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Historically, Total Return Swaps (“TRS”), which share characteristics with both interest rate swaps and credit default swaps, have operated as obscure financial derivative products. Recently, however, TRS have gained heightened attention due to various investigations and regulatory scrutiny. Questions about LIBOR (London Interbank Offered Rate) manipulation and ISDA fix rate manipulation may have an impact on interest rate derivatives. Allegations of manipulation of credit default swaps, including that banks conspired with other parties to control the credit default swaps market, resulting in trading of CDS at artificially large bid-ask spreads have arisen.
Perhaps because of the unique structure of total return swaps and the resulting flow of risk, in recent years, these vehicles have received increased regulatory attention. The Dodd-Frank regulations expressly address total return swaps, which will be regulated by either the Commodity Futures Trading Commission (“CFTC”) or the Securities and Exchange Commission (“SEC”) depending on the type of TRS. Even the IRS has started to crack down on TRS as a means to avoid taxes on dividends paid to foreign investors.
This article begins with a description and diagram of the structure and risk relationships inherent in total return swaps. Next, this article considers scenarios in which investing in a TRS could bring advantages, which is followed by an analysis of the vehicle’s vulnerability to manipulations. Finally, this article examines some of the unique regulatory aspects of this complex investment vehicle.
What is a Total Return Swap?
A total return swap transfers or swaps the total economic performance of a reference asset between two parties. The total return payer transfers the total return on a reference obligation, such as a bond, loan pool, or commodity index, to the total return receiver. The total return receiver is paid the cash flows from the underlying obligation as well as any appreciation in the value of the obligation. But, the total return receiver must pay the total return payer any depreciation in the value and compensate the payer for any default losses. The total return receiver is also obligated to pay periodic interest equal to a money market rate, usually LIBOR, plus a negotiated spread.
TRS have common features with other derivatives such as interest rate swaps and credit default swaps. As stated above, in a TRS the total return payer transfers the total return, including losses due to default, to the total return receiver. This transaction transfers the credit risk from the total return payer to the total return receiver for the duration of the swap. The transfer of credit risk puts the total return payer in a similar position to that of a protection buyer in a cash settled credit default swap.1 The TRS also exposes the total return payer to interest rate risk as they are accepting LIBOR in exchange for the reference obligation’s total return. This gives the total return payer a position that is similar to the payer position in an interest rate swap.
Who Might Invest in a TRS and Why?
TRS originated as a way for commercial banks to change the risk profile of their loan portfolios, which were traditionally concentrated in specific industries and/or geographical regions. By acting as a total return payer, a TRS allowed a bank to reduce its risk exposure to a specific industry or geographic location without having to sell its customers’ loans. On the flip side, if a bank wanted to diversify the risk in its loan portfolio, it could enter into a TRS as a total return receiver and obtain exposure to other industries or geographic regions that were outside its traditional area of expertise.
Diversification is also the reason why non-traditional investors, such as hedge funds, are drawn to TRS. By entering into a TRS as a total return receiver these investors can obtain exposure to illiquid or untraded asset classes. For example, these investors have obtained exposure to the returns of commercial loans and other illiquid asset classes such as lightly traded stocks, bonds and commodities, or an untraded commodity index using TRS.2 As long as the returns of the illiquid assets are not correlated with the returns on the investor’s existing holdings the diversification reduces the risk level of the non-traditional investor.
There are financial motivations for entering a TRS. The total return payer may be able to lock in profits by entering to a TRS. This occurs whenever the total return payer has a funding cost that is less than the payment they receive in the TRS (LIBOR plus a spread).3
On the other hand, the total return receiver is able to obtain financing at favorable rates since they finance their exposure to the reference obligation at a spread to LIBOR. Generally, this spread is smaller than what the total return receiver could obtain if they financed an outright purchase of the reference obligation. This lower rate is because the total return receiver does not have to borrow the capital necessary to purchase the reference obligation. Since the total return receiver does not have to make an initial outlay to purchase the reference obligation and place the reference entity and financing on its balance sheet, this effectively gives the total return receiver a leveraged position in the reference obligation.4
Manipulations of Similar Products Affects the TRS
The common features between TRS and other derivative products means that manipulation and alleged manipulations that impact interest rate swaps or credit default swaps will also impact total return swaps. This is clear in the case of LIBOR manipulation. The banks that set LIBOR have been accused of pushing LIBOR down, resulting in lower payments to the total return payer just as in interest rate swaps. Several banks have entered into settlement agreements with the U.S. regulators regarding manipulation of LIBOR.
Various investigations and recent litigation have alleged that banks used their position in the over-the-counter (“OTC”) market to maintain high bid-ask spreads and sell credit default swaps at non-competitive prices. Since both credit default swaps and total return swaps are credit derivatives sold in OTC markets, total return swaps may have been similarly impacted as credit default swaps.
