On June 25, 2014, the Securities and Exchange Commission (“SEC” or “Commission”) unanimously adopted final rules regarding the application of “Security-Based Swap Dealer” and “Major Security-based Swap Participant” definitions to cross-border security-based swap activities (“Final Rules”) under the Securities Exchange Act of 1934 and Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank Act”). These rules, which Chair Mary Jo White said “lay the foundation for moving forward” on remaining rules, also define “who is — and who is not — covered by [the SEC’s] regulatory regime” and who must register with the Commission as either a “Security-Based Swap Dealer” or a “Major Security-Based Swap Participant.”
These regulations may impact participants that deal in or rely upon security-based swaps to mitigate commercial or financial risk, such as banks, hedge funds, large financial enterprises, and market participants actively involved in security-based swaps. Entities that find themselves subject to the Commission’s jurisdiction must comply with a series of requirements, including registration, reporting, recordkeeping requirements, business conduct standards, and capital and margin rules.
The Commission’s rules are designed to provide consistency with the Commodity Futures Trading Commission’s (“CFTC”) cross-border interpretative guidance for cross-border swaps activity. Moreover, the Final Rules also provide procedures for foreign regulators or market participants to apply for substituted compliance, which would permit market participants to comply with U.S. requirements by complying with foreign requirements.
Importantly, the SEC’s Final Rules establish clear guidelines for when a U.S. person provides a guarantee – a legally enforceable right of recourse– for certain non-U.S. entities. Chair White indicated that the recent move by some U.S. financial firms to “de-guarantee” foreign affiliates may allow the affiliates to evade SEC oversight because of the lack of a legally enforceable right of recourse against a U.S. person, but that the SEC “will work with [ ] regulators here and abroad to actively monitor these and other developments and the potential exposure of the United States — and work to develop and use our collective powers to address them as necessary.”
This client alert provides some of the specifics surrounding the SEC’s Final Rules.
SECURITY-BASED SWAP DEALER REGISTRATION FOR NON-U.S. PERSONS
A. DEFINITION OF A “U.S. PERSON”
A “U.S. person” is defined in a territorial manner that encompasses:
- Any natural person who resides in the U.S.;
- Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the U.S. or having its principal place of business in the U.S.;
- Any discretionary or non-discretionary account of a U.S. person; and
- Any estate of a decedent who was a resident of the United States at the time of death.
The final “U.S. person” definition excludes certain international organizations, regardless of where they are organized or where their primary place of business is located.
Consistent with rules adopted by the SEC jointly with the CFTC regarding the Title VII definitions of dealer and major participant, foreign branches of U.S. banks and U.S. branches of foreign banks are not separate legal persons for purposes of Title VII and have the same U.S.-person status as the bank’s home office.
B. DEFINITION OF A PRINCIPAL PLACE OF BUSINESS
A “principal place of business” means the location from which the officers, partners, or managers of the legal person primarily direct, control, and coordinate the activities of the legal person. The definition provides that, with respect to an externally managed investment vehicle, this location is the office from which the manager of the investment vehicle primarily directs, controls, and coordinates the investment activities of the investment vehicle.
C. TRANSACTIONS INCLUDED IN THE DEALER CALCULATION
A market participant would be considered a security-based swap dealer required to register with the SEC if its dealing transactions conducted in the past 12 months exceeded certain thresholds. U.S. persons are required to count their security-based swap dealing transactions toward the thresholds, including dealing transactions conducted through their foreign branches. Non-U.S. persons are required to count the following against the thresholds:
- Dealing transactions with counterparties that are U.S. persons, including foreign branches of U.S. banks (unless the foreign branch is a branch of a registered security-based swap dealer);
- Dealing transactions with any counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person in connection with the non-U.S. person’s obligation under the security-based swap.; and
- All dealing activity if a non-U.S. person acts as a “conduit affiliate.”
