On June 29, 2012, the Commodity Futures Trading Commission (the CFTC) released its long-awaited proposed interpretative guidance and policy statement (the Proposed Guidance) regarding the extra-territorial application of the swaps provisions of Title VII (Title VII) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), along with a proposed order to temporarily exempt certain market participants from the application of certain aspects of Title VII (the Proposed Order).
Together the Proposed Guidance and Proposed Order form the first detailed framework that any regulator around the world has offered as to how to implement the G20 derivatives reforms across jurisdictional borders. It is unclear, however, whether market participants should view this as being a true glimpse of the future or merely a strong opening statement in an ongoing debate. Strong differences of opinion continue to be evident within the CFTC itself, with two of the five Commissioners filing highly critical concurrences and signaling that they will not support the Proposed Guidance as a final statement if it remains in its current form. At the same time, the Securities and Exchange Commission (the SEC), with whom the CFTC is required to work in tandem on such key issues as the definition of "Swap" and "Swap Dealer", has not indicated what approach it will take on these issues, and the Proposed Guidance differs in key respects from certain analogous aspects of U.S. securities law (such as the definition of "U.S. person" under Regulation S). Further, the Proposed Guidance differs significantly from the treatment of cross-border financial transaction by the U.S. bank regulators. Perhaps more importantly, it remains to be seen how regulators of the global swaps market in other jurisdictions will react to the CFTC's approach, particularly those aspects of the Proposed Order that require the CFTC to determine the adequacy of analogous non-U.S. regulations.1
Specifically, the Proposed Guidance:
- describes in broad terms the CFTC's interpretation of the limitation on its jurisdiction in Section 722(d) of the Dodd-Frank Act (specifically, the circumstances under which cross-border swaps activity has "a direct and significant connection" with activities in, or effect on, commerce of the United States");
provides further guidance as to which entities that participate in cross-border swaps activities must register as a Swap Dealer (SD) or Major Swap Participant (MSP) with the CFTC, including:
- explaining which swaps a non-U.S. entity must count in determining whether it meets the de minimis threshold for tripping the requirement to register as a SD or MSP;
- reiterating previously informally articulated guidance that a non-U.S. entity that meets the registration requirement as an SD must register the entity itself, rather than simply the U.S. branch or agency that may have solicited or negotiated the swaps;
- explaining that a foreign branch of a U.S. SD would not register separately, but a non-U.S. affiliate of a U.S. SD would need to do so if it independently meets the definition of an SD on the basis of its swaps activities with U.S. persons (other than its U.S. SD affiliates);
- provides that certain non-U.S. entities should be exempted from having to comply with certain aspects of Title VII;
- categorizes the relevant Title VII requirements in respect of SDs into two categories: Entity-Level and Transaction-Level (defined below) for purposes of determining whether a particular type of entity (U.S. entity, foreign branch or affiliate of a U.S. entity, or a non-U.S. SD or affiliate) must comply directly with such provisions, may do so through” substituted compliance" with home country regulations or need not do so at all;
- sets out a process by which a non-U.S. entity that registers as an SD or MSP may apply to the CFTC to request recognition of substituted compliance, as well as the standards against which the CFTC proposes to measure the relevant foreign regulatory requirements for purposes of determining whether to grant such request.2
The Proposed Order then implements certain aspects of the Proposed Guidance by granting an extension of the period for compliance with many provisions of Title VII for SDs and MSPs. Specifically:
a non-U.S. SD or MSP is permitted to delay compliance with most Entity-Level requirements (other than certain reporting requirements) until one year after the date of publication of the Proposed Order in the Federal Register, provided it:
- registers as an SD or MSP, as applicable, by the date on which such registration is required (i.e., 60 days after the effective date of the rules defining "Swap"), and
- files a substituted compliance plan within 60 days of filing its application for registration, detailing the home country regulatory requirements with which it will comply in place of the comparable Title VII requirements;
- a U.S. entity is permitted to delay compliance with most Entity-Level requirements (other than certain recordkeeping and reporting requirements) until January 1, 2013;
- a non-U.S. entity must comply with Transaction- Level requirements with respect to swaps with U.S. persons but need not do so with respect to swaps with non-U.S. persons; and
- a U.S. entity must comply with Transaction-Level requirements whenever they are effective (except that a foreign branch of a U.S. entity need not comply with the Transaction-Level requirements for swaps with non-U.S. persons as long as substituted compliance has been recognized).3
The CFTC is careful to note, however, that both the Proposed Guidance and the Proposed Order apply only to the Title VII requirements that they specifically address and are not intended to limit the jurisdiction of the CFTC with respect anti-fraud and anti-manipulation enforcement and regulation.
