On December 21, 2012, the Commodity Futures Trading Commission (CFTC) issued a final exemptive order delaying the application to non-U.S. swap activity of various swap-related provisions of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The final order may provide insight into how the CFTC ultimately will rule on the cross-border issues relating to the application of the Dodd-Frank swap rules. It appears that, compared to its initial position, the CFTC may be inclined to adopt a less sweeping definition of a “U.S. person” subject to its jurisdiction and a less expansive position on the cross-border application of the rules. The CFTC, however, has yet to make a final determination on issues of extraterritoriality.
The CFTC’s final order:
- Adopts a revised temporary definition of “U.S. person”;
- Clarifies the swap activity that a non-U.S. person may exclude from its determination of its status as a swap dealer or major swap participant;
- Provides temporary relief from the requirement that a non-U.S. person must aggregate the U.S. swap dealing activity of its non-U.S. affiliates;
- Allows non-U.S. swap dealers and major swap participants to delay compliance with respect to many of the entity-level swap requirements of the Dodd-Frank Act, and allows non-U.S. swap dealers and major swap participants, as well as non-U.S. branches of U.S. swap dealers and major swap participants, to delay compliance with respect to transaction-level swap requirements with non-U.S. persons and, in certain circumstances, non-U.S. branches of U.S. persons; and
- Seeks public comment on several additional proposals.
The final order, which expires on July 12, 2013, is available here.
Background: Proposed guidance, proposed order, and no-action letter
The Dodd-Frank Act amended the Commodity Exchange Act (CEA) to add section 2(i), which provides the CFTC the authority to regulate swap-related activity outside of the United States if the activity has a direct and significant connection with activities in, or effect on, U.S. commerce.
Proposed guidance. This language of section 2(i), however, does not provide much guidance on the regulation of cross-border swap activities under the statute. Accordingly, on June 29, 2012, the CFTC proposed guidance interpreting section 2(i) as it applies to the CFTC’s regulations under the Dodd-Frank Act regarding such activities. In the proposed guidance, among other topics, the CFTC described the manner in which it proposed to consider (1) whether a non-U.S. person’s swap dealing activities or swap positions are sufficient to require registration as a swap dealer or major swap participant, respectively, and (2) the treatment of foreign branches, agencies, affiliates and subsidiaries of U.S. swap dealers and of U.S. branches of non-U.S. swap dealers. The proposed guidance also described the policy and procedural framework under which the CFTC may permit compliance with a comparable regulatory requirement of a foreign jurisdiction to substitute for compliance with the CEA’s requirements. The proposed guidance sets forth the manner in which the CFTC proposed to interpret section 2(i) as it applies to the clearing, trading, and certain reporting requirements under the Dodd-Frank Act with respect to swaps between counterparties that are not swap dealers or major swap participants.
The proposed guidance generated significant controversy, particularly with respect to its provisions relating to the definition of U.S. person in the case of foreign entities whose obligations are guaranteed by U.S. persons. Regulators from the United Kingdom, Switzerland, and Japan were among those who objected to the seemingly expansive definition of U.S. person and its potential for conflict with their regulations.
Proposed order. Also on June 29, 2012, the CFTC published a proposed order delaying compliance with certain provisions of the Dodd-Frank Act to give market participants and foreign regulators time to coordinate on the regulation of cross-border swaps activity. The CFTC’s final order modifies the proposed order, but the CFTC is not finalizing the proposed guidance at this time.
No-action letter. In response to comments, the CFTC issued a no-action letter on October 12, 2012 that adopts a narrower definition of U.S. person. October 12 was the effective date of the entity rules defining “swap dealer” and “major swap participant” and the date by which market participants needed to begin the calculations to determine whether they are required to register as a swap dealer or major swap participant.
