By Micah Green, Michael Dunn, Matthew Kulkin, and Grace Kim
Micah Green is Partner and Co-Chair, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP. Michael Dunn is Senior Policy Advisor, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP. He is former Commissioner, Commodity Futures Trading Commission. Matthew Kulkin is Associate, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP. Grace Kim is Associate, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP.
In the last few months, U.S. financial regulators have taken significant steps towards implementation of regulations impacting over-the-counter derivatives markets and the scope of their jurisdiction for activity around the world. On May 1, 2013, the Securities and Exchange Commission (“SEC”) issued its proposed rules and interpretive guidance for parties to cross-border security-based swap transactions (“SEC Proposed Rule”).1 On July 12, 2013, the Commodity Futures Trading Commission (“CFTC”) adopted its final interpretive guidance and policy statement regarding compliance with certain swap regulations (“CFTC Final Guidance”).2
These documents serve as the foundation for how the SEC and CFTC will apply its Dodd-Frank Wall Street Reform and Consumer Protection Act3 (“Dodd-Frank”) rulemakings for cross-border transactions, global market participants, and activity that takes place outside the U.S. but has a “direct and significant connection with activities in, or effect on, commerce of the United States.”4
While the CFTC's work appears to be complete, the SEC and the majority of international regulators continue to formulate their regimes. At the recent G-20 summit in St. Petersburg, Russia, the Leaders' Declaration referenced the “recent set of understandings by key regulators on cross-border issues related to OTC derivatives reforms,” describing these efforts as “a major constructive step forward for resolving remaining conflicts, inconsistencies, gaps and duplicative requirements globally.”
Market participants are working diligently to analyze the regulatory burdens and structure their businesses based on the new regulatory framework. International regulatory bodies, such as the OTC Derivatives Regulators Forum, the Committee on Payment and Settlement Systems (“CPSS”), and the International Organization of Securities Commissions (“IOSCO”) are developing global standards to ensure cooperation between jurisdictions.
Despite nearly identical authorizing provisions under Dodd-Frank, the CFTC and SEC's approaches to cross-border regulation have significant distinctions in both the scope of their application and in the substantive requirements. There are also differences in the pace of implementation, regulatory authority of the releases, and the methods by which the Commissions intend to enforce their approaches.
While the bulk of the CFTC's rulemaking under Dodd-Frank is complete, implementation of these rules continue to raise new questions for market participants. Most recently, the CFTC's Division of Swap Dealer and Intermediary Oversight issued a staff advisory on November 14, 2013 related to the imposition of transaction-level requirements and the extraterritorial reach of Dodd-Frank.5 This publication highlights the jurisdictional disagreements between the CFTC and other international regulators in terms of cross-border regulatory oversight, as European Union regulators were “surprised” by the advisory, noting that it “seem[s] to us to go against both the letter and spirit of the path forward agreement” and is “another step away from the kind of inter-operable global system that [EU regulators] want to build.”6 These recent actions are the subject of a lawsuit brought in Federal court by three financial industry groups. In the complaint filed on December 4, 2013, the Securities Industry and Financial Markets Association, the International Swaps and Derivatives Association, and the Institute of International Bankers allege that the CFTC's cross-border guidance and the recent staff advisories violate the Administrative Procedure Act and the Commodity Exchange Act and should be vacated and set aside.
In order to better understand the current status of U.S. regulation of cross-border swap activity, this article identifies and analyzes four important distinctions between the SEC's and CFTC's recent releases. It then profiles the indemnification and confidentiality requirement contained in Dodd-Frank and the two Commissions' respective approaches to implementing the provision.
