In the wake of the financial crisis, global regulators have endeavored to undertake significant regulatory reform of the swaps markets. In 2009, the members of the G-20 agreed that: (i) the OTC derivatives contracts should be reported to trade repositories; (ii) standardized OTC derivatives contracts should be cleared through central counterparties by the end of 2012; and (iii) non-centrally cleared contracts should be subject to higher capital requirements. In light of such reform initiatives, there has been substantial concern that regulation be coordinated on an international basis to avoid duplicative and/or conflicting regulatory requirements.
Regulatory requirements for derivatives have advanced to different levels in various jurisdictions, and the Commodities Future Trading Commission (CFTC) is the first regulator to have attempted to define its jurisdictional reach. As of the date of this alert, the Securities and Exchange Commission (SEC) has not yet issued a proposal as to its extraterritorial authority, but the CFTC has cautioned that "there are differences in the markets and products overseen by each agency, which may lead to divergent approaches to cross-border activities."1 And so, there is the possibility of potential disharmony not only between various overlapping international regulatory regimes, but also between approaches taken by the two U.S. regulators of swaps. This alert outlines the CFTC's proposed extraterritorial regulatory regime, and certain time-limited relief it has granted while it consults with international and domestic regulators in an effort to harmonize cross-border regulatory approaches.
Considerations of