Final exemptive order
Temporary definition of U.S. person. Seemingly in response to the controversy generated by its proposed order, the CFTC has adopted in the final order a temporary definition of U.S. person that is substantially similar to the definition included in the no-action letter referred to above. The temporary definition, which may differ from the final definition, provides that a U.S. person is any person that is:
- A natural person who is a resident of the United States;
- A 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 (1) organized or incorporated under the laws of a state or other jurisdiction in the United States or (2) effective as of April 1, 2013 for all such entities other than funds or other collective investment vehicles, having its principal place of business in the United States;
- A pension plan for the employees, officers or principals of a legal entity described above, unless the pension plan is primarily for foreign employees of such entity;
- An estate of a decedent who was a resident of the United States at the time of death, or a trust governed by the laws of a state or other jurisdiction in the United States if a court within the United States is able to exercise primary supervision over the administration of the trust; or
- An individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described above.
This definition differs most significantly from the definition of U.S. person in the proposed guidance in that, among other changes, it excludes from the definition of U.S. person (1) certain corporate or similar persons whose direct or indirect owners are responsible for the liabilities of such persons where one or more of such owners is a U.S. person and (2) provisions relating to commodity pools. The definition in the final order differs from the definition in the no-action letter with respect to the location of an entity’s principal place of business, the treatment of pension plans for foreign employees, the treatment of trusts and estates, and the treatment of joint accounts.
For purposes of the final order, the CFTC expands the criteria in the no-action letter and will treat as a U.S. person a legal entity that is not incorporated in the United States, but that has its “principal place of business” in the United States. The CFTC will consider an entity’s principal place of business to be the single place where the entity’s officers direct, control, and coordinate the entity’s activities. This generally will be where the entity maintains its headquarters. Market participants that would be U.S. persons solely under the principal place of business test will not be considered U.S. persons until April 1, 2013. This test will not apply to funds or other collective investment vehicles.
The definition of U.S. person in the final order provides that pension plans will not be considered U.S. persons if such plans are “primarily” for foreign employees, whereas the definition in the no-action letter excluded pension plans that were “exclusively” for foreign employees. The final order’s definition eliminates the requirement that the income of a trust or estate be subject to U.S. taxation and adds joint accounts whose beneficial owners are entities as described in the definition.
Swap dealers and major swap participants may rely on a counterparty’s representation in determining whether the counterparty is a U.S. person, but cannot ignore “red flags” that raise a question concerning the truth of the representation.
Calculations for defining swap dealers and major swap participants. As discussed in the SEC Update we issued in July 17, 2012, which is available here, the CFTC published in May 2012 final rules defining “swap dealers” and “major swap participants.”
Under the rules, a swap dealer is a person engaged in certain enumerated types of dealing activity that exceeds a de minimis amount. A swap dealer whose swap dealing activity is de minimis (defined as activity that does not exceed US$3 billion in aggregate notional amount over the previous 12 months, subject to a phase-in level of US$8 billion) is not required to register with the CFTC as a swap dealer. A major swap participant is a person, other than a dealer, (1) that maintains a substantial position in swaps or security-based swaps for certain categories of swaps and security-based swaps, (2) whose outstanding swaps or security-based swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets or (3) that is a financial entity that (a) is highly leveraged relative to the amount of capital such person holds and is not subject to certain capital requirements and (b) maintains a substantial position in outstanding swaps or security-based swaps in certain categories of swaps or security-based swaps. A more extensive discussion of the final rules can be found here.
The final order provides that, in applying the swap dealer de minimis test or the major swap participant threshold, a non-U.S. person, regardless of whether that non-U.S. person’s swaps are guaranteed by a U.S. person, need not include in its calculation of aggregate gross notional amount of swaps connected with its swap dealing activity any swap with respect to which:
- Its counterparty is a non-U.S. person; or
- Its counterparty is a foreign branch of a U.S. person that is registered as a swap dealer or represents that it intends to register as a swap dealer by March 31, 2013.
Under the proposed guidance, determination of whether a non-U.S. person exceeded the de minimis test and would have to register as a swap dealer required aggregation of swaps entered into by its non-U.S. person affiliates. The final order modifies that guidance to provide that if a non-U.S. person (1) is engaged in swap dealing with U.S. persons as of December 21, 2012 and (2) is an affiliate of a registered swap dealer, the non-U.S. person is not required to aggregate its swap dealing positions with those of any non-U.S. person affiliate that is either engaged in swap dealing with U.S. persons as of December 21, 2012 or is a registered swap dealer. In addition, the final order provides that:
- A non-U.S. person is not required to include swaps entered into by its non-U.S. affiliates with non-U.S. person counterparties, regardless of whether the non-U.S. person affiliates are guaranteed by U.S. persons; and
- A non-U.S. person that is engaged in swap dealing activities with U.S. persons as of December 21, 2012 is not required to aggregate its swap dealing activity with that of its U.S. person affiliates.
