On October 11, 2016, the Commodity Futures Trading Commission (“CFTC”) unanimously approved a proposed rule on the Cross-Border Application of the Registration Thresholds and External Business Conduct Standards Applicable to Swap Dealers and Major Swap Participants (the “Proposed Rule”).1 The proposal pertains to the cross-border application of certain entity-level and transaction-level swap provisions of the Commodity Exchange Act (“CEA”). It includes a regulatory definition of “U.S. Person,” registration threshold requirements, and external business conduct standards applicable to swap dealers (“SD”) and major swap participants (“MSP”). The Proposed Rule, if finalized, would replace certain aspects of the CFTC’s controversial non-binding interpretive guidance on crossborder transactions issued in 2013 (the “Cross-Border Guidance”).2
The Proposed Rule also addresses issues related to a November 2013 request for comment on CFTC Staff Advisory No. 13-69, also known as the “elevator rule,” regarding non-U.S. SDs’ use of U.S. personnel to “arrange, negotiate, or executive” swap transactions (“ANE Transactions”). The Proposed Rule is another indication that, as CFTC Chairman Timothy Massad recently stated, the CFTC is committed to “address[ing] cross-border issues in swaps rules.” The chairman noted that the CFTC is “actively working on harmonizing data reporting standards,” and recently harmonized clearinghouse regulation through an accord with the European Commission. Moreover, earlier this year, the CFTC harmonized requirements on margin for uncleared swaps and issued a related comparability determination. These significant developments in the cross-border regulation of swaps are detailed below.
I. Rulemakings on Cross-Border under the G-20 Commitments
The CFTC’s Cross-Border Guidance guided market participants for more than three years; however, at the end of 2015, the Commission began to issue rulemakings to supplant its prior guidance.3 In May 2016, the CFTC issued a final rule on the cross-border application of margin requirements for uncleared swaps for SDs and MSPs. Shortly thereafter, the CFTC issued a comparability determination for Japan on margin requirements for uncleared swaps. The CFTC’s proposal on the cross-border application of the registration thresholds and external business conduct standards applicable to SDs and MSPs is the latest in its efforts to establish a framework for the application of its swaps regulations abroad. Notably, the CFTC’s Proposed Rule generally follows the approach taken by the Securities and Exchange Commission (“SEC”) with its rulemakings on cross-border.4
In relation to EU derivatives regulation, the EU has a reasonably well-developed set of rules relating to the application of EMIR to entities established in a third country. The main current development relates to the G-20 margining commitments for uncleared derivatives. On October 4, 2016, the EU Commission published a draft Commission Regulation under EMIR that, once it is adopted and fully in force, will require financial counterparties (“FC”) and non-financial counterparties above the clearing threshold (“NFC+”) under EMIR to collect margin from counterparties that are themselves FCs, NFCs+ or third country entities (i.e., non-EU entities) that would be FCs or NFCs+ if they were established in the EU. The regulation would therefore regulate the exchange of margin across border. Implementation is going to be implemented in phases, and in some cases will depend on when the Commission Regulation is adopted. As a result, while the largest derivatives counterparties will likely be subject to margining obligations from mid/end January 2017, the variation margin requirements will apply to all remaining covered entities beginning on March 1, 2017. Our EU colleagues will report on the detail of the new requirements shortly.
II. Proposed Rule on the Application of Certain Swap Provisions of the CEA in Cross-Border Transactions
The Proposed Rule explains that “the current swap market is global in scale and characterized by a high level of interconnectedness among market participants, with transactions negotiated, executed, and arranged between counterparties in different jurisdictions.” The proposal strives to achieve the aims of the Dodd-Frank Act while minimizing unnecessary burdens and disruptions to market practices. It includes new definitions of “U.S. Person” and “Foreign Consolidated Subsidiary”; an interpretation regarding transactions where a non-U.S. SD uses U.S. personnel to arrange, negotiate, or execute a swap with a Non-U.S. Person; and addresses registration thresholds, external business conduct standards for SDs and MSPs, and the use of guaranties cross-border.
