can affect whether such index CDS would be a swap, a security-
based swap, or both (i.e., a mixed swap). The Commissions believe that
if an index CDS that is not based on a narrow-based

security index under the Commissions' proposed rules includes a
mandatory physical settlement provision that would require the delivery
of, and therefore the purchase and sale of, a non-exempted security
\268\ or a loan in the event of a credit event, such an index CDS would
be a mixed swap.\269\ Conversely, the Commissions believe that if an
index CDS that is not based on a narrow-based security index under the
Commissions' proposed rules includes a mandatory cash settlement \270\
provision, such index CDS would be a swap, and not a security-based
swap or a mixed swap, even if the cash settlement were based on the
value of a non-exempted security or a loan.
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    \268\ The Commissions note that section 3(a)(68)(C) of the
Exchange Act, 15 U.S.C. 78c(a)(68)(C), provides that ``[t]he term
``security-based swap'' does not include any agreement, contract, or
transaction that meets the definition of a security-based swap only
because such agreement, contract, or transaction references, is
based upon, or settles through the transfer, delivery, or receipt of
an exempted security under paragraph (12) [of the Exchange Act], as
in effect on the date of enactment of the Futures Trading Act of
1982 (other than any municipal security as defined in paragraph (29)
[of the Exchange Act] as in effect on the date of enactment of the
Futures Trading Act of 1982), unless such agreement, contract, or
transaction is of the character of, or is commonly known in the
trade as, a put, call, or other option.''
    \269\ The Commissions' views as to the legal basis for such a
conclusion differ. The SEC also notes that there must either be an
effective registration statement covering the transaction or an
exemption under the Securities Act would need to be available for
such physical delivery of securities and compliance issues under the
Exchange Act would also need to be considered.
    \270\ The Commissions are aware that the 2003 Definitions supra
note 35, include ``Cash Settlement'' as a defined term and that such
``Settlement Method'' (also a defined term in the 2003 Definitions)
works differently than auction settlement pursuant to the ``Big Bang
Protocol'' or ``Auction Supplement'' (each as defined below). The
Commissions' use of the term ``cash settlement'' in this section
includes ``Cash Settlement,'' as defined in the 2003 Definitions,
and auction settlement, as described in the ``Big Bang Protocol'' or
``Auction Supplement.''
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    The Commissions believe that an index CDS that is not based on a
narrow-based security index under the Commissions' proposed rules and
that provides for cash settlement in accordance with the 2009 ISDA
Credit Derivatives Determinations Committees and Auction Settlement
Supplement to the 2003 Definitions (the ``Auction Supplement'') or with
the 2009 ISDA Credit Derivatives Determinations Committees and Auction
Settlement CDS Protocol (``Big Bang Protocol'') \271\ would be a swap,
and would not be considered a security-based swap or a mixed swap
solely because the determination of the cash price to be paid is
established through a securities or loan auction.\272\ In 2009, auction
settlement, rather than physical settlement, became the default method
of settlement for, among other types of CDS, index CDS on corporate
issuers of securities.\273\ The amount of the cash settlement is
determined through an auction triggered by the occurrence of a credit
event.\274\ The Auction Supplement ``hard wired'' the mechanics of
credit event auctions into the 2003 Definitions.\275\ The Commissions
understand that the credit event auction process that is part of the
ISDA terms works as follows:
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    \271\ See Int'l Swaps and Derivatives Ass'n, Inc., ``2009 ISDA
Credit Derivatives Determinations Committees and Auction Settlement
CDS Protocol,'' available at http://www.isda.org/bigbangprot/docs/Big-Bang-Protocol.pdf.
    \272\ The possibility that such index CDS may, in fact, be
physically settled if an auction is not held or if the auction fails
would not affect the characterization of the index CDS.
    \273\ The Commissions understand that the Big Bang Protocol is
followed for index CDS involving corporate debt obligations but is
not followed for index CDS based on asset-backed securities, loan-
only CDS, and certain other types of CDS contracts. To the extent
that such other index CDS contain auction procedures similar to the
auction procedures for corporate debt to establish the cash price to
be paid, the Commissions also would not consider such other index
CDS that are not based on narrow-based security indexes under the
Commissions' proposed rules to be mixed swaps.
    \274\ The Commissions understand that other conditions may need
to be satisfied as well for an auction to be held.
    \275\ See supra note 35.
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    Following the occurrence of a credit event under a CDS, a
determinations committee (``DC'') established by ISDA, following a
request by any party to a credit derivatives transaction that is
subject to the Big Bang Protocol or Auction Supplement, will determine,
among other matters: (i) Whether and when a credit event occurred; (ii)
whether or not to hold an auction to enable market participants to
settle those of their credit derivatives transactions covered by the
auction; (iii) the list of deliverable obligations of the relevant
reference entity; and (iv) the necessary auction specific terms. The
credit event auction takes place in two parts. In the first part of the
auction, dealers submit physical settlement requests, which are
requests to buy or sell any of the deliverable obligations (based on
the dealer's needs and those of its counterparties), and an initial
market midpoint price is created based on dealers' initial bids and
offers. Following the establishment of the initial market midpoint, the
physical settlement requests are then calculated to determine the
amount of open interest.
    The aggregate amount of open interest is the basis for the second
part of the auction. In the second part of the auction, dealers and
investors can determine whether to submit limit orders and the levels
of such limit orders. The limit orders, which are irrevocable, have a
firm price in addition to size and whether it is a buy or sell order.
The auction is conducted as a ``dutch'' auction, in which the open buy
interests and open sell interests are matched.\276\ The final price of
the auction is the last limit order used to match against the open
interest. The final price in the auction is the cash price used for
purposes of calculating the settlement payments in respect of the
orders to buy and sell the deliverable obligations and it is also used
to determine the cash settlement payment under the CDS.
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    \276\ The second part of the credit event auction process
involves offers and sales of securities that must be made in
compliance with the provisions of the Securities Act and the
Exchange Act. First, the submission of a physical settlement request
constitutes an offer by the counterparty to either buy or sell any
one of the deliverable obligations in the auction. Second, the
submission of the irrevocable limit orders by dealers or investors
are sales or purchases by such persons at the time of submission of
the irrevocable limit order. Through the auction mechanism, where
the open interest (which represents physical settlement requests) is
matched with limit orders, buyers and sellers are matched. Finally,
following the auction and determination of the final price, the
counterparty who has submitted the physical delivery request decides
which of the deliverable obligations will be delivered to satisfy
the limit order in exchange for the final price. The sale of the
securities in the auction occurs at the time the limit order is
submitted, even though the identification of the specific
deliverable obligation does not occur until the auction is
completed.
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I. Security-Based Swaps as Securities Under the Exchange Act and
Securities Act