Point #1: Regulatory authority of interpretive guidance versus formal rulemaking
The CFTC has opted to release its cross-border framework through “interpretive guidance and policy statement.” Unlike the SEC's formal administrative rulemaking, which will ultimately yield binding rules, the CFTC Final Guidance is “a statement of the [CFTC's] general policy regarding cross-border swap activities and allows for flexibility in application to various situations.”7 By issuing interpretive guidance, as opposed to proposed rules, the CFTC has avoided subjecting its cross-border approach to the formal requirements of the Administrative Procedure Act (“APA”) and the Commodity Exchange Act requirement that the CFTC conduct a cost-benefit analysis.
In terms of regulatory rulemakings under the APA, federal courts have stated that an agency must “examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choices made.”8 Further, a regulatory agency has a “statutory obligation to determine as best it can the economic implications of the rule.”9 Had the CFTC chosen to undertake a formal rulemaking to promulgate cross-border rules, it would have been required to conduct and make publicly available such analyses.
CFTC Commissioner Scott O'Malia has expressed concern that the CFTC “crosse[d] the line between interpretive guidance and rulemaking” by issuing interpretive guidance regarding the cross-border application of the swaps provisions. He stated that the “guise of 'guidance’ … does not change its content or consequences,” and observed that the “guidance has a practical binding effect [on market participants] and should have been promulgated as a legislative rule under the APA.” Representative Scott Garrett (R-NJ) and Representative Randy Neugebauer (R-TX) expressed similar concerns in a letter addressed to CFTC Chairman Gary Gensler regarding the interpretive guidance, stating that “issuing informal guidance will not allow either American businesses or the American people to adequately assess the impact of the Commission's action.” Instead, the Representatives urged the Chairman to undertake a formal rulemaking process with cost-benefit analysis.
Point #2: Different approaches to the “U.S. person” definition
The SEC has stated that it uses a “tailored territorial approach” to define the term “U.S. person” by focusing on individuals or entities that--by virtue of their location within the U.S. or their relationship with the U.S.--(1) may impact the U.S. market even if they transact with non-U.S. persons, (2) are part of the U.S. security-based swap market and should receive Dodd-Frank protections, or (3) would pose a risk to the U.S. financial system by virtue of their counterparties' resident or domicile status.
In particular, the SEC defines a U.S. person as any natural person who is a resident in the U.S.; any partnership, corporation, trust, or other legal person organized or incorporated under U.S. laws or having its principal place of business in the U.S.; or any account of a U.S. person. Under the SEC's Proposed Rule, persons that are resident or organized in the U.S., or with their principal place of business in the U.S., would count all of their dealing transactions toward the de minimisthreshold, “including transactions that arise from dealing activity that occurs in part outside the United States.” With respect to the SEC's approach regarding guaranteed transactions, the SEC would not require a non-U.S. person that receives a guarantee from a U.S. person of its performance on security-based swaps with non-U.S. persons outside the U.S. to count such dealing transactions toward the de minimis threshold, as a U.S. person would be required to do. In terms of foreign branches of U.S. banks, the SEC's Proposed Rule would exclude transactions conducted through a foreign branch from a non-U.S. person's de minimis threshold calculation when the foreign branch is the named counterparty and the transaction is not “solicited, negotiated, or executed” by a person within the U.S. on behalf of the foreign branch or its counterparty.
The CFTC's interpretation of the term “U.S. person” highlights additional differences in the respective regulatory approaches of the Commissions. For example, the CFTC's interpretation of the term “U.S. person” enumerates several types of entities, including, for example, any natural person who is a resident of the U.S. and any corporation that is organized or incorporated under U.S. laws or having its principal place of business in the U.S.
In terms of the CFTC's approach to determining whether an entity's dealing activity requires registration as a swap dealer or major swap participant (“MSP”), similar to the SEC's proposed approach, a U.S. person should generally count its swap dealing activity towards the de minimis threshold, regardless of whether the activity is with U.S. or non-U.S. counterparties. Unlike the SEC, however, the CFTC would expect a guaranteed affiliate to count all of its swap dealing transactions, whether with U.S. or non-U.S. counterparties, toward the de minimis threshold. Further, with respect to its treatment of a foreign branch of a U.S. person, unlike the SEC's Proposed Rule, the CFTC views the activities of a foreign branch as the activities of the principal entity and, therefore, a foreign branch of a U.S. person is also a U.S. person.