Definitions. The Proposed Rule provides definitions of “U.S. Person” and “Foreign Consolidated Subsidiary” that are generally consistent with the Cross-Border Margin Rule and would apply to future cross-border rulemakings. The question of whether a market participant falls under the definition of a U.S. Person or Foreign Consolidated Subsidiary affects how the SD/MSP registration thresholds would apply. Under the proposal, a U.S. Person is defined as:
(i) Any natural person who is a resident of the United States;
(ii) Any estate of a decedent who was a resident of the United States at the time of death;
(iii) Any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of entity similar
to any of the foregoing (other than an entity described in paragraph (iv) or (v)) (“legal entity”), in each case that is organized or incorporated under
the laws of the United States or that has its principal place of business5 in the United States, including any branch of the legal entity;
(iv) Any pension plan for the employees, officers or principals of a legal entity described in paragraph (iii), unless the pension plan is primarily for foreign employees of such entity;
(v) Any 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;
(vi) Any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have
limited liability) that is owned by one or more persons described in paragraphs (i) through (v) who bear(s) unlimited responsibility for the obligations and liabilities of the legal entity, including any branch of the legal entity; and
(vii) Any 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 in paragraphs (i) through (vi).6
This new definition would replace the CFTC’s current interpretation of the term in its 2013 Cross-Border Guidance, although the Proposed Rule largely mirrors the Cross-Border Guidance. However, unlike the guidance, the Proposed Rule would not treat commodity pools, pooled accounts, investment funds, and other collective investment vehicles majority-owned by one or more U.S. Persons as U.S. Persons. Notably, consistent with the CFTC’s final rule on the cross-border application of its margin requirements, the definition includes an “unlimited U.S. responsibility prong” that encompasses legal entities that are owned by one or more U.S. Persons who bear unlimited responsibility for the obligations and liabilities of the legal entity. Moreover, the definition is limited to those entities enumerated in the rule, and does not include the prophylactic “catchall” provision from the interpretive guidance.
Non-U.S. Persons that are consolidated for accounting purposes with an ultimate parent entity that is a U.S. Person would be regulated as Foreign Consolidated Subsidiaries. The proposal defines a Foreign Consolidated Subsidiary as:
a non-U.S. person in which an ultimate parent entity that is a U.S. person (“U.S. ultimate parent entity”) has a controlling financial interest, in accordance with U.S. generally accepted accounting principles, such that the U.S. ultimate parent entity includes the non-U.S. person’s operating results, financial position and statement of cash flows in the U.S. ultimate parent entity’s consolidated financial statements, in accordance with U.S. generally accepted accounting principles.7
The “ultimate parent entity” is the parent entity in a consolidated group in which none of the other entities in the group has a controlling interest, in accordance with U.S. generally accepted accounting principles.
The Proposed Rule asserts that counterparties of the FCS often look to both the FCS and its U.S. ultimate parent for fulfillment of the FCS’s obligations under a swap even without any explicit guarantee. Accordingly, Foreign Consolidated Subsidiaries would be required to include relevant swaps for the SD/MSP registration calculation like a U.S. Person and U.S. Guaranteed Entity.
ANE Transactions. In 2013, then-CFTC Chairman Gary Gensler laid the groundwork for the “elevator rule.” He stated that “[a] U.S. swap dealer on
the 32nd floor of a New York building and a foreign-based swap dealer on the 31st floor of the same building, have to follow the same rules when arranging, negotiating or executing a swap.” The Proposed Rule would set forth an official CFTC interpretation on whether persons engaged in ANE Transactions fall within its jurisdiction.
Under the Proposed Rule, persons who use personnel located in the United States to arrange, negotiate, or execute their swap dealing transactions are within the ambit of the Dodd-Frank Act, and therefore the CFTC may choose to apply specific Dodd-Frank swap requirements to such transactions. The Proposed Rule would require compliance with certain external business conduct standards in these situations, as explained in more detail below. The CFTC will address the application of Dodd-Frank to ANE Transactions in future rulemakings “as necessary and appropriate.” In the interim, Commissioner Giancarlo urged CFTC Staff to “commit to extend no-action letter 16-64 in order to provide clarity that those swaps requirements do not apply to ANE transactions.”
Registration Thresholds. Market participants are required to register as SDs if their dealing activity exceeds the de minimis threshold.8 Under the Proposed Rule, in making the de minimis calculation, U.S. Persons and Foreign Consolidated Subsidiaries would include all of their swap dealing transactions. Under the current Cross-Border Guidance, only Non-U.S. Persons that are an affiliate of and guaranteed by a U.S. Person, known as “guaranteed affiliates,” and entities that qualify as “conduit affiliates” are required to include swap dealing transactions with Non-U.S. Persons.
