SEC Adopts Certain Final Rules Relating to Cross-Border Security-Based Swap Activities

by Dechert LLP
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The U.S. Securities and Exchange Commission (SEC) adopted its final rules on the definition of the term “U.S. person” solely for purposes of certain aspects of cross-border security-based swap activities (Final Rules) on July 9, 2014.1 A “security-based swap” is essentially a swap based on a single security, a single loan, a narrow-based security index, or an event relating to a single issuer of a security or the issuer of securities in a narrow-based security index (such as a credit default swap).2 The Final Rules have been anticipated since the U.S. Commodity Futures Trading Commission (CFTC) published its “U.S. person” definition guidance in July 2013 that applies solely for purposes of cross-border commodity interest “swaps.”3 The terms “security-based swap” and “swap” are intended to cover the universe of swaps. For a comparison of the CFTC and SEC “U.S. person” definitions, please see Appendix A below. For a more detailed discussion of the CFTC’s definition of U.S. person, please refer to the DechertOnPoint, CFTC Issues Cross-Border Swaps Regulation Guidance and Exemptive Order.

SEC Definition and Interpretation of U.S. Person

The Final Rules provide the SEC’s definition of “U.S. person” solely with respect to the application of Title VII (Title VII) of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) to cross-border security-based swap activity. This activity includes security-based swap transactions occurring within the United States between a U.S. person and a non-U.S. person or between two U.S. persons. The SEC expressly excluded from consideration in the Final Rules “activities involving a transaction between two non-U.S. persons where one or both are conducting dealing activity within the United States,” and stated that it will address this issue in a subsequent release.4

The SEC only provided its U.S. person definition at this time,5 and stated that requirements relating to mandatory clearing, trade execution, regulatory reporting, and public dissemination of swap data (which will also apply to U.S. persons) will be addressed in future SEC rulemakings.

Under the Final Rules, the U.S. person definition includes:

i. any natural person residing in the United States; or

ii. any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States; or

iii. any account (whether discretionary or non-discretionary) of a U.S. person; or

iv. any estate of a decedent who was residing in the United States at the time of death. 

Unlike the CFTC, the SEC specifically excluded an enumerated list of international organizations from its U.S. person definition.6

The Final Rules state that a party to a transaction may rely on its counterparty’s representation regarding the counterparty’s status as a U.S. person, unless such party knows, or has reason to know, that the representation is inaccurate.

Natural Person Residents

Any person residing within the United States is considered a “natural person resident” regardless of the individual’s citizenship status. However, persons residing abroad are not considered “natural person residents” even if they are U.S. citizens.

Entities and Investment Vehicles

Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its “principal place of business” in the United States is considered a U.S. person.

The U.S. person status of an entity is determined at the entity level and therefore applies to the entire legal person, which includes foreign operations. As a result, a non-U.S. branch, agency, or office of a U.S. person is treated as a U.S. person if it lacks legal independence from the U.S. entity; however, the U.S. person status of an entity has no bearing on the U.S. person status of separately incorporated or organized legal persons in the entity’s affiliated corporate group. Thus, a non-U.S. subsidiary of a U.S. person is not a U.S. person solely by virtue of its relationship with its U.S. parent, and a non-U.S. parent with a U.S. subsidiary is not a U.S. person simply because of its relationship with its subsidiary.

“Principal Place of Business”

An entity’s “principal place of business” is defined as “the location from which the officers, partners, or managers of the legal person direct, control, and coordinate the activities of the legal person.”

The SEC stated that, with respect to an externally managed investment vehicle, the principal place of business “is the office from which the manager of the vehicle primarily directs, controls, and coordinates the investment activities of the vehicle.” For example, an investment fund organized in the Cayman Islands but managed by a portfolio manager conducting such management in the United States would be treated as a U.S. person. However, the location of the individuals simply effecting the trades for the fund (e.g., trade execution desk) will not by itself determine the fund’s U.S. person status. This differs from the CFTC’s U.S. person definition, which is vague about the effect of the location of trade execution on an entity’s U.S. person status.

Fund Ownership

The SEC will not look to the beneficial ownership of an investment fund to determine if it falls within the U.S. person definition. Rejecting the CFTC’s reasoning, the SEC explained that it does not believe the risks associated with ownership interests in “passive investment vehicles” or in “majority-owned operating companies” are the risks that Title VII was meant to address. Rather, the SEC observed that, where an investment manager is located in the United States, “a significant portion of the financial and legal relationships of such vehicles, as a general matter, are in the United States, including some combination of equity ownership by managers (or their affiliates) and outside investors, credit relationships with prime brokers and other lenders, and relationships with other market participants and service providers.” This is often the case, but not always true. The SEC appears to be focused on the location of the web of relationships that a fund may have with service providers as the appropriate focus of its systemic-risk mitigation efforts, rather than the ownership of a fund which the SEC noted “typically is capped at the amount of [investors’] investment.”

