On December 21, 2012, the US Commodity Futures Trading Commission (“CFTC”) issued a release (the “Release”)1 containing a final exemptive order (the “Order”) and proposing for public comment additional cross-border guidance (the “Further Proposed Guidance”) regarding the cross-border regulation of swaps. The Release represents the latest effort in the CFTC’s attempt to meet its statutory mandate to regulate swaps that “have a direct and significant connection with activities in, or effect on, [US] commerce….”2

The Order is generally consistent with the proposed exemptive order that the CFTC issued in July 2012 (the “Proposed Order”).3 In brief, the Order, which took effect on December 21, and expires on July 12, 2013, permits swap dealers (“SDs”) and major swap participants (“MSPs”) who are not “US persons” (as defined below), as well as non-US branches of SDs and MSPs who are US persons, to delay compliance with certain “Transaction-Level Requirements” and, in the case of non-US entities, “Entity-Level Requirements” (both as defined below).4 The Order adopts a revised interim definition of US person and, among other changes to the SD de minimis andMSP threshold calculations for non-US persons, includes a welcome scaling back of certain aggregation requirements. The Order also abandons the Proposed Order’s requirement for SDs and MSPs to submit a compliance plan, with unclear impact on the prospects for comparability determinations and substituted compliance.

The Further Proposed Guidance is intended to build upon, but not finalize, the CFTC’s cross-border proposal issued in July 2012 (the “July 2012 Proposed Guidance”),5 issued in conjunction with the Proposed Order. The Further Proposed Guidance includes a proposed alternative definition of US person and an alternative approach to the aggregation requirement for a non-US person’s SD de minimis calculations (each of which is different from the version adopted on an interim basis in the Order).

The Release includes several other significant interpretive elements and policy statements, including an acknowledgement by the CFTC of market participants’ concerns that full compliance with all of the Dodd-Frank swaps requirements may not currently be “practically feasible” given the many interpretive uncertainties and technical and other practical difficulties that must be addressed. As a consequence, the CFTC states that it does not intend to bring any enforcement action against an SD or an MSP for failure to comply with applicable Dodd-Frank swap requirements prior to July 12, 2013, provided that such noncompliance results from practical or technical impediments or interpretive uncertainty, and the registrant “is acting reasonably and in good faith to fully comply with the applicable Dodd-Frank requirements.”6

The CFTC states in the Adopting Release that this good faith compliance requirement would include:

  1. Material progress toward timely implementation and compliance with the Dodd-Frank requirement(s);
  2. Identification of any implementation or interpretive issue as soon as reasonably possible;
  3. Timely elevation of any such issue(s) to the SD’s orMSP’s senior management for consideration and resolution; and
  4. Timely consultation with other industry participants and the CFTC as necessary to seek resolution of any such issue(s).

The Order shows the CFTC largely unresponsive to the concerns of US SDs that the relative burden of US regulation on them and their customers will render US SDs uncompetitive in many instances. It also does not adopt the recommendations of non-US regulators that more comprehensive deference should be afforded to foreign regulatory regimes.7 The CFTC also did not respond to the comments that extraterritorial policymaking should be subject to full rulemaking procedures.

The release emphasizes the CFTC’s anticipation of continued discussions with foreign and domestic regulators. Accordingly, it is possible that these ongoing discussions will also contribute to further changes in the next phase of the cross-border regulatory regime that will need to be put in place after July 12, 2013, as well as to the ultimate goal of international harmonization.

Public comments on the Further Proposed Guidance s will be due 30 days after publication in the Federal Register.

SD and MSP Registration

The CFTC rejected requests from commenters to delay further the registration requirement for non-US SDs and MSPs until final cross-border guidance is adopted, taking the position that such a delay would frustrate the purpose of Dodd-Frank. Accordingly, the Order does not change the timing of registration for non-US entities. However, the Order does provide “targeted, time-limited exemptive relief with respect to the swap dealing transactions to be included in the de minimis threshold calculation,” which the CFTC believes will “substantially address” industry concerns for the interim period that the Order is in effect. That relief relies, in part, on yet another revised version of the definition of US person.