Under the proposal, Non-U.S. Persons would be required to include all swap dealing transactions for which it is a U.S. Guaranteed Entity. The Proposed Rule broadly defines “guarantee,” noting that it would encompass “arrangements, pursuant to which one party to a swap has rights of recourse against a guarantor, with respect to its counterparty’s obligations under the swap,” and “any arrangement pursuant to which the guarantor itself has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from any other guarantor with respect to the counterparty’s obligations under the swap.”
An Other Non-U.S. Person would be required to include its dealing activities with U.S. Persons, U.S. Guaranteed Entities, and Foreign Consolidated Subsidiaries. Other Non-U.S. Persons would not be required to include transactions executed anonymously on a swap execution facility, designated contract market, or foreign board of trade, and cleared through a registered or exempt derivatives clearing organization. Potential SDs, whether a U.S. Person or Non-U.S. Person, would aggregate all swaps connected with its dealing activity with those of persons controlling, controlled by, or under common control with the potential SD to the extent that these affiliated persons are themselves required to include those swaps in their own de minimis thresholds, unless the affiliated person is registered as a SD. The counting framework for MSPs mirrors these guidelines.
External Business Conduct Standards. The Proposed Rule would establish business conduct standards governing the conduct of SDs and MSPs in their swap counterparties in a cross-border context. U.S. SDs and MSPs, other than in transactions conducted through their foreign branches, would be required to comply with the CFTC’s applicable external business conduct standards, irrespective of the status of the counterparty as a U.S. Person without substituted compliance. Foreign branches of U.S. SDs and MSPs and Non-U.S. SDs and MSPs would be required to comply with all of the CFTC’s applicable external business conduct standards, without substituted compliance, to the extent that the counterparty is a U.S. Person. Additionally, foreign branches of U.S. SDs and non-U.S. SDs that use personnel located in the U.S. to arrange, negotiate, or
execute such transactions would be required to comply with CFTC Rule 23.410 (Prohibition on Fraud, Manipulation, and other Abusive Practices), and 23.433 (Fair Dealing), without substituted compliance. These provisions apply even if the swap is not ultimately entered into.
The comment period for the Proposed Rule ends December 19, 2016.
III. CFTC-FCA Memorandum of Understanding
CFTC Chairman Timothy Massad has publicly stated that cooperation with EU regulation is a priority for the CFTC. Prior to publishing the Proposed Rule, the CFTC and the FCA negotiated the Memorandum of Understanding Concerning Cooperation and the Exchange of Information in the Context of Supervising Covered Firms (the “MOU”), which is intended to facilitate transparency between the agencies as they regulate derivatives transactions and market participants across borders. The MOU is a statement of intent to consult, cooperate and share information related to relevant activities of entities that are registered as, or applied for registration as SDs or MSPs and entities that are authorized, or applied to be authorized, by the FCA in accordance with any of the European single market directives mentioned in Article 2(8) of the European Market Infrastructure Regulation (“EMIR”).
In other words, it appears that on its plain words, the MOU would apply to FCs under EMIR that are authorized by FCA, but (because they are not “authorized” by FCA) not to NFCs. This is the case even where the NFC exceeds the EMIR clearing threshold (an NFC+), and so would be regarded as systemically significant and subject to mandatory clearing/margining. This is perhaps surprising, given that SDs and MSPs are included but it may reflect the tight statutory controls on information sharing by the FCA.
The CFTC and FCA intend to cooperate and share information in various circumstances, such as where an entity from one jurisdiction (U.S. or UK) applies for registration or authorization in the other, or when questions arise regarding its compliance or where foreign regulatory action may materially impact its domestic operations. Under UK and EU law, the FCA is subject to extensive statutory provisions regulating the circumstances in which it may share information (e.g., with overseas regulators). Under those provisions, information can sometimes only be disclosed in accordance with a cooperation agreement put in place with an overseas regulator, such as the CFTC.
Although the CFTC and FCA do not intend for the MOU to serve as a device for building investigations, the sharing of non-public information between the agencies may prompt increased enforcement activity across borders. Market participants should accordingly verify that their cross-border compliance policies and procedures are up-to-date, and prepare for the upcoming finalization of the new CFTC cross-border rules.