Who is a U.S. Person?
The CFTC's guidance as to whether a non-U.S. entity must register as a SD or MSP, as well as whether the Transaction-Level requirements should apply or substituted compliance is available, turns on the nature of the counterparty to the non-U.S. entity's swaps. Where that counterparty is a "U.S. person," as defined in the Proposed Guidance, such swap would count towards the de minimis threshold for purposes of the registration requirement and will trigger the application of the Title VII Transaction- Level requirements. Much of the impact of the Proposed Guidance, then, will depend on the practical application of the CFTC's definition of U.S. person.
For purposes of the Proposed Guidance, the CFTC proposes that the term "U.S. person" include but not be limited to (emphasis added):
- any natural person who is a resident of the U.S.;
any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund, or any form of enterprise similar to any of the foregoing, in each case that is either:
- organized or incorporated under the laws of the U.S. or having its principal place of business in the U.S., or
- in which the direct or indirect owners are U.S. persons;
- any individual account (discretionary or not) where the beneficial owner is a U.S. person;
- any commodity pool, pooled account, or collective investment vehicle (whether or not organized or incorporated in the U.S.) of which a majority ownership is held, directly or indirectly, by a U.S. person;
- any commodity pool, pooled account, or collective investment vehicle the operator of which would be required to register as a commodity pool operator under the Commodity Exchange Act (CEA);
- a pension plan for the employees, officers, or principals of a legal entity with its principal place of business inside the U.S.; and
- an estate or trust, the income of which is subject to U.S. income tax regardless of source.4
We believe this definition of "U.S. person" will need to be refined further before it can be applied with clarity in the wide variety of situations in which it will be used. At the outset we note that some aspects of the definition appear to be circular or duplicative. First, for the definition to be useful, it cannot be subject to ad hoc policy-based expansion over time, as is suggested by the phrase "includ[ing] but not limited to" at the outset of the list of components. Second, we wonder whether prong (iv) of the definition is necessary if prong (v) is retained, as any commodity pool with a majority of U.S. person owners would have to be registered as a commodity pool operator in any event, now that the exemption for ownership by qualifying persons has been withdrawn (unless it engages in a de minimis amount of swaps trading). Third, the inclusion of any business entity indirectly owned by a U.S. person in (ii)(B) of the proposed definition seems overly broad, as it would cause any foreign indirect subsidiary of a U.S. parent company to be treated as a U.S. person. We believe this outcome is not intended, as it would seem to undermine other aspects of the Proposed Guidance in which the CFTC distinguishes between the requirements of Title VII applicable to U.S. persons from those applicable to foreign affiliates and subsidiaries of U.S. persons. More generally, if this prong of the definition were to remain, parties outside the U.S. might have difficulty discerning whether their potential non-U.S. counterparties are U.S. persons or not.
We also believe a comparison with the definition of "U.S. person" in Regulation S under the Securities Act is instructive. One key difference between the two definitions is that discretionary individual accounts for which the investment manager is organized outside the U.S. are not considered to be U.S. persons under Regulation S but do fall within the CFTC's proposed definition. While the CFTC may have drawn this distinction in order to close off one avenue by which overseas swap risk could flow into the U.S., we think this limited benefit should be outweighed by the market confusion that is likely to ensue from treating accounts managed on a discretionary basis by non-U.S. asset managers as U.S. persons. In general, we believe that conforming the CFTC's definition with the definition of U.S. person in Regulation S would be helpful as that definition has generally served the capital markets well and, in any event, now benefits from a body of interpretative guidance, reliance upon which would enhance legal certainty for these determinations. Although the CFTC asserts that the term U.S. person is intended to serve a different purpose here than in Regulation S, it is not clear that any such difference actually requires a distinction between the definitions, as most of the relevant Title VII relate to market regulation in any event.