The manipulations of the LIBOR and potential manipulations of ISDAfix Rate and even credit default swaps has affected the pricing, payments, and possible termination amounts within the TRS.
The Evolving Regulatory Landscape Relating to TRS
The proposed Dodd-Frank regulations of TRS gives authority to two different regulatory agencies depending on the type of TRS. Pursuant to the Dodd-Frank Act, the CFTC has authority to regulate “swaps,” while the SEC is charged with regulating “security-based swaps.” The Securities and Exchange Commission and the United States Commodity Futures Trading Commission published regulations in 2012 outlining their authority to govern TRS. The scope of the term “swap” and “security-based swap” determines which TRS transactions, and which parties to a TRS transaction, will be subject to many of the derivatives regulatory provisions of the Dodd-Frank Act, i.e., requirements for recordkeeping and reporting, mandatory clearing and trade execution, collateral segregation and margin levels, and registration as a regulated entity such as a swap dealer or major swap participant.
Regarding “security-based swaps,” the Dodd-Frank Act explains that they are based on “(I) an index that is a narrow-based security index...; (II) a single security or loan...; or (III) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or 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.”5 While this statutory definition provides that a swap based on a single loan is classified as a “security-based swap,” it does not expressly include other types of loan-based transactions, including TRS based on multiple loans or borrowers. The Final Rules published by the SEC and CFTC confirm that TRS based on a single loan will be treated as a “security-based swap” and clarify that a TRS “based on two or more non-security loans are swaps, and not security-based swaps.”6 Therefore, the CFTC regulates TRSs based on two or more loans and the SEC regulates TRS based on a single loan.
Parties engaging in a TRS transaction should carefully understand what agency will regulate their transactions. For example, when counterparties seek TRS exposure to several loans, they might document their trades under multiple individual confirmations subject to a single “Master Confirmation” agreement. The SEC and CFTC have now made clear that each transaction for which a separate confirmation is sent constitutes an individual instrument that must be analyzed independently to determine whether it is a security-based swap. Multiple individual transactions under a single master agreement or master confirmation “would not constitute a Title VII instrument based on one ‘index or group’ under the security-based swap definition but instead would constitute multiple Title VII instruments.”7 Therefore, multiple single-name TRS transactions documented using separate “supplemental confirmations” under a single “Master Confirmation” will be classified as security-based swaps.
Increased IRS scrutiny to TRS
Another concern with TRS is that they allegedly may be used to avoid tax on dividends on U.S. securities paid to foreign persons. The Internal Revenue Code imposes a “withholding tax” on certain types of U.S. source income, including dividends, paid to foreign persons. The “withholding tax” is generally withheld from the dividend payment by a payor (“withholding agent”).8 Pursuant to a 20 year old Treasury regulation, payments to a foreign person on a notional principal contract are treated as foreign source income.9 Thus, it has been generally accepted that there is no “withholding tax” imposed on TRS payments, including dividend equivalent payments with respect to U.S. securities. In 2009, legislative proposals were introduced in Congress that, under certain circumstances, would subject dividend equivalent payments under TRS referencing U.S. securities to withholding tax as if they were actual dividends on the referenced shares. Along those lines, the IRS has designated the issue as a “Tier I” issue, meaning one of high strategic importance to the IRS. As such, in 2010 the IRS issued an “Industry Directive on Total Return Swaps (“TRSs”) Used to Avoid Dividend Withholding Tax” (the “Directive”).10
The Directive states that its intent is to provide guidance on developing facts for determining when a transaction that is in form a TRS will be respected in substance as a notional principal contract, and when such a swap will be recharacterized in accordance with its substance as an agency agreement, repurchase agreement, lending transaction, or some other form of economic benefit by the foreign person.”11 Thus, the IRS indicates that an agency agreement, repurchase agreement, and lending transaction are examples of transactions that will incur the “withholding tax.” Additionally, the Directive identifies four factual situations that may constitute improper tax avoidance: (1) cross-in/cross-out, (2) cross-in/inter-dealer broker out, (3) cross-in/foreign affiliate out, and (4) fully synthetic.12 The four factual situations are representative examples of common variations of TRS transactions.13 The Directive notes that particular transactions under examination may not fit exactly within any one of the four situations.14 The Directive instructs revenue agents to develop facts showing that the form of the TRS should be disregarded for U.S. federal income tax purposes.15 In those situations, revenue agents are directed to develop facts supporting a legal conclusion that the foreign person retained ownership of the reference securities for U.S. federal income tax purposes even though the foreign person may have transferred the legal title to such securities.16
TRS transactions are complicated and widely used, although they formerly operated in a rather obscure part of the financial markets. However, with changes to the regulatory environment and allegations of various manipulations schemes, total return swaps will be the subject of increased scrutiny. This may increase the legal spotlight on these formerly obscure financial derivatives.
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