Point #3: Divergent views on the regulation of mandated service providers: Clearinghouses, SDRs, and SEFs
The SEC Proposed Rule discusses the impact of the cross-border framework on mandated service providers, such as security-based swap clearing agencies, security-based swap data repositories (“SDRs”), and security-based swap execution facility (“SEF”). For example, in terms of clearing agencies, the SEC proposes that a clearing agency perform the function of a central counterparty within the U.S. if a U.S. person is a member of the clearing agency. In these instances, therefore, the SEC would require such a clearing agency to register.
Recognizing that the SEC Proposed Rule may impact security-based SDRs, the SEC addressed the application of the SDR regulations in the cross-border context. The SEC Proposed Rule provides that any U.S. person that performs the functions of a security-based SDR would be required to register with the SEC and comply with the security-based SDR requirements. For non-U.S. persons that perform the functions of a security-based SDR within the U.S., however, the SEC provides an exemption from U.S. registration, provided that the Commission determines that the relevant authority is “appropriate” for requesting security-based swap data from a security-based SDR.
Lastly, the SEC Proposed Rule discusses when a foreign security-based swap market would be required to register with the SEC, as well as the circumstances under which the SEC may consider granting an exemption from registration for a foreign security-based swap market. For example, the SEC proposes that when a foreign security-based swap market provides U.S. persons, or non-U.S. persons located in the U.S., with the direct ability to trade or execute security-based swaps on the foreign security-based swap market by accepting bids and offers made by one or more participants, then such market would be required to register as a SEF.
Conversely, unlike the SEC's Proposed Rule, the CFTC Final Guidance does not focus upon the impact of the cross-border framework on mandated service providers. Rather, the CFTC Final Guidance focuses on the application of swap provisions to various counterparties. It is therefore unclear how the CFTC will handle issues involving, for example, the potential registration and regulation of foreign-based mandated service providers.
Point #4: Recognition of foreign regulations through “substituted compliance”
Generally speaking, the CFTC allows a non-U.S. swap dealer, non-U.S. MSP, U.S. bank that is a swap dealer or MSP with respect to its foreign branches, or non-U.S. non-registrant that is a guaranteed or conduit affiliate, to substitute compliance with the requirements of the relevant home jurisdiction's law and regulations (or in the case of foreign branches of a bank, the foreign location of the branch) instead of complying with otherwise applicable CFTC Entity-Level Requirements and/or Transaction-Level Requirements. This can be done in instances where the CFTC concludes that the home jurisdiction's requirements (or in the case of foreign branches of a bank, the foreign location of the branch) are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.
Substituted compliance determinations will be made by the CFTC in response to petitions by interested parties, which may include foreign regulators, an individual non-U.S. entity, or group of non-U.S. entities; a U.S. bank that is a swap dealer or major swap participant with respect to its foreign branches; or a trade association, or other group, on behalf of similarly-situated entities.
The CFTC will then undertake an analysis of whether “the requirements of the home jurisdiction are comparable and comprehensive to the applicable requirement(s) under the CEA and Commission regulations based on a consideration of all relevant factors, including among other things: (i) the comprehensiveness of the foreign regulator's supervisory compliance program and (ii) the authority of such foreign regulator to support and enforce its oversight of the registrant's branch or agency with regard to such activities to which substituted compliance applies.” During the July 12, 2013 CFTC open meeting, CFTC staff indicated that the European Union, Switzerland, Hong Kong, Australia, Canada, and Japan already submitted petitions for substituted compliance determinations, and that the process “will take a matter of months.” Following a comparability determination for a jurisdiction, it will apply for all entities or transactions in that jurisdiction to the extent provided in the determination, as approved by the CFTC.