DEFINITION OF US PERSON UNDER THE ORDER

The Order includes a new definition of US person that will apply (for purposes of the swap provisions of Title VII of Dodd-Frank generally) until the Order expires on July 12, 2013. This definition is based largely on the prior temporary definition of US person adopted by the CFTC in No-Action Letter 12-22 (which is set to expire on December 31, 2012).8 The principal change from the prior temporary definition is that, beginning on April 1, 2013, a “US person” will include typical forms of business organizations (other than funds or other collective investment vehicles) whose principal place of business is in the United States, in addition to those organizations incorporated or organized in the United States.9 The Order’s definition of US person also includes several technical modifications related to whether pension plans for foreign employees, estates, trusts and joint accounts will be deemed US persons.10

  • Non-US Persons; Diligence Requirement. The Order states that any person not explicitly identified as a US person is a non-US person, addressing commenters’ concerns about potential expansion of the definition as it had been originally formulated. In addition, the CFTC has confirmed in the Release that parties may continue to reasonably rely on representations of a counterparty as to its status as a US person or non-US person (as under No-Action Letter 12-22). Such reliance would generally be reasonable in the absence of “red flags” and provided that representations are subject to periodic review. Representations in relationship documentation must be subject to a commitment to update.
  • As Applied to Branches. In the Release, the CFTC reaffirms its previously stated position that a non-US branch of a US person is a US person, since the branch is not a separate legal entity. The Release recognizes exceptions to this principle, however, with regard to how non-US branches of a US registrant are treated by their counterparties for purposes of the de minimis andMSP calculations and, when the branch’s counterparty is itself an SD orMSP, the counterparty’s compliance with Transaction-Level Requirements (as described below). The CFTC does not discuss the status of US branches of non-US banks, but its adherence to the “single entity” theory reinforces the view that US branches of non- US persons should generally continue to be treated as non-US persons.

DEFINITION OF “US PERSON” UNDER THE FURTHER PROPOSED GUIDANCE

Separate from the interim definition of US person in the Order, the CFTC is requesting comment in the Further Proposed Guidance on proposed modifications to two aspects of the US person definition from the July 2012 Proposed Guidance.

  • Majority-Owned Subsidiaries of Unlimited Liability Parent. First, the CFTC proposes to define US person to include any non-US entity that is directly or indirectly majority-owned by a natural person resident in the United States or an entity organized, incorporated or having its principal place of business in the United States, if such US person bears “unlimited responsibility for the obligations and liabilities” of the non-US entity. The Release indicates that this aspect of the definition would apply to “unlimited liability corporations” and similar entities that are majority-owned by US persons; it would not include limited liability companies or limited liability partnerships. This prong of the definition also would not cover a legal entity organized or domiciled in a foreign jurisdiction simply because the entity’s swap obligations were guaranteed by a US person.
  • Certain Collective Investment Vehicles. Second, the CFTC proposes to define US person to include a commodity pool, investment fund or other collective investment vehicle (regardless of whether it is organized or incorporated in the United States) that is directly or indirectly majority-owned by one or more US persons, except for any such pool or fund that is publicly traded but not offered to US persons. The exclusion provided for publicly traded collective investment vehicles not offered to US persons is being proposed in response to commenters’ concerns regarding the difficulty of verifying the ownership of such publicly traded vehicles.

SD DE MINIMIS AND MSP THRESHOLD CALCULATIONS UNDER THEORDER

Under the Order, a non-US person is not required to include in either its SD de minimis calculation or its MSP threshold calculations (i) any swap where the counterparty is not a US person, or (ii) any swap where the counterparty is a non-US branch of a US person that is registered as a SD or represents that it intends to register as a SD by March 31, 2013. The exclusion provided by prong (i) applies regardless of whether the swap obligations of the non-US person testing its SD or MSP status are guaranteed by a US person, thus narrowing the scope of swap transactions that count toward the de minimis threshold from that required by the July 2012 Proposed Guidance. The exclusion provided by prong (ii) effectively confirms that the approach to swaps with non-US branches of registered SDs (and those that intend to register) as set forth in No-Action Letter 12-22 will continue to apply, at least for the duration of the Order. This includes the expansion of the exemption for trades with such non-US branches to theMSP calculations (rather than just the SD de minimis calculation, as under the July 2012 Proposed Guidance).