How do cross-border swaps affect the determination of who must register as a Swap Dealer or Major Swap Participant?
The Proposed Guidance clarifies that swaps activity conducted by non-U.S. entities with counterparties outside the U.S. should not be counted toward determining whether such entity's swap book exceeds the relevant de minimis thresholds to require registration with the CFTC as an SD or MSP, as long as such trades are not with U.S. persons.
The Proposed Guidance also describes the CFTC's views on the treatment of branches and affiliates, as well as the effect of U.S. guarantees.
First, the CFTC acknowledges that, unlike the definition of U.S. person in Regulation S, it intends to treat foreign branches of U.S. entities as extensions of the main entity and therefore would generally apply the Title VII registration requirements to a U.S. person and its foreign branches and agencies on an entity-wide basis, with the principal entity being responsible for compliance throughout the organization. At the same time, the CFTC recognizes the need for foreign branches of U.S. banks to participate in their local swaps markets according to local rules. As a result, as discussed in more detail below, the Proposed Guidance includes specific accommodations to allow foreign branches of U.S. SDs to meet their obligations under Title VII through substituted compliance in some cases.
Second, the Proposed Guidance clarifies that U.S. persons who use a “central booking” model will be required to register as SDs, regardless of whether the swaps were directly booked by the U.S. person or indirectly transferred to the U.S. person from a branch or affiliate (including through the use of a back-to-back swap). The Proposed Guidance also notes, however, that any foreign affiliate may also be required to register as an SD if its activities independently meet the definition of an SD.
Third, consistent with advice previously given informally by CFTC staff, the Proposed Guidance explains that if a non-U.S. entity is the booking entity for its swaps, it must register as an SD or MSP, as applicable, even if the U.S. branch, agency, affiliate or subsidiary of such non-U.S. entity solicits or negotiates the swaps entered into by the non-U.S. entity. Specifically, the Proposed Guidance notes that a non-U.S. Person who engages in more than a de minimis level of swap dealing with U.S. persons (or non-U.S. persons whose obligations are guaranteed or otherwise formally supported5 by U.S. persons) would be required to register as an SD (such non-U.S. person, the non-U.S. Registrant). In determining whether the de minimis threshold is met, therefore, the non-U.S. Registrant must include the aggregate notional value of:
swaps between (A) the non-U.S. Registrant or any of its non-U.S. affiliates and (B) a U.S. person counterparty (or a non-U.S. person counterparty whose obligations are guaranteed by a U.S. person); and
swaps of the non-U.S. Registrant or any of its non-U.S. affiliates where the obligations of the non-U.S. Registrant or its non-U.S. affiliates are guaranteed by U.S. persons.
The Proposed Guidance therefore clarifies that swaps entered into by the U.S. affiliates of a non-U.S. entity are not counted towards the de minimis threshold determination for such non-U.S. entity. The Proposed Guidance goes on to state that, in determining whether the threshold is met, the non-U.S. Registrant should not include the notional value of:
swaps between the non-U.S. Registrant and foreign branches of registered U.S. SDs; or
swaps between the non-U.S. Registrant and another non- U.S. person.
We also note that pursuant to Regulation 1.33(ggg)(6)(i) swaps between majority owned affiliates (whether inside or outside the U.S.) are also excluded from the aggregation requirement.
The Proposed Guidance also clarifies whether a non-U.S. entity must register as an MSP. To determine whether the non-U.S. entity has a substantial enough position to require registration as an MSP, the non-U.S. person (the non-U.S. MSP Registrant) must include the aggregate notional value of:
- swaps where the non-U.S. MSP Registrant's counterparty is a U.S. person; and
- swaps where the non-U.S. MSP Registrant's counterparty is a non-U.S. person whose obligations are guaranteed by a U.S. person.
However, in determining whether the threshold is met, the non-U.S. MSP Registrant would not include the aggregate notional value of:
- swaps where the non-U.S. MSP Registrant's counterparty is a non-U.S. person; or
- swaps where the non-U.S. MSP Registrant's obligations are guaranteed by a U.S. person (in this case, the swap positions should be attributed to the U.S. person).6
Which Requirements Apply When and to Whom?
