Over 300 pages of new regulations were released by the U.S. Commodity Futures Trading Commission (CFTC) on July 15, 2013. Ordinarily, this release would not be newsworthy – after all, the CFTC has already released over ten thousand pages of regulations, proposed and final. However, this July 2013 regulatory development in the U.S. is important because these regulations provide clarification for, and impose requirements on, entities operating outside of the U.S. in certain circumstances involving a broad category of over-the-counter (OTC) derivatives now known as “Swaps”.
The CFTC continues to further regulate the global derivatives market – this time, in greater collaboration with, and deference with respect to, its regulator counterparts throughout the world. While many countries have proposed rules for regulating the global OTC derivatives market, the CFTC has implemented in final form 69 regulations. A primary criticism leveled against the U.S. regulator is that it has done so largely on its own; the doctrine of “substitute compliance” which constitutes one of the pillars of the July 2013 regulations, is an important initiative that addresses this criticism, promotes collaboration and seeks to prevent regulatory arbitrage in the $600 trillion-plus, global derivatives market.
The good news this week for many participants in the derivatives markets outside of the U.S. is that the CFTC has tightened the definition of the term “U.S. Person” in many important respects. This means less U.S. regulation generally for those outside of the U.S. entering into Swaps, unless a Swap involves a U.S. Person. In that case, Canadian and other non-U.S. market participants have to indirectly comply with CFTC regulations because that U.S. Person will presumably be requiring compliance with U.S. derivatives law when entering into the Swap. For these market participants, this means:
- The July 15th release is an important development for Canadian hedge funds, mutual funds, banks, energy, insurance and real estate companies that enter into Swaps.
- Some Canadian banks trade Swaps in volumes that trigger registration requirements as “Swap Dealers”. The trigger points were confirmed in the recent CFTC release.
- Some U.S. banks trade Swaps with Canadian counterparties but enter into those trades via Canadian subsidiaries in Canadian markets. The recent release clarifies the status and requirements of those banks and their Canadian affiliates: branches of U.S. banks located in Canada and other countries outside of the U.S. are U.S. Persons.
- Some Canadian hedge funds, pensions, credit unions, energy, insurance and other companies trade in Swaps and commodities to such an extent that registration is required with the CFTC. Those market participants that were required to register with the CFTC before July 15, 2013 are still required to do so.
- An important new development for funds and other collective investment vehicles in Canada and elsewhere outside of the U.S. is that they can remain outside of the “U.S. Person” definition if those entities are not majority-owned by U.S. persons; even if they are, if their interests are not offered to U.S. Persons, then the funds or collective investment vehicles are not U.S. Persons. This is an important development. In prior proposed guidance on the U.S. Person definition, if the sponsor of a fund had to register with the CFTC through the National Futures Association as a “commodity pool operator”, then the fund itself is a U.S. Person – even if that fund is a non-U.S. fund. This is no longer the case.
The CFTC has provided this helpful guidance to the markets outside of the U.S. It has done so in an Exemptive Order that is effective on July 13, 2013 and expires on December 31, 2013 or such earlier date specified in the order. The “U.S. Person” definition that was the subject of the January 7, 2013 order continues in effect until 75 days after the July 2013 order (described in greater detail below) is published in the U.S. Federal Register, at which point the U.S. Person definition discussed below will take effect. The CFTC solicits comments on the July 2013 release for 30 days.
Since Dodd-Frank became law on July 21, 2010, many people outside of the U.S. have been waiting for clarification from the CFTC, the primary derivatives regulator in the U.S., as to just how far its regulatory arm reaches into the Swap trading activities in Canada and countries other than the U.S. The CFTC released its answer on July 15, 2013: an eight-prong definition of what it means to be a “U.S. Person”.