By comparison, the SEC's proposed approach to substituted compliance focuses on four primary areas: (1) security-based swap dealers; (2) regulatory reporting and public dissemination; (3) clearing for security-based swaps; and (4) trade execution for security-based swaps. The SEC's approach to substituted compliance is more holistic. For each category, the SEC will apply a “comparability” standard as the basis for making a substituted compliance determination. The SEC Proposed Rule notes that the SEC will ultimately focus on regulatory outcomes as a whole when looking at a requirement within a category “rather than a rule-by-rule comparison.”10 The SEC Proposed Rule adds that applications for substituted compliance must be in writing and contain full information regarding the requesting party, and the SEC may modify or withdraw any substituted compliance determination.
The SEC's proposed review process for a substituted compliance determination would generally involve review by the Division of Trading and Markets staff and a recommendation to the Commission. The Commission reserves the right to schedule a hearing or solicit public comment on the application.
The SEC and CFTC substituted compliance regimes have many similar characteristics and may prove to achieve similar results. There are, however, several important distinctions. The rule-by-rule approach adopted by the CFTC was rejected in the SEC's Proposed Rule, which instead adopted a more rounded analysis focused on consistent outcomes regardless of the regulatory regime. Though the CFTC will review an “outcomes-based approach,”11 it will conduct its substituted compliance analysis across each of the thirteen Entity-Level and Transaction-Level Requirements. By comparison, the SEC has divided its possible substituted compliance areas into four wide ranging areas.
Until the CFTC and SEC review and respond to substituted compliance applications, it will be difficult to predict the practical implications of the approaches to substituted compliance. Both Commissions have sworn themselves to act in a manner consistent with principles of international comity, but the extent to which they are willing to defer to and cooperate with foreign regulators remains to be seen.
Point #5: Case study-confidentiality and indemnification requirements
To better appreciate the differences between the Commissions, it is worth exploring the CFTC's and SEC's approaches to the Dodd-Frank “Indemnification Provision” that applies to derivatives clearing houses and trade repositories.
Section 21(c)(7) of the CEA and Section 13(n)(5)(H) of the Securities Exchange Act of 1934 each provide that, before sharing information with certain regulatory entities, an SDR must obtain a written agreement from the entity stating that the entity shall abide by the confidentiality requirements described in the CEA and the Exchange Act, respectively, and the rules and regulations thereunder, relating to the information on swap transactions that is provided. In addition, the requesting entity must agree to indemnify the SDR and the CFTC or SEC, as applicable, for any expenses arising from litigation relating to the information provided under the CEA or the Exchange Act and the rules and regulations thereunder.
In response to this provision, the CFTC proposed, and then finalized in October 2012 an interpretative statement to minimize the impact of the Indemnification Provision. The CFTC's approach exempts certain requesting entities (foreign regulators) from entering into a confidentiality and indemnification agreement with an SDR if the swap data is reported pursuant to foreign law and if the SDR is “registered, recognized, or otherwise authorized by the country's law and regulation.”
The SEC Proposed Rule contemplates that a registered SDR need not comply with the Exchange Act's Indemnification Provision if: (i) the requesting entity requires the data to fulfill a regulatory mandate and/or legal responsibility of the entity; (ii) the request of such entity pertains to a person or financial product subject to the jurisdiction, supervision, or oversight of the entity; and (iii) the entity has entered into a supervisory and enforcement memorandum of understanding or other arrangement with the SEC that addresses the confidentiality of the security-based swap information provided and any other matters as determined by the SEC. The SEC's rulemaking must still be adopted by the Commission as a final rule before it takes effect, but the SEC Proposed Rule indicates a distinct method of implementing the Indemnification Provision in a manner that does not violate principles of international comity and permits global information sharing.