Largely in keeping with some of the early suggestions from swaps market participants, the CFTC has proposed to adopt a compliance structure for the various requirements under Title VII that applies separately for (a) those requirements under Title VII that can be considered to apply to the entire entity, without regard to the specific counterparty to a swap (the Entity-Level requirements) and (b) those requirements under Title VII that must be considered on a transaction-by-transaction basis depending upon the identity of the counterparty to the swap (the Transaction-Level requirements). The Proposed Guidance sets out the CFTC's proposed philosophy for market participants to comply with each category of requirements (each group of which is set out in more detail below), and the Proposed Order provides exemptive relief accordingly to those Title VII requirements that apply to SDs and MSPs
Balancing the requirement to regulate non-U.S. SDs and MSPs with the need to accommodate the relevant home country regulation, the Proposed Guidance permits registered non-U.S. SDs and non-U.S. MSPs to comply with all of the Entity-Level requirements by means of substituted compliance where the non-U.S. SD or MSP is subject to comparable regulation in its home jurisdiction. With respect to the requirement to report swap data to a swap data repository (SDR) in accordance with Part 45 and Part 46, however, the CFTC will permit the SD or MSP to avail itself of substituted compliance only if the CFTC has direct access to the swap data for such non-U.S. SD or MSP.
Accordingly, the Proposed Order specifically provides that a non-U.S. SD or MSP is permitted to delay compliance with most Entity-Level requirements (other than certain reporting requirements) until one year after the date of publication of the Proposed Order in the Federal Register, provided it:
- registers as an SD or MSP, as applicable, by the date on which such registration is required (i.e., 60 days after the effective date of the rules defining "Swap"), and
- files a substituted compliance plan within 60 days of filing its application for registration, detailing the home country regulatory requirements with which it will comply in place of the comparable Title VII requirements.7
The Proposed Order requires that non-U.S. SDs and MSPs that are affiliated with U.S. SDs or MSPs must comply with the swap data reporting and large trader reporting requirements as soon as they are effective, while non-U.S. SDs and MSPs that are not affiliated with U.S. SDs or MSPs may delay compliance with those rules during the pendency of the Proposed Order.
Presumably to maintain a somewhat more "level playing field," the Proposed Order also allows U.S. SDs and MSPs to delay compliance with most Entity-Level requirements (other than the large trade reporting requirements under Part 20, the swap data reporting requirements under Part 45 and the swap data recordkeeping requirements under Part 46) until January 1, 2013.
The Proposed Guidance clarifies that the CFTC's jurisdiction with respect to the Transaction-Level requirements does not extend to swaps between two non- U.S. entities,8 even if one of the non-U.S. entities is a registered SD or MSP. In those cases in which a non-U.S. SD or MSP faces a non-U.S. entity whose obligations are guaranteed by a U.S. person, the non-U.S. SD or MSP may seek to comply with the Transaction-Level requirements by means of substituted compliance (except with respect to the External Business Conduct requirements9, which would not apply to swaps with non- U.S. persons regardless of whether or not they are guaranteed by a U.S. person). On the other hand, the Proposed Guidance also makes clear that non-U.S. SDs and MSPs must comply with all Transaction-Level requirements for any swaps facing U.S. persons.
Determinations of which non-U.S. entities are to be treated under the Proposed Guidance as having their obligations guaranteed by a U.S. entity may prove tricky, however, as the Proposed Guidance seems to include in this category swaps with affiliate “conduits” for U.S. persons, i.e. swaps in which (i) a non-U.S. counterparty is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. counterparty regularly enters into swaps with one or more other U.S. affiliates or subsidiaries of the U.S. person; and (iii) the financials of such non-U.S. counterparty are included in the consolidated financial statements of the U.S. person.10 As noted earlier with regard to the range of financial support that could constitute a guarantee for purposes of aggregating swaps to determine if the de minimis threshold is reached (see footnote 5 above), expansion of the definition of guarantee may cause counterparties to be difficult to categorize for purposes of the purposed guidance, and the resulting market confusion may disrupt existing swaps markets.
