Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Dodd-Frank Act”), was enacted on July 21, 2010.1 Under the Dodd-Frank Act, which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) has primary responsibility for the regulation of “swaps” and the Securities and Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) has primary responsibility for the regulation of “securitybased swaps.” A summary of certain noteworthy developments since our last update follows.
Effective Date for Swap Regulation
In an effort to provide additional market clarity as it finalizes its numerous rulemakings in connection with the Dodd-Frank Act,2 on June 17th, the CFTC issued a notice of proposed order (the “Proposed Order”)3 in which it proposed, pursuant to its exemptive authority under Section 4(c) of the Commodity Exchange Act, as amended (the “CEA”), to temporarily exempt persons or entities from provisions of the CEA that were added or amended by the Dodd-Frank Act that reference one or more terms that must be “further defined,” including, most significantly, the terms “swap,” “swap dealer,” “major swap participant” and “eligible contract participant,” to the extent that such provisions (or portions thereof) specifically relate to such terms. The Proposed Order further proposed granting relief from certain provisions of the CEA that will or may apply to certain contracts in exempt or excluded commodities (e.g., financial, energy and metals commodities) as a result of the repeal of various CEA exemptions or exclusions.
Following a brief comment period, the CFTC issued its final order (the “Final Order”)4 granting the temporary relief, which was largely based on the provisions set forth in its Proposed Order. Specifically, the CFTC broadly grouped the provisions of the Dodd-Frank Act into four categories: (i) provisions that require a rulemaking (which include most of the core reforms of the Dodd-Frank Act, such as capital and margin requirements applicable to swap dealers and major swap participants, as well as key defined terms); (ii) self-effectuating provisions (i.e., provisions that do not require a rulemaking) that reference terms that require further definition under the first category; (iii) self-effectuating provisions that do not reference terms that require further definition and that repeal provisions of current law; and (iv) self-effectuating provisions for which the CFTC did not grant relief. The provisions falling into the first category did not require relief, as they take effect not less than 60 days after the corresponding final rules are published. The provisions falling into the second category were granted relief, but only to the extent they specifically relate to the referenced terms. The provisions falling into the third category5 were granted relief to allow existing trading practices to continue without being “unduly disrupted” until the effectiveness of the required final rulemakings (for example, the CFTC confirmed that market participants could continue to temporarily rely on exemptions for options on energy commodities or metals and swaps on agricultural commodities). Finally, the provisions falling into the fourth category (many of which require the CFTC to undertake studies or are otherwise administrative and not directly relevant to market participants) were not granted relief because they would not result in undue disruption, and so, took effect on July 16th.6 Where granted, the specified relief expires upon the earlier of the effective date of the applicable final rule (or the repeal, withdrawal or replacement of the applicable exemption or exclusion) and December 31, 2011. The Final Order does not limit, in any way, the CFTC’s anti-fraud or anti-manipulation authority under the CEA.
On the same day the Final Order was issued, the CFTC also produced a “no action” letter in connection with the Dodd-Frank Act’s implementation. This letter provides comfort that enforcement actions temporarily will not be commenced against: (i) persons for failure to comply with certain collateral segregation requirements for uncleared swaps imposed on swap dealers and major swap participants; (ii) derivatives clearing organizations clearing swaps for failing to register with the CFTC; and (iii) persons in connection with the designation and duties of a chief compliance officer for swap dealers and major swap participants. The relief under the no-action letter expires upon the earlier of the effective date of the applicable final rule and December 31, 2011.
International Reform Implementation and Harmonization
Section 722(d) of the Dodd-Frank Act provides that certain of its requirements may apply to non-U.S. activities that have a “direct and significant connection with activities in, or effect on, commerce” of the United States. U.S. and non-U.S. banks have both been concerned with the ambiguity and potential applicability of this provision on banks with global operations. In particular, it is not entirely clear how the Dodd-Frank Act will apply to non-U.S. banks with large U.S. operations. In recent statements, the Commissions appear to be acutely aware of this ambiguity, with the SEC stating that it intends to prepare clarifying guidance.
On a related note, derivatives market participants and, especially, U.S. banks, have continued to voice concerns regarding the pace of implementation of U.S. derivatives reform in comparison with similar reform efforts in Europe and Asia. Specifically, they are concerned that U.S. banks could be disadvantaged if they become subject to the contemplated regulation (and its related burdens and costs) long before their non-U.S. competitors.7 Market participants may engage in regulatory arbitrage, resulting in the outflow of capital and liquidity to more accommodating jurisdictions. Throughout the reform effort, U.S. legislators and regulators have repeatedly acknowledged the importance of international harmonization (both with respect to substance and timing). So far, however, there is no indication that there will be any delay in the implementation of the Dodd-Frank Act to allow other jurisdictions to catch up in their reform efforts.
CFTC Issues Final Rule one Swap Data Repositories
Section 728 of the Dodd-Frank Act established swap data repositories (“SDRs”), new entities to which swap data would be required to be reported. The primary purpose of SDRs is to promote transparency and standardization, as well as to help reduce systemic risk by making swap data and information directly and electronically available to regulators. The CFTC was charged with establishing the registration requirements and core duties and responsibilities for SDRs. On December 23, 2010, the CFTC published for comment proposed rules to this end. On August 4th, the CFTC adopted final rules (the “Final SDR Rules”) implementing this portion of the Dodd-Frank Act.
Among other things, the Final SDR Rules (which have not yet been published in the Federal Register) will require that prospective SDRs file electronically for registration using new Form SDR. The CFTC is required to review an application within 180 days (although it may extend the review period in certain circumstances) and will register an SDR that it finds is appropriately organized and, inter alia, has the capacity to operate in a fair, equitable and consistent manner. Upon request, the CFTC may grant an applicant provisional registration if it is in substantial compliance for registration. An SDR located outside the United States also must certify (and provide a supporting opinion of counsel) that it is legally able to provide the CFTC with prompt access to its books and records and that it may submit to on-site inspection and examination by the CFTC.
Under the Final SDR Rules, SDRs will be responsible for, inter alia: (i) establishing, maintaining and enforcing policies and procedures for the reporting of swap data; (ii) accepting and promptly recording all relevant swap data; (iii) establishing policies ensuring the accuracy of swap data and other information required to be reported; (iv) monitoring, screening and analyzing swap data in such manner as the CFTC requires; (v) maintaining books and records in accordance with specified requirements; and (vi) making available all data obtained to specified foreign and domestic regulators.
The Final SDR Rules also will require that SDRs maintain sufficient financial resources and establish provisions ensuring non-discriminatory access and fees for their services. Moreover, SDRs will be required to establish governance arrangements and manage and minimize conflicts of interest (including establishing processes for resolving such conflicts)