If your fund, energy or insurance company or other market participant falls within the definition of a “U.S. Person” and the entity enters into a “Swap”, then the CFTC has jurisdiction over the entity and, depending on the characterization of the parties to the Swap, the CFTC imposes substantial requirements relating to every stage of the life cycle of that Swap, no matter where the Swap was executed. This begs the question: who or what is a “U.S. Person”?
The CFTC’s interpretation of the statutory term “U.S. Person” generally encompasses two broad categories and the CFTC specifically listed eight “prongs” to clarify this term.
The broad categories are:
- Persons or classes of persons and corporate entities that are located within the U.S.; and
- Persons or corporate entities that may be domiciled or may operate outside of the U.S. but whose Swap activities nonetheless have a “direct and significant connection with activities in, or effect on, commerce of the U.S.” within the meaning of Section 2(i) of the U.S. Commodities Exchange Act. There remains ambiguity over the circumstances which trigger the application of CFTC jurisdiction between two non-U.S. Persons under Commodity Exchange Act section 2(i) (The author has, since July 15, 2013, been in touch with the CFTC to determine the meaning of “direct and significant connection”).
Of the eight prongs (which generally focus on the origin and laws governing the parties to the Swap), these are two of the most critical:
- Any fund, corporation, partnership, limited liability company, business or other trust … or any form of entity similar to any of the foregoing … that is either organized or incorporated under the laws of the U.S. or has its principal place of business in the U.S. (this is prong (iii) of the eight parts of the “U.S. Person” definition);
- Any fund, commodity pool, pooled account, or other collective investment vehicle that is not described in prong (iii) (so this part of the definition includes any fund or other collective investment vehicle, whether or not it is organized or incorporated in the U.S.) that is majority-owned by an entity that is organized in the U.S. or has its principal place of business in the U.S., except if the commodity pool, pooled account, or investment fund otherwise fits within this “prong” but does not offer its interests to U.S. Persons (then it is not a “U.S. Person”).
While the definition of this term is largely territorial-based, a U.S. Person still includes a non-U.S. collective investment vehicle (such as a hedge fund) organized outside of the U.S. if its principal place of business is in the U.S., based on relevant facts such as whether the senior personnel responsible for formation or fund promotion or the implementation of fund strategy are in the U.S. CFTC Chairman Gary Gensler’s written remarks following the CFTC’s public meeting on July 11, 2013 included this statement:
“Thus, within several months, the public will gain greater protection as hedge funds, organized in the Cayman Islands, but with their principal place of business here in the U.S., will be subject to reforms applicable to all other U.S. persons, including the clearing requirement.”1
Also, “guaranteed affiliates” and “conduit affiliates” outside of the U.S. are U.S. Persons. Factors relevant to a finding that a non-U.S. entity is a “conduit affiliate” of a U.S. Person (and therefore the non-U.S. entity is a U.S. Person) include the manner in which the U.S. Person controls or owns the affiliate or whether the financials of the affiliate are consolidated with those of the U.S. Person.
A U.S. Person also would include a non-U.S. branch of a U.S. Person on the basis that the “branch” is an extension or outgrowth of a U.S. person. So even if the branch is in Canada (or a country other than the U.S.), that branch is a U.S. Person, however, the non-U.S. branch may be able to satisfy some Swap requirements through compliance with its “home” country’s derivative regulations.
The U.S. Person definition for many market participants outside of the U.S. is arguably more restrictive (and less expansive) than previous versions of this definition. This regulatory guidance remains open to public comment.
IMPLICATIONS FOR THE MARKETPLACE
Several compliance requirements have not changed. Non-U.S. Persons entering into Swaps with U.S. Persons still must indirectly comply with U.S. derivatives law (otherwise, the U.S. Person that is a party to the Swap will be offside and may not enter into the Swap in the first place or the U.S. Person may terminate the Swap).
A U.S. Person counts towards the thresholds (for determining whether it is a “Swap Dealer” or “Major Swap Participant”) all Swap activity, whether a U.S. Person or a non-U.S. Person is its counterparty in the Swap.