The application of the Transaction-Level requirements is more complex with respect to foreign branches of U.S. SDs or U.S. MSPs. Like non-U.S. SDs and MSPs, for their swaps facing non-U.S. entities guaranteed by a U.S. entity, they are permitted to avail themselves of substituted compliance (except with respect to the External Business Conduct requirements, which would not apply). Unlike non-U.S. SDs and MSPs, for whom no U.S. Transaction- Level requirements apply to swaps with non- -U.S. entities foreign branches of U.S. SDs and MSPs must either demonstrate substituted compliance with the Transaction- Level requirements (other than the External Business Conduct requirements) or comply with the requirements themselves when transacting with non-U.S. entities. The only exception to this rule is that foreign branches of U.S. SDs or MSPs transacting with non-U.S. entities in emerging markets where the regulatory infrastructure for swaps is not well developed (presumably a country other than one of the G20, but the Proposed Guidance is not so explicit), the foreign branch of the U.S. SD or MSP need not comply with the Transaction-Level requirements (provided that the aggregate amount of all such noncompliant swaps across all such jurisdictions does not exceed 5 per cent. of the notional amount of the aggregate of all the swaps of the U.S. SD or MSP).
While the Proposed Guidance clarifies which Transaction- Level requirements are to apply to whom, the Proposed Order does not delay the timeline for compliance with these requirements to the extent they are applicable.
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What is the Process for Requesting Substituted Compliance?
The Proposed Guidance clarifies the CFTC's intent to recognize substituted compliance in only those areas that the CFTC determines to be comparable to Title VII and the CFTC implementing regulations. The CFTC anticipates that it will develop an approach for making comparability determinations based on its experience exempting foreign brokers from registration as a futures commission merchant (FCM) under rule 30.10. Comparability determinations would be made on an individual requirement basis, rather than on the basis of the foreign regime as a whole. In evaluating a particular foreign regulatory requirement, the CFTC would take into consideration all relevant factors, including, but not limited to:
- the scope and objectives of the foreign regulatory requirement;
- the comprehensiveness of the foreign requirement;
- the comprehensiveness of the foreign regulator’s supervisory compliance program; and
- the foreign regulator’s authority to support and enforce its oversight of the non-U.S. SD or non-U.S. MSP.16
The CFTC would retain broad discretion to determine whether a foreign regulatory requirement is acceptable, and small the CFTC could find that a jurisdiction has comparable law(s) and regulation(s) in some, but not all, of the applicable Dodd-Frank Act provisions.
A non-U.S. person subject to CFTC regulation would be required to request the CFTC's permission to comply with comparable requirements in its home jurisdiction. A group of non-U.S. persons from the same jurisdiction, or a foreign regulator, could submit an application for substituted compliance on behalf of non-U.S. persons subject to such foreign supervisory regime. The application would be required to state with specificity the factual basis for requesting that the CFTC recognize comparability and include with specificity all applicable legislation, rules and policies. The CFTC also expects that the non-U.S. SD or non-U.S. MSP would notify the CFTC of any material changes to information submitted in support of an application for substituted compliance.
The CFTC expects that it would enter into a memorandum of understanding or similar arrangement with the relevant foreign supervisor in order to establish a process for ongoing coordination.17 Such coordination would involve, among other things, procedures for confirming continuing oversight, access to information, on-site visits and notification.
Like the Volcker Rule18, the CFTC's extra-territorial reach in implementing the SD and MSP requirements of Title VII creates a largely unprecedented volume of overlapping and even conflicting regulation across jurisdictional boundaries. While the international regulatory goals of the G20 group with respect to the regulation of derivatives are broadly accepted, the details of implementing such cooperation are complex and not yet well understood. Accordingly, over the next few weeks we plan to follow up with more detailed analyses of the practical implications of the Proposed Guidance, including:
- How might the CFTC evaluate specific non-U.S. regulatory regimes, such as that of the EU or Canada, for purposes of providing "substitute compliance"?
- How might the proposed Volcker Rule interact with the Proposed Guidance?
- What booking models might be advantaged under the Proposed Guidance and why? and
- How would the Proposed Guidance affect foreign funds?