CFTC v. Archegos Capital Management LP: CFTC Lacks Jurisdiction Over Total Return Swaps Based on ETFs and Custom Baskets | Practical Law

CFTC v. Archegos Capital Management LP: CFTC Lacks Jurisdiction Over Total Return Swaps Based on ETFs and Custom Baskets | Practical Law

The US District Court for the Southern District of New York (SDNY) held that the CFTC does not have jurisdiction over short total return swaps (TRS) based on exchange-traded funds (ETFs) and custom baskets of securities. The SDNY held that these transactions are security-based swaps (SBS) subject to SEC oversight.

CFTC v. Archegos Capital Management LP: CFTC Lacks Jurisdiction Over Total Return Swaps Based on ETFs and Custom Baskets

by Practical Law Finance
Published on 04 Oct 2023 • USA (National/Federal)
The US District Court for the Southern District of New York (SDNY) held that the CFTC does not have jurisdiction over short total return swaps (TRS) based on exchange-traded funds (ETFs) and custom baskets of securities. The SDNY held that these transactions are security-based swaps (SBS) subject to SEC oversight.
On September 19, 2023, in CFTC v. Archegos Capital Management LP, the US District Court for the Southern District of New York (SDNY) issued an opinion and order holding that, under US swaps rules, the CFTC lacks jurisdiction over short total return swaps (TRS) based on exchange-traded funds (ETFs) and custom baskets of securities, holding that these transactions are security-based swaps (SBS) subject to SEC oversight. (Commodity Futures Trading Comm'n v. Archegos Cap. Mgmt. LP, (S.D.N.Y. Sept. 19, 2023)).

Background

Beginning in March 2020, Archegos Capital Management LP (Archegos) managed the Archegos Fund and began to pursue a long/short strategy using two types of swaps:
  • Long, single-name TRS referencing single-name securities.
  • Short TRS (short swaps) designed to hedge the risk of the long swaps, specifically:
    • short TRS based on ETFs (ETF TRS); and
    • short TRS based on custom baskets (custom basket TRS).
According to the order, the CFTC alleged that Archegos began to build "massive, highly concentrated, illiquid long positions in a small number of small securities through long TRS" while partially hedging through the short swaps. The CFTC also alleged that defendants made false and misleading statements about the size, composition, and liquidity of Archegos' overall swap portfolio to induce its counterparties to extend Archegos additional trading capacity for long TRS positions and to preserve favorable trading terms.
According to the order, the CFTC alleged that the prices of the securities underlying Archegos' concentrated long single-name TRS positions plummeted, and Archegos began to face large and escalating margin calls on those transactions. Defendants made additional false representations to counterparties to stave off the collapse of Archegos, including lying to secure the return of excess margin. By the end of the week of March 26, 2021, Archegos had collapsed, and its counterparties unwound the TRS positions, incurring in some cases billions of dollars of losses.
On April 27, 2022, the CFTC filed an amended complaint against defendants Archegos and its chief financial officer, Patrick Halligan (collectively, defendants) for violating Section 6(C)(1) of the CEA (7 U.S.C. § 9(1)) and CFTC Regulation 180.1(a)(1)-(3) (17 C.F.R. § 180.1(a)(1)-(3)), alleging that defendants committed fraud by the use of a deceptive device or contrivance.
Defendants filed motions to dismiss the CFTC's amended complaint, alleging that the CFTC exceeded its regulatory jurisdiction under Title VII of the Dodd-Frank Act, which allocates regulatory authority over SBS to the SEC and swaps to the CFTC, while both the SEC and CFTC jointly hold authority over "mixed swaps" (see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Types of Swaps Under Title VII). The SEC and CFTC also issued a joint rulemaking (joint release) on August 13, 2012 that further defines these terms for jurisdictional purposes (Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208-01) (see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance).
As explained in the order, the term "swap" excludes SBS, which include swaps based on a single security or loan, or on a narrow-based security index. Consequently, swap instruments based on a broad-based security index or a portfolio of securities are swaps rather than SBS. But where a TRS is based on a single security or loan, or a narrow-based security index, the TRS would be an SBS. Finally, a mixed swap is a swap that is both based on a single security or narrow-based security index and also based on another financial or economic interest falling within the CFTC's regulatory authority, such as a broad-based security index. According to the order, the CFTC does not dispute that the single-name long TRS were SBS subject to the SEC's sole authority, so the only question before the court was whether the ETF TRS and custom basket TRS fall under the CFTC's regulatory jurisdiction.

Outcome

The SDNY granted defendants' motions to dismiss finding the ETF swaps and custom basket TRS fall under the SEC's regulatory jurisdiction because:
  • ETF TRS. The ETF TRS, by definition, reference a single security, specifically a share or shares of the underlying ETF named in the swap. According to the court, the fact that an ETF might track the value of hundreds of index securities does not change this analysis. Additionally, the court found the ETF TRS were not mixed swaps because the joint release makes clear that mixed swaps are intended to be a narrow category and must be based on multiple underlying references, one that is subject to SEC authority and one that is subject to CFTC authority. Because the ETF TRS incorporate only a single reference of a share of an ETF and nothing else, they are not mixed swaps.
  • Custom basket TRS. According to the order, the question of whether the custom basket TRS are subject to CFTC regulatory authority turns on whether they are properly categorized as being based on a narrow-based or broad-based securities index, because swaps falling into the narrow-based category are subject to SEC authority and swaps falling into the broad-based category are subject to CFTC authority. In its definition of a narrow-based security index, the joint release states "where the counterparties, either directly or indirectly (e.g., through an investment adviser or through [a] third-party index provider), have this discretionary authority to change the composition or weighing or securities in a security portfolio, that security portfolio will be treated as a narrow-based security index." According to the order, the SDNY reviewed the swap agreements submitted by defendants and concluded that each swap agreement gave Archegos, its counterparty, or both parties discretionary authority to change the composition of each custom basket TRS on an ongoing basis. The court reasoned that the framing of "discretionary authority" in the joint release indicates that the type of discretion permitted by the Archegos swap agreements requires the SDNY to characterize them as narrow-based rather than broad-based, meaning they fall under the SEC's regulatory authority.
According to the order, the CFTC requested an opportunity to replead if defendants' motions to dismiss were granted. The SDNY denied this request because, according to the court, the CFTC has not shown that repleading would correct the substantive deficiencies in its complaint.