  • Denial of Counting Relief for US SDs. The CFTC specifically rejected the argument of some commenters that US SDs that engage directly in overseas business (i.e., rather than through a non-US branch network) are placed at a competitive disadvantage due to the exemption from the de minimis calculation provided to non-US persons for swaps with non-US branches of registered SDs (since non- US persons may shift trading to non-US branches in order to avoid registration). The CFTC did emphasize, however, that a non-US person engaging in a swap with a non-US affiliate of a US SD would also be permitted to exclude that transaction from its de minimis calculation (regardless of any guarantees that may exist). According to the Release, it is this competitive parity between non-US affiliates and non-US branches of US SDs that supports the exemption afforded the latter. In the CFTC’s view, this rationale does not support extending the exemption to US SDs that trade directly with non-US persons.
  • Denial of Specific Relief for Legacy Swaps. Based on its view that “bright-line tests and categorical exclusions from the term ‘swap dealer’ … are unwarranted,” the CFTC declined to confirm specifically that limited swap activity in furtherance of the unwinding of legacy swap portfolios would not be deemed to be swap dealing. However, the Release does provide that the CFTC “does not intend to preclude its staff from considering appropriate relief in this regard on a case-by-case basis.”
  • Central Booking Clarification. The CFTC clarifies in the Release the discussion in the July 2012 Proposed Guidance regarding the central booking model, in which the CFTC stated that a non-US affiliate or subsidiary of a central booking entity may be required to register as a SD (i.e., in addition to the central booking entity itself) if the non-US affiliate or subsidiary “independently meets the definition of an SD.” The Release states that a non-US person in the central booking model would not include in its de minimis calculation any swap to which it is not a party (i.e., because the swap is entered into by the central booking entity).

AGGREGATION REQUIREMENT FOR NON-US PERSONS UNDER THE ORDER

Under the July 2012 Proposed Guidance, a non-US person would have been required, for purposes of its SD de minimis calculation, to aggregate the US-facing swap dealing transactions of its non-US affiliates. Swap dealing transactions of US affiliates, however, could be excluded. The Order retains for a non- US person engaged in swap dealing with US persons (as of December 21, 2012) the exclusion from aggregation of swap dealing transactions of US affiliates, but further scales back the aggregation requirement for a non-US person with respect to the swaps of its non-US affiliates, if the non-US affiliates are part of a corporate group that includes at least one registered SD.

Specifically, for purposes of the Order, a non-US person that was engaged in swap dealing activities with US persons as of December 21, 2012, and that is an affiliate under common control with a registered SD, is not required to include in its de minimis calculation the swaps of any non-US affiliate that either was also engaged in swap dealing activities with US persons as of December 21, 2012, or is registered as an SD. Thus, where at least one entity within an affiliated group registers as an SD, another non- US entity within that group generally would be required to register as an SD only if its own swap dealing transactions with US persons, considered individually, exceeded the de minimis threshold. Conversely, non-US persons in groups that do not include a registered SD obtain no relief from the requirements to aggregate the US facing swaps of all of their non-US affiliates.

  • Anti-evasion Measure. As noted above, the relief from the aggregation requirement for swap dealing activities of non-US affiliates is only available for entities that were engaged in swap dealing transaction with US persons as of December 21, 2012 (i.e., the effective date of the Order). The intent of this requirement appears to be to prevent non-US entities from commencing US-facing swap dealing business after December 21 in order to take advantage of the exemption during the temporary relief period. In light of this rationale, it seems that the relief should be interpreted as being available to non-US entities that have swap dealing transactions with US persons on their books as of December 21, 2012, even if such entities have not entered into new swaps with US persons since October 12.

