On May 1, 2013, the Securities and Exchange Commission (“SEC”) unanimously voted to propose rules and interpretive guidance to persons engaging in cross-border security-based swap transactions.1 The rules and guidance are intended to apply to transactions that occur partially within the United States and partially outside the United States. The proposal also addresses when certain entities, including security-based swap dealers and major security-based swap participants, and market infrastructures, including clearing agencies, execution facilities and data repositories, are required to register with the SEC. This client alert is designed to provide a high-level summary of some of the most significant aspects of a lengthy and extraordinarily complex document, and is not intended to be detailed or comprehensive.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd–Frank Act”) directs the SEC to create a regulatory regime for security-based swap transactions.2 Under the SEC’s territorial approach, the proposed rules are intended to cover security-based swaps involving: (i) a U.S. person and a non-U.S. person, (ii) two non-U.S. persons where one or both are located within the United States, or (iii) two non-U.S. persons conducting a security-based swap transaction that occurs in part within the United States.
Title VII Applicability
Security-based swap transactions would be subject to the requirements of Title VII if: (i) they are entered into with a “U.S. person” or (ii) otherwise “conducted within the United States.”
For this purpose, “U.S. person” is defined as:
- Any natural person resident in the U.S.
- Any partnership, corporation, trust or other legal person organized or incorporated under the laws of the United States or having its principal place of business in the U.S.3
- Any account (whether discretionary or non-discretionary) of a U.S. person.
- “Conducted within the United States” means “solicited, negotiated, executed or booked within the United States” by or on behalf of either party to the transaction, regardless of the location, domicile, or residence of either party to the transaction.
- Under certain circumstances, market participants may comply with foreign regulatory requirements (“substituted compliance”) if such foreign requirements are determined to be comparable to U.S. requirements.
- Note that the proposed rules would classify an offshore fund managed by a domestic adviser as having its principal place of business in the United States and, therefore, as a U.S. person.
Registration as a Security-Based Swap Dealer
In 2012, the SEC and CFTC jointly adopted rules requiring registration as a security-based swap dealer or a swap dealer, respectively, if the notional amount of transactions in each category exceeded a defined de minimis level in the prior 12 months. The proposed rules and interpretive guidance sets forth the methodology under which this level of activity for security-based swaps would be calculated.
- U.S. persons would need to include all of their security-based swap transactions.
Non-U.S. persons would only be required to count dealing activity:
- conducted with U.S. persons or
- conducted within the U.S.
- Non-U.S. persons would not be required to include transactions with foreign branches of U.S. banks. A non-U.S. person that receives a guarantee of its performance obligations from a U.S. person need not include its transactions with non-U.S. persons.
- Under a joint rule adopted by the SEC and the CFTC, the dealing activities of a commonly controlled affiliate that is registered with the SEC as a security-based swap dealer may exclude the affiliate’s security-based swap transactions from the calculation as long as its security-based swap activities are conducted in an operationally separate manner from those of the affiliate.
Regulatory Requirements Applicable to a Security-Based Swap Dealer
The proposal would classify the regulatory requirements applicable to a security-based swap dealer into two separate categories:
- Entity-level, which apply to the security-based swap dealer as a single entity (e.g. capital, margin and risk management requirements)
- Transaction-level, which apply to the individual security-based swap transactions (e.g. external business conduct requirements).
A foreign registered security-based swap dealer would be required to comply with:
- Entity-level requirements (with the ability to comply with “substituted compliance” requirements of its home jurisdiction).
- External business conduct requirements as to their U.S. business, but not their foreign business (with the ability to comply with “substituted compliance” requirements of its home jurisdiction).
- Segregation requirements only as to counterparties who are U.S. persons.
U.S. persons which are security-based swap dealers would be required to comply with all such requirements (except as to external business conduct requirements with respect to foreign business conducted out of a foreign branch of such U.S. persons). For the purpose of determining the applicable requirements for registered security-based swap dealers, “U.S. business” means transactions (i) entered into with a “U.S. person” or (ii) otherwise “conducted within the United States.” “Foreign business” is anything not defined as “U.S. business.”