    Pursuant to the Dodd-Frank Act, a security-based swap is defined as
a ``security'' under the Exchange Act \277\ and Securities Act.\278\ As
a result, security-based swaps are subject to the Exchange Act and the
Securities Act and the rules and regulations promulgated
thereunder.\279\ To the

extent that security-based swaps differ from more traditional
securities products, however, the SEC is soliciting comment on whether
additional guidance may be necessary regarding the application of
certain provisions of the Exchange Act and the Securities Act, and the
rules and regulations promulgated thereunder, to security-based swaps.
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    \277\ See section 761(a)(2) of the Dodd-Frank Act (inserting the
term ``security-based swap'' into the definition of ``security'' in
section 3a(10) of the Exchange Act, 15 U.S.C. 78c(a)(10)).
    \278\ See section 768(a)(1) of the Dodd-Frank Act (inserting the
term ``security-based swap'' into the definition of ``security'' in
section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1)).
    \279\ Sections 761(a)(3) and (4) of the Dodd-Frank Act amend
sections 3(a)(13) and (14) of the Exchange Act, 15 U.S.C. 78c(a)(13)
and (14), and section 768(a)(3) of the Dodd-Frank Act adds section
2(a)(18) to the Securities Act, 15 U.S.C. 77b(a)(18), to provide
that the terms ``purchase'' and ``sale'' of a security-based swap
shall mean the ``the execution, termination (prior to its scheduled
maturity date), assignment, exchange, or similar transfer or
conveyance of, or extinguishing of rights or obligations under, a
security-based swap, as the context may require.''
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Request for Comment
    119. Are there Exchange Act or Securities Act provisions, or rules
and regulations promulgated thereunder, that contemplate application to
cash market securities products or other securities products for which
additional guidance may be necessary when applied to security-based
swaps? If so, which provisions, and why? Please provide detailed
analysis and empirical data, to the extent feasible.
    120. What additional guidance or modifications would be necessary
to any such provisions in order to address the application of these
provisions to security-based swaps while still achieving the regulatory
purposes of those provisions?