IV. EU Substituted Compliance Framework
In March, the CFTC approved a substituted compliance framework for dually registered central counterparties (“CCP”) located in the EU, and a comparability determination pertaining to certain EU rules.9 Under Notice of Comparability Determination issued by the CFTC, CCPs authorized in the EU and registered with the CFTC as derivatives clearing organizations will be deemed compliant with CFTC requirements for financial resources, risk management, settlement procedures, and default rules, as long as they comply with corresponding EMIR requirements. CFTC Chairman Timothy Massad noted that the determination “provides a foundation for cooperation among regulators in the oversight of the global clearinghouses that are so important in our financial system today.” The CFTC’s Division of Clearing and Risk also issued a no-action letter that provided limited relief from the application of CFTC regulations to certain aspects of a CCP’s non-U.S. clearing activities.
V. Cross-Border Margin Developments
In May, the CFTC issued a final rule pertaining to cross-border implementation of its margin requirements for uncleared swaps (“Cross-Border Margin Rule”).10 Pursuant to the Cross-Border Margin Rule, the vast majority of covered swap entities (“CSE”) must comply with the CFTC’s margin requirements for all uncleared swaps in cross-border transactions. On September 15, the CFTC issued a related comparability determination permitting substituted compliance with parallel requirements in Japan.11 The CFTC determined that the margin requirements for uncleared swaps under the laws and regulations of Japan are comparable to those under the CEA and CFTC regulations, with one exception. As a result, CSEs that are subject to both the CFTC’s margin requirements and the Japan Financial Services Agency’s margin rules with respect to an uncleared swap that is also a non-cleared OTC Derivative, may rely on substituted compliance for all aspects of the CFTC’s margin requirements for uncleared swaps and the
Cross-Border Margin Rule, except that such CSE must comply with the inter-affiliate margin requirements of 17 C.F.R. § 23.159.
These developments evidence the CFTC’s continuing commitment to developing its cross-border regulatory framework. Over the past several months, the Commission has issued a number of significant rulemakings and orders pertaining to cross-border swap transactions and more are likely on the horizon. If you have any questions about the regulation of cross-border swap transactions, please contact Reed Smith LLP.
- The Proposed Rule is available here.
- The CFTC’s Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations is available here.
- In 2013, the Securities Industry and Financial Markets Association (“SIFMA”), the International Swaps and Derivatives Association, Inc. (“ISDA”), and the Institute of International Brokers (“IIB”) brought a lawsuit against the CFTC in the U.S. District Court for the District of Columbia, challenging the CFTC’s Cross-Border Guidance under the Administrative Procedure Act. The District Court issued an order in favor of the CFTC, concluding that the Cross-Border Guidance is a non-binding policy statement that need not go through formal notice and comment as an administrative rule. See Sec. Indus. & Fin. Markets Ass’n v. CFTC, 67 F.Supp. 3d 373 (D.D.C. 2014). Prior to issuing the Cross-Border Guidance, the CFTC issued a number of exemptive orders pertaining to compliance with certain swap regulations.
- The SEC has also issued a rulemaking on the cross-border application of its swaps provisions pertaining to security-based swap dealers, available here. The SEC rule requires non-U.S. companies that use U.S. personnel to arrange, negotiate, or execute a security-based swap in connection with its dealing activity to include that transaction in its de minimis threshold calculation when determining whether to register as a security-based swap dealer. As noted below, the CFTC’s proposal does not require that these swaps be counted toward the de minimis threshold, but does require compliance with certain business conduct standards for ANE transactions.
- The Proposed Rule states that the CFTC’s 2013 “interpretation of the principal place of business test regarding funds, would also apply in the context of the Proposed Rule.”
- Cross-Border Application of the Registration Thresholds and External Business Conduct Standards Applicable to Swap Dealers and Major Swap Participants, 81 Fed. Reg. 71946, 71973 (Dec. 19, 2016).
- The CFTC recently issued an order extending the $8 billion phase-in period until December 31, 2018, available here. This one-year delay will enable the CFTC to finalize the SD capital rule and assess implementation for uncleared swaps.
- The Comparability Determination is available here.
- The Cross-Border Margin Rule is available here.
- The Comparability Determination for Japan is available here.
Client Alert 2016-274