Registration of Non-U.S. Persons as Major Security-Based Swap Participants
Similar to security-based swap dealers, a major security-based swap participant would be required to register under a joint SEC-CFTC rule if its security-based swap positions exceed a certain defined substantial position or substantial counterparty exposure threshold. A U.S. person must consider all of its security-based swap transactions, but a non-U.S. person is required only to consider such transactions with U.S. persons, including foreign branches of U.S. banks.
Under joint SEC-CFTC guidance, all positions that are guaranteed as to performance must be included in calculating the threshold of a person providing such guarantees. Guaranteed positions must be attributed according to the guidance as follows:
- A non-U.S. person guaranteeing the performance of U.S. persons must include all such transactions in its calculation.
- A non-U.S. person guaranteeing the performance of non-U.S. persons must include only the transactions with U.S. persons as counterparties.
- A U.S. person guaranteeing the performance of non-U.S. persons must include all of the transactions of the non-U.S. persons, regardless of where the counterparties are located.
Regulatory Requirements Applicable to Major Security-Based Swap Participants
Non-U.S. persons registered as major security-based swap participants are required only to comply with the entity-level requirements, but not the transaction-level requirements.
Transaction Reporting, Dissemination, Clearing and Execution on a Swap Execution Facility
Reporting of security-based swap transactions must be made to a data depository for the following counterparties: (i) U.S. persons, (ii) non-U.S. persons receiving guarantees from U.S. persons and (iii) registered security-based swap dealers. Any security-based swap transactions conducted within the United States also must be reported.
The requirements as to the public dissemination of trade information, clearing and execution on a swap execution facility apply when: (i) the counterparty is a U.S. person (including foreign branches of U.S. banks), (ii) the counterparty is a non-U.S. person receiving a guarantee from a U.S. person or (iii) a transaction is conducted in the United States. These requirements do not apply to transactions conducted outside the United States between:
- A foreign branch of a U.S. bank and an unregistered non-U.S. person with no guarantee from a U.S. person.
- A non-U.S. person with a guarantee from a U.S. person and an unregistered non-U.S. person not receiving such a guarantee from a U.S. person.
- A non-U.S. person registered as a security-based swap dealer and a non-U.S. person not receiving a guarantee from a U.S. person.
- Non-U.S. persons that are not security-based swap dealers that do not receive a guarantee from a U.S. person.
Registration of Infrastructures
Security-based swap market infrastructures would have to analyze whether or not they are performing their relevant functions within the United States. For each of them, there are the following considerations:
- Clearing agencies should consider whether they have one or more U.S. persons as members.
- Swap execution facilities should determine whether they provide U.S. persons, or non-U.S. persons located in the United States, the direct ability to trade or execute security-based swap transactions on the foreign market for such instruments.
- Swap data repositories should determine whether they receive data on security-based swaps from U.S. persons, and whether they operate in the United States. Such entities also need to consider the possible availability of an exemption based on comparable regulation in their home countries.
The SEC’s proposed rules and guidance contain many similarities to the CFTC’s cross-border release on swaps other than security-based swaps. However, a potentially significant difference is the SEC approach to the concept of “substituted compliance” under which a market participant may opt for the regulatory regime of its home country when it has comparable regulatory requirements to those of the United States. The SEC apparently intends to apply a holisitic approach, focusing on equivalence of regulatory outcomes, rather than a precise rule-by-rule comparison. Although the CFTC’s release does include a concept of “substituted compliance,” it is intended to be applied in a more prescriptive and less flexible manner and, if it is adopted as proposed, it could result in different regulatory regimes for security-based swaps and other swaps. However, the CFTC’s proposed concept of “substituted compliance” has been the subject of extensive comment and public disagreement, including from foreign governmental and regulatory authorities and among CFTC commissioners, which may affect the final form of the cross-border release.
The comment period for the SEC’s proposal ends 90 days after its publication in the Federal Register. In a separate action, the SEC reopened the comment period for all rules under Title VII of the Dodd-Frank Act that have not been finalized for 60 days after notice is published in the Federal Register.