To date, two of the four current CFTC Commissioners have publicly supported a legislative amendment to this provision to remove the statutory provision that remains12 and Chairman Gary Gensler identified the Indemnification Provision as one that Congress may address.13 The CFTC's general counsel took no position before a House subcommittee in 2012.14 At the SEC, former Chairman Elisse Walter reiterated the SEC's public support for a legislative fix,15 a position previously established during a Congressional hearing on the topic.16
The CFTC's rapid pace of rulemaking placed a marker for the SEC and global financial regulators. For the sake of harmonization and efficiency, some regulators may feel compelled to consider an approach that mirrors the CFTC Final Guidance. However, the CFTC Final Guidance does not have the same regulatory authority as a formal rulemaking, as contemplated by the SEC. The CFTC Final Guidance also fails to fully reflect years of global regulatory coordination and risks becoming the outlier to another approach adopted through multilateral negotiations.
The issues identified in this article are among the most important topics for regulators to consider. Ultimately, given the global connectedness of OTC markets, the ability for regulators to identify and minimize systemic risk will depend upon the cooperation of regulatory authorities and the ease by which information may be shared among counterparts.
1 Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (May 23, 2013). Concurrent with the issuance of the SEC Proposed Rule, the SEC also reopened the public comment period for its pending proposed rules required by Title VII of Dodd-Frank for 60 days. The public comment period for the SEC Proposed Rule closed on August 21, 2013 and garnered feedback from regulators, legislators, industry groups, and market participants from around the world. The SEC will not finalize this regulation until 2014 at the earliest.
2 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292 (July 26, 2013). The CFTC Final Guidance became effective on July 26, 2013, though compliance with some of its provision was delayed through exemptive order.
3 7 Public Law 111-203, 124 Stat. 1376 (2010).
4 Commodity Exchange Act of 1936, 7 U.S.C. § 2(i) (1936).
5 Applicability of Transaction-Level Requirements to Activity in the United States, CFTC Staff Advisory No. 13-69 (Nov. 14, 2013).
6 Jim Brunsden, EU Says Gensler Swaps Rule Clashes with Trans-Atlantic Pact, BLOOMBERG, Nov. 21, 2013.
7 78 Fed. Reg. at 45,297.
8SeeBus. Roundtable & Chamber of Comm. v SEC, 647 F.3d 1144, 1148 (D.C. Cir. 2011) (quoting Motor Vehicle Mrfs. Ass'n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)).
9Id. (quoting Chamber of Comm. v. SEC, 412 F.3d 133, 143 (D.C. Cir. 2005)).
10 78 Fed. Reg. 30,975.
11 78 Fed. Reg. 45,352.
12See Commissioner Jill Sommers and Commissioner Scott O'Malia, Dissenting Statement, Interpretative Statement Regarding the Confidentiality and Indemnification Provisions of Section 21(d) of the CEA, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/sommers_omailadissentstatement; see also Dodd-Frank Derivatives Reform: Challenges Facing U.S. and International Markets: Hearing Before the H. Comm. on Agric., 112th Cong. (2012) (Commissioner Bart Chilton expressing support for a legislative solution), transcript available at http://agriculture.house.gov/sites/republicans.agriculture.house.gov/files/transcripts/112/112-35New.pdf
13See Oversight of the Commodity Futures Trading Commission: Hearing Before the S. Comm. on Agric., Nutrition, and Forestry, 113th Cong. (2011) (colloquy between Chairman Gensler and Senator Saxby Chambliss).
14 Written Testimony of Daniel Berkowitz, House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises (Mar. 21, 2012), available at http://financialservices.house.gov/uploadedfiles/hhrg-112-ba-wstate-dberkovitz-20120321.pdf.
15 Chairman Elisse Walter, Secs. and Exch. Comm'n, Remarks at the American Bar Association Spring Meeting, Regulation of Cross-Border OTC Derivatives Activities: Finding the Middle Ground (Apr. 6, 2013).
16 Written Testimony of Ethiopis Tafara, House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises (Mar. 21, 2012), available athttp://financialservices.house.gov/UploadedFiles/HHRG-112-BA-WState-ETafara-20120321.pdf.
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