Accordingly, the SEC did not adopt a fund ownership test. The SEC declined to include investment vehicles that are majority-owned by U.S. persons (which the CFTC included in its definition). Because the SEC’s definition does not include an ownership test, the SEC reasoned that it was not necessary to adopt a carve-out from the definition for funds that are publicly offered only to non-U.S. persons in the way that the CFTC did. The latter carve-out was meant to address situations where the public fund could not confirm its ownership demographic because of the manner in which the fund is distributed and possibly transferred. As a result, many U.S. asset managers which have created UCITS and other funds that are publicly offered only to non-U.S. persons will be non-U.S. persons under the CFTC’s definition, but will be U.S. persons for security-based swap transactions under the SEC’s definition. The SEC’s declining to include an ownership test in its U.S. person definition means that asset managers will not need to conduct further due diligence on the characteristics of their investor base in order to make a determination regarding their funds.

Accounts

Any account of a U.S. person is considered a U.S. person, irrespective of whether the person through which the account is held or maintained is a U.S. person. A person’s status for purposes of the SEC’s definition generally does not differ if the person enters into a security-based swap through an account or if the person’s account is held or maintained at a U.S. or non-U.S. person intermediary or financial institution. In instances where an account is owned by both U.S. and non-U.S. persons, the U.S. person status of the account should be based upon the existence of any security-based swap obligations incurred by the U.S. person owner.

Estates

Any estate of a natural person who was residing in the United States at the time of such person’s death is itself a U.S. person.

SEC Procedures for Substituted Compliance

The Final Rules set forth the procedures for submitting an application for “substituted compliance.” Requests may be submitted by (i) a party to a cross-border security-based swap transaction or (ii) a non-U.S. financial regulatory authority. The SEC may publish substituted compliance requests in the U.S. Federal Register, but applicants may seek confidential treatment for their requests. The availability of substituted compliance will be addressed in future SEC rulemakings.

Appendix A

Comparison of the CFTC and SEC “U.S. person” Definitions for Title VII Purposes

CFTC

SEC

Implications

Aspects of the U.S. person definitions as to which the CFTC and SEC largely agree

Any natural person who is a resident of the United States.

Any natural person residing in the United States.

  

 

 

 

Any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund, or any form of enterprise similar to any of the foregoing (other than a pension plan or trust), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States.7

Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States.

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 U.S. person.

Any account (whether discretionary or non-discretionary) of a U.S. person.

Any estate of a decedent who was a resident of the United States at the time of death.

Any estate of a decedent who was residing in the United States at the time of death.

Aspects of the U.S. person definitions as to which the CFTC and SEC diverge, and some implications

Any pension plan for the employees, officers, or principals of a U.S. person entity, unless the pension plan is primarily for foreign employees of such entity.

Silent on pension plans, per se, but pension plans are implicitly addressed by any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States.

Without the carve-out for pension plans, a pension plan for a non-U.S. company that is advised by a U.S. asset manager could be deemed to have its principal place of business in the United States and thus be a U.S. person for SEC purposes.

Any commodity pool, pooled account, investment fund, or other collective investment vehicle that is majority-owned by one or more U.S. persons.

Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States. Note that ownership is not a factor for the SEC.

Funds that are organized outside of the United States and operated by non-U.S. person managers could be treated as U.S persons under CFTC rules but treated as non-U.S. persons under SEC rules.

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.

Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States.

For CFTC purposes, a U.S. court need only have primary jurisdiction over a trust in order for it to be a U.S. person, whereas for SEC purposes the trust must either be organized in the United States (which likely creates primary jurisdiction for U.S. courts) or have its principal place of business in the United States.

This raises the question of what constitutes the principal place of business for a trust, and whether hiring a U.S. manager could shift a non-U.S. person trust to being a U.S. person for SEC purposes, whereas the court jurisdiction over the trust would not have necessarily changed.

Any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons is NOT a U.S. person.

Ownership is not a factor for the SEC.

A non-U.S. fund that is publicly-offered only to non-U.S. persons but managed by a U.S. asset manager would be a non-U.S. person under CFTC rules but would be a U.S. person under SEC rules.

Footnotes

1) Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, 79 Fed. Reg. 39068 (July 9, 2014) (SEC Guidance).

2) U.S. Securities Exchange Act of 1934 as amended Sections 3(a)(68), (69), and (55)(B)-(F) and U.S. Commodity Exchange Act as amended (CEA) Sections 1a(42) and (35).

3) Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45292 (July 26, 2013) (CFTC Guidance). “Swaps” are agreements with “commodity interests” as their underlying reference asset. See CEA Section 1a(47) and CFTC Rule 1.3 (yy).

4) SEC Guidance at 39069 n.2.

5) The Final Rules also set forth guidelines governing which cross-border transactions are counted toward meeting the thresholds for a “security-based swap dealer” or a “major security-based swap participant,” which designations subject the entity to SEC regulation.

6) The excluded organizations are the International Monetary Fund, the International Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the United Nations, and their agencies and pension plans, and any other similar international organizations, their agencies and pension plans. SEC Guidance at 39096.

7) The CFTC Guidance specifies different attributes for an operating company that are relevant to the determination of its principal place of business than for a collective investment vehicle’s principal place of business. For collective investment vehicles, the CFTC would look at the “actual center of direction, control and coordination” of the vehicle. This “center” is the location from which senior officers implement and assess the investment and trading strategy and manage the vehicle’s risks. The location from where decisions regarding formation of the vehicle are made and the vehicle is promoted are also principal place of business considerations. CFTC Guidance at 45310.

 

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