IV. Mixed Swaps

A. Scope of the Category of Mixed Swap

    The category of mixed swap is described, in both the definition of
the term ``security-based swap'' in the Exchange Act and the definition
of the term ``swap'' in the CEA, as a security-based swap that is also:
based on the value of 1 or more interest or other rates, currencies,
commodities, instruments of indebtedness, indices, quantitative
measures, other financial or economic interest or property of any kind
(other than a single security or a narrow-based security index), or the
occurrence, non-occurrence, or the extent of the occurrence of an event
or contingency associated with a potential financial, economic, or
commercial consequence (other than an event described in subparagraph
(A)(ii)(III) [of section 3(a)(68) of the Exchange Act]).\280\
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    \280\ Section 3(a)(68)(D) of the Exchange Act, 15 U.S.C.
78c(a)(68)(D); CEA section 1a(47)(D), 7 U.S.C. 1a(47)(D).
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    A mixed swap, therefore, is both a security-based swap and a
swap.\281\
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    \281\ Id. The exclusion from the definition of the term ``swap''
for security-based swaps does not include security-based swaps that
are mixed swaps. See CEA section 1a(47)(B)(x), 7 U.S.C.
1a(47)(B)(x).
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    The Commissions believe that the scope of mixed swaps is, and is
intended to be, narrow. Title VII establishes robust and largely
parallel regulatory regimes for both swaps and security-based swaps and
directs the Commissions to jointly prescribe such regulations regarding
mixed swaps as may be necessary to carry out the purposes of the Dodd-
Frank Act.\282\ More generally, the Commissions believe the category of
mixed swap was designed so that there would be no gaps in the
regulation of swaps and security-based swaps. Therefore, in light of
the statutory scheme created by the Dodd-Frank Act for swaps and
security-based swaps, the Commissions believe the category of mixed
swap covers only a small subset of Title VII instruments.\283\
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    \282\ See section 712(a)(8) of the Dodd-Frank Act.
    \283\ See Morgan Stanley Letter (expressing the view that ``the
universe of mixed swaps should be relatively small''); Letter from
Timothy W. Cameron, Esq., Managing Director, Asset Management Group,
Securities Industry and Financial Markets Association (``SIFMA
Letter'') (suggesting that the scope of products included in the
mixed swap category should be limited to ``avoid unnecessary and
duplicative regulation'').
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    For example, a Title VII instrument in which the underlying
references are the value of an oil corporation stock and the price of
oil would be a mixed swap. Similarly, a Title VII instrument in which
the underlying reference is a portfolio of both securities (assuming
the portfolio is not an index or, if it is an index, that the index is
narrow-based) and commodities would be a mixed swap. Mixed swaps also
would include certain Title VII instruments called ``best of'' or ``out
performance'' swaps that require a payment based on the higher of the
performance of a security and a commodity (other than a security).\284\
As discussed elsewhere in this release, the Commissions also believe
that certain Title VII instruments may be mixed swaps if they meet
specified conditions.
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    \284\ See Cleary Letter (providing as examples of mixed swaps,
``a swap based on the out-performance of gold, oil or another
commodity relative to a security or narrow-based security index,''
``a security-based swap with knock-out/knock-in events tied to the
value of gold, oil or another commodity,'' and ``[s]waps on indices
or baskets that include narrow-based security index and physical
commodity components''); Deutsche Bank Letter (indicating that
``best-of'' swaps should be treated as mixed swaps); Morgan Stanley
Letter (``An example of a mixed swap might be a contract under which
one party takes long exposure to the common stock of a U.S.
corporation while simultaneously taking short exposure to the price
of gold.'').
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