Relief from entity-level and transaction-level requirements. The final order provides that, until July 12, 2013, non-U.S. swap dealers and major swap participants may delay compliance with entity-level requirements in effect as of December 21, 2012. Entity-level requirements include capital adequacy, retention of a chief compliance officer, risk management, swap data recordkeeping, swap data reporting to swap data repositories, and large trader reporting. Nevertheless, the final order provides that:
- Non-U.S. swap dealers and major swap participants must comply with swap data reporting and large trader reporting requirements for all swaps with U.S. counterparties, upon their respective compliance dates; and
- Non-U.S. swap dealers and major swap participants that are part of an affiliated group in which the ultimate parent is a U.S. swap dealer, major swap participant, bank, financial holding company, or bank holding company must comply with the swap data reporting and large trader reporting requirements for swaps with non-U.S. counterparties, upon their respective compliance dates.
With respect to transaction-level requirements, non-U.S. swap dealers and major swap participants may delay compliance for transactions with non-U.S. person counterparties, so long as such non-U.S. swap dealers and major swap participants comply with the regulatory requirements of their local jurisdictions. Transaction-level requirements include clearing and swap processing, margining and segregation for uncleared swaps, trade execution, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, trade confirmation, daily trading records, and external business conduct standards. The final order clarifies that this relief extends to swaps between non-U.S. swap dealers and major swap participants and foreign branches of U.S. swap dealers and major swap participants. The relief also applies to swaps between foreign branches of U.S. swap dealers and major swap participants. The final order indicates that a swap is with a foreign branch of a U.S. person (rather than being with the U.S.-based entity) where (1) the personnel negotiating and agreeing to the terms of the swap are located in the jurisdiction of the foreign branch, (2) the documentation of the swap specifies that the counterparty or “office” for the U.S. person is the foreign branch and (3) the swap is entered into by the foreign branch in its normal course of business.
CFTC enforcement actions. The CFTC stated in the final order that it does not intend to bring an enforcement action against a swap dealer or major swap participant for failing to comply fully with applicable Dodd-Frank Act requirements before July 12, 2013 if the failure is attributable to an inability to comply with relevant compliance deadlines or to uncertainty in interpreting particular Dodd-Frank Act requirements and the swap dealer or major swap participant is acting reasonably and in good faith to comply fully with the applicable requirements. Those requirements would include, at a minimum:
- Material progress toward timely implementation and compliance;
- Identification of any implementation or interpretive issue as soon as reasonably possible;
- Timely elevation of any such issue to the senior management of the swap dealer or major swap participant for consideration and resolution; and
- Timely consultation with other industry participants and the CFTC as necessary to seek resolution of any such issue.
Additional proposed guidance. The final order seeks comment on proposed further guidance on the de minimis aggregation rule and the U.S. person definition.
The CFTC has requested comment on an alternative swap dealer de minimis aggregation rule under which a non-U.S. person would be required to aggregate its swap dealing activities with both U.S. and non-U.S. person affiliates, but would not be required to aggregate those activities with its non-U.S. affiliates that are registered as swap dealers.
The CFTC has proposed and requested comment on two additional prongs to the U.S. person definition. The first additional prong would include as a U.S. person a foreign entity that is majority-owned by U.S. persons, but only if the U.S. owner bears unlimited responsibility for the foreign entity’s obligations and liabilities. This proposal would not cover foreign entities solely because the entity’s swaps are guaranteed by a U.S. person.
The second additional prong would include as a U.S. person any commodity pool, pooled account, investment fund, or other collective investment vehicle that is, directly or indirectly, majority-owned (through beneficial ownership of 50% or more of the equity or voting interests) by one or more U.S. residents or entities organized under the laws of a state or other jurisdiction in the United States. A collective investment vehicle that is publicly traded would be deemed a U.S. person only if the investment is offered, directly or indirectly, to a U.S. person.