AGGREGATION REQUIREMENT FOR NON-US PERSONS UNDER THE FURTHER PROPOSED GUIDANCE

The CFTC is proposing an alternative interpretation of the aggregation requirement in the Further Proposed Guidance—i.e., one that differs from the approach to aggregation taken in both the July 2012 Proposed Guidance and the Order. Under this alternative approach, a non- US person would be required to include in its de minimis calculation the swap dealing transactions of all affiliates under common control (i.e., US and non-US), but could exclude the swap dealing transactions of any affiliate that is registered as an SD.11 Thus, non-US persons within a group that has an affiliated SD could engage in a limited amount of swap dealing activity without being required to register, provided that the aggregate amount of dealing activity conducted by non-registrants in the group did not exceed the de minimis threshold. (Under the approach taken to aggregation in the July 2012 Proposed Guidance, such affiliates that are members of a corporate group with a registered SD transacting above the de minimis threshold would have been subject to registration for engaging in any US facing swap dealing transactions.)

The CFTC has requested comment on “all aspects” of this proposed alternative approach to aggregation, including whether the interpretation should apply to non-US persons “guaranteed” by a US person and whether the aggregation requirements for non- US persons should include the swap dealing activity of US affiliates.

Substantive Regulation of Non-US SDs and MSPs; Delayed Compliance

The Order classifies SD and MSP regulations into Entity-Level Requirements and Transaction-Level Requirements that are the same as in the Proposed Order.12

  • Entity-Level Requirements. These consist of: (i) capital adequacy; (ii) chief compliance officer; (iii) risk management; (iv) swap data recordkeeping; (v) swap data reporting (“SDR Reporting”); and (vi) large-trader reporting for physical commodity swaps reporting (“LTR”). The Release lists the specific CFTC regulations that correspond to Entity-Level Requirements as CFTC regulations 1.31, 3.3, 23.201, 23.203, 23.600-603, 23.605-609 and Parts 20, 45 and 46.
  • Transaction-Level Requirements. These consist of: (i) clearing and swap processing; (ii) margining and segregation for uncleared swaps; (iii) trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct standards. The Release lists the specific provisions of the CEA and CFTC regulations that correspond to Transaction- Level Requirements as CEA section 2(h)(8) and CFTC regulations 23.202, 23.400-451, 23.501-503, 23.504(a), (b)(2), (b)(3) and (b)(4), 23.505(b)(1), 23.506, 23.610 and Part 43.
  • Pending Requirements. Neither the CFTC, the SEC nor the banking agencies have adopted final rules for capital adequacy, an Entity-Level Requirement, or for the Transaction-Level Requirements relating to margin and segregation of uncleared swaps and trade execution. These requirements are outside the scope of the Order. Should CFTC final rules for any of these requirements come into effect prior to the expiration of the Order, the CFTC will consider extending the Order to such requirements at that time.

RELIEF FROM ENTITY- AND TRANSACTION-LEVEL REQUIREMENTS FOR NON-US REGISTRANTS AND NON-US BRANCHES

The Order generally allows non-US SDs and MSPs to delay compliance with Entity-Level Requirements that are in effect as of the effective date of the Order. With respect to SDR Reporting and LTR, however, the Order provides more limited relief. A non-US SD or MSP may delay compliance with SDR Reporting and LTR only with respect to swaps with non-US counterparties, and only if the non-US SD or MSP is not part of an affiliated group in which the ultimate parent entity is a US SD orMSP, US bank, US financial holding company or US bank holding company. The Order does not permit SDs or MSPs (whether US or non-US) to delay compliance with SDR Reporting or LTR for swaps with US counterparties, including non-US branches of US persons. Nor does it excuse US SDs or MSPs from compliance with any other Entity-Level Requirements.