A Non-U.S. Person, in conducting its calculations to determine whether it is a “Major Swap Participant” or a “Swap Dealer”, generally is required to include in its calculations any Swap that it enters into with a U.S. Person and Swaps between it and a guaranteed affiliate or conduit, with certain exceptions.
Once an entity exceeds certain thresholds and comes within the category of a “Swap Dealer” or a “Major Swap Participant”, that entity must comply with the most onerous requirements of Title VII of Dodd Frank. These requirements are categorized as either Entity-Level Requirements (i.e., those that apply to a Swap Dealer or Major Swap Participant as a whole, in the areas of capital adequacy, reporting and recordkeeping) or Transaction-Level Requirements (i.e., those that apply to Swap Participants on a transaction-by-transaction basis, such as Swap clearing). In the author’s text on derivatives reform, The Post-Reform Guide to Derivatives and Futures (2012, Wiley), he describes derivatives regulations that exist by virtue of the parties, or the financial product or the platform (in other words, certain parts of derivatives reform apply because of the financial product or platform, regardless of the parties to the Swap for example); the division of regulations based on the entity or transaction generally follows this approach.
THE DOCTRINE OF SUBSTITUTED COMPLIANCE
The CFTC proposes to generally require non-U.S. Swap dealers and non-U.S. Major Swap Participants to comply with the derivatives requirements imposed on those entities by their “home” countries (to the extent that they exist) in lieu of compliance with Entity- and Transaction-Level Requirements imposed by the CFTC.
The CFTC is, however, continuing to require non-U.S. Swap Dealers and non-U.S. Major Swap Participants to comply with external business conduct standards when those entities face a U.S. Person on a Swap, notwithstanding the existence of non-U.S. derivatives regulation.
This is a new and important development. The governments of Australia, Canada, the European Union, Hong Kong, Japan and Switzerland have submitted applications to the CFTC for determinations from the CFTC that would enable non-U.S. Swap Dealers and non-U.S. Major Swap Participants to comply with their “home” country regulations.
U.S. Swap Dealers and U.S. Major Swap Participants are required to comply with all Entity-Level Requirements in all jurisdictions, no matter where the Swap is executed.
The CFTC’s application of the Entity-Level Requirements and Transaction-Level Requirements to both U.S. Persons and Non-U.S. Persons are illustrated in the tables at the end of this advisory, which are patterned after the CFTC’s Exemptive Order Requiring Compliance with Certain Swap Regulations.
REQUIREMENTS FOR MARKET PARTICIPANTS THAT ARE NOT SWAP DEALERS OR MAJOR SWAP PARTICIPANTS
The CFTC created a new category of requirements that generally apply to parties that are neither Swap Dealers nor Major Swap Participants: “Non-Registrant Requirements”. These include:
- Any requirement that a Swap be centrally-cleared by a clearinghouse and executed on a regulated exchange;
- Real-time, Large Trader and Swap Data Repository reporting of a Swap; and
- Swap data recordkeeping.
While Swap Dealers and Major Swap Participants are required to comply with the foregoing, the Non-Registrant Requirements listed above also apply to persons or counterparties whose Swap volumes do not bring them into the category of the largest Swap participants in the OTC market (i.e., Swap Dealers and Major Swap Participants).
According to the CFTC’s latest release, in a Swap between two non-U.S. Persons, the Non-Registrant Requirements “generally” do not apply. If the Swap involves one U.S. Person, the Non-Registrant Requirements apply to both parties to the Swap. If the parties to a Swap are both non-U.S. Persons and non-registrants (i.e., neither party to the Swap is a Swap Dealer, Major Swap Participant or U.S. Person), but both are “guaranteed” or “conduit” affiliates, then the Non-Registrant Requirements apply unless substituted compliance with a similar home jurisdiction requirement takes place.
A further summary of the CFTC’s July 2013 cross-border rules is included in the tables that follow.
Click here to view appendices.