D. NON-U.S. DEALERS WHOSE COUNTERPARTIES HAVE RIGHTS OF RECOURSE AGAINST A U.S. PERSON AFFILIATE
A non-U.S. person is required to count against the dealer thresholds its dealing transactions with a non-U.S. counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person. Recourse exists if the counterparty has a legally enforceable right against the U.S. affiliate in connection with the non-U.S. person’s obligation under the security-based swap.
E. CONDUIT AFFILIATES
As an anti-evasion measure, the Final Rules expand the proposal’s treatment of non-U.S. affiliates of U.S. persons by requiring non-U.S. persons that act as “conduit affiliates” to count all of their dealing transactions towards the dealer thresholds. A “conduit affiliate” is a non-U.S. affiliate of a U.S. person that enters into security-based swaps with non-U.S. persons or with certain foreign branches of a U.S. bank on behalf of its U.S. affiliates (other than U.S. affiliates that are registered as security-based swap dealers or major security-based swap participants) and enters into offsetting transactions with its U.S. affiliates to transfer the risks and benefits of those security-based swaps.
F. AGGREGATING TRANSACTIONS INVOLVING DEALING ACTIVITY OF AFFILIATES
A person may exclude from its dealer threshold calculations the dealing transactions of any affiliate registered with the SEC as a security-based swap dealer. The exclusion is not conditioned on the person and its affiliate being operationally independent.
G. CLEARED ANONYMOUS TRANSACTIONS
Non-U.S. persons are not required to count a transaction against the thresholds if the transaction is entered into anonymously and is cleared.
H. FURTHER CONSIDERATION OF ACTIVITY IN THE UNITED STATES INVOLVING ONLY NON-U.S. PERSONS
The Final Rules do not include an element of the proposal that would have required dealing activity between two non-U.S. persons to be counted for purposes of the dealer definition if the security-based swap transaction was conducted within the United States. Given the complex and important issues raised by that proposed requirement, the SEC expects to solicit additional comment regarding when a transaction between two non-U.S. persons should be included in the relevant dealer thresholds because one or both counterparties are engaged in security-based swap activity within the U.S.
MAJOR SECURITY-BASED SWAP PARTICIPANT REGISTRATION FOR NON-U.S. PERSONS
A. TRANSACTIONS INCLUDED IN THE MAJOR PARTICIPANT CALCULATIONS
A market participant would be deemed to be a “major security-based swap participant” if its security-based swap positions exceed certain thresholds. U.S. persons are required to count all of their security-based swap positions when determining whether they are major participants. Non-U.S. persons are required to count the following positions against the major participant thresholds:
- Positions with U.S. persons, including foreign branches of U.S. banks (unless the foreign branch is a branch of a registered security-based swap dealer);
- Positions with a counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person in connection with the non-U.S. person’s obligation under the security-based swap; and
- All positions if a non-U.S. person acts as a “conduit affiliate.”
B. ATTRIBUTION OF GUARANTEED POSITIONS
Persons generally should include within their major participant calculations any positions they guarantee. Guaranteed positions are attributed as follows in the cross-border context:
- A non-U.S. person that provides a recourse guarantee of the security-based swap obligations of a U.S. person counts all of the U.S. person’s security-based swap positions that it guarantees;
- A non-U.S. person that provides a recourse guarantee of the security-based swap obligations of another non-U.S. person counts only the guaranteed security-based swap positions arising from transactions with U.S.-person counterparties; and
- A U.S. person that provides a recourse guarantee of the security-based swap obligations of a non-U.S. person counts all of that non-U.S. person’s security-based swap positions that it guarantees.
A guarantor is not required to count any guaranteed positions entered into by a non-U.S. person if the non-U.S. person is subject to Basel capital standards, to capital regulation by the SEC or the CFTC, or is regulated as a bank in the United States.
Chair White indicated that the SEC will move quickly to address trade reporting and dissemination of trade details to the public, mandatory clearing and trade execution, and rules applicable to registered security-based swap dealers and major security-based swap participants, and security-based swap market infrastructure.
Specifically, the SEC “will next look to consider a recommendation on security-based swap transaction reporting [Proposed Regulation SBSR] and the registration and regulation of security-based swap data repositories.”