The Order does not affect the obligation of an SD or an MSP to comply with Transaction-Level Requirements for swaps with US counterparties. For swaps with non-US counterparties, non-US SDs and MSPs and non-US branches of US SDs and MSPs may comply with such requirements only as may be required by the local jurisdiction of the non-US registrant or branch. In addition, for swaps between non-US branches of US SDs and MSPs, non-US branches may comply with such requirements only as may be required by the local jurisdiction of such branches. For purposes of the relief relating to swaps between non-US branches of US persons, a swap is considered to be with the non-US branch of a US person when (i) the personnel negotiating and agreeing to the terms of the swap are located in the jurisdiction of the branch, (ii) the documentation of the swap specifies that the counterpart or “office” for the US person is such non-US branch and (iii) the swap is entered into by the non-US branch in its normal course of business. Unlike the Proposed Order, the Order does not treat external business conduct requirements separately from other Transaction Level Requirements.

The CFTC clarifies in the Release that a non-US SD may treat the non-US branch of a US registrant as a non-US person for purposes of the Order’s relief from Transaction-Level Requirements.

  • Denial of Parity for US SDs. The CFTC rejected requests from many commenters who had sought, in various forms, extension of the relief granted to non-US SDs and MSPs and non-US branches of such registrants to US SDs and MSPs dealing with non-US counterparties. According to the CFTC, extension of relief from the substantive regulation of SDs andMSPs to US registrants would be contrary to the requirements of the Dodd-Frank Act and the CFTC’s supervisory interest in swap activities occurring in the United States. The CFTC states its view in the Adopting Release that issues of “regulatory disparity” among jurisdictions will be best addressed by working with non-US regulatory bodies to enhance and harmonize standards in other jurisdictions.

Commenters had pointed out difficulties posed in the cross-border context by CFTC requirements applicable to principals and associated persons of a non-US SD or MSP. The CFTC declined to grant relief in the Order from such requirements, stating that it believes staff action to be the more appropriate vehicle for such relief.13

Privacy and Confidentiality Laws

A number of commenters called attention to the potential for conflicts between Dodd-Frank requirements and local privacy and data protection laws, in particular with regard to SDR Reporting, LTR and US regulators’ access to registrants’ books and records. Although the CFTC did not address such conflicts in the Order directly, the Release cites other mitigating actions taken by the CFTC and its staff. The CFTC states that it is revising its Form 7-R (the registration application form) by making the agreement therein that foreign firms produce books and records upon CFTC request subject to the provisions of any applicable blocking, privacy or secrecy laws. Although the CFTC states in the Release that it intends to exercise its access and examination rights regardless of a registrant’s location, it further states that it will endeavor to achieve an understanding with each relevant regulator and that it believes such a “balanced and flexible approach” will allow it to achieve access to information “in a manner designed to ensure continuing cooperative relationships with its counterparts overseas.”

In addition, the CFTC cites a recent staff noaction letter, issued in response to a request from the International Swaps and Derivatives Association Inc., which permits certain counterparty identifying information to be omitted from SDR Reporting and LTR reports, subject to the conditions and time limitations stated in the letter.14

Concluding Observations

While the relief afforded in the Order will be significant for some non-US entities (particularly those that are part of a corporate group that includes a registered SD), it has much less to offer US swap market participants. The CFTC was largely unreceptive to the arguments made by a number of commenters that certain aspects of the exemptive relief provided by the Order should be extended to US SDs and MSPs.

In any case, the Order represents yet another temporary measure for market participants to contend with and does not provide the final word on any aspect of the CFTC’s regulation of crossborder swap activities. Nevertheless, for non-US swap market participants currently engaged in SD de minimis and MSP threshold calculations to determine whether they may be required to register with the CFTC, the Order provides the (temporary) operative guidance with respect to which swaps will be included in those calculations.15

Additional certainty for domestic and non-US swap market participants will likely be available only after the cross-border guidance is finalized, which is subject to the CFTC’s ongoing efforts to coordinate with domestic and non-US regulators, and will also need to take into account public comments on the newly issued Further Proposed Guidance. Those comments will be due 30 days after publication of the Further Proposed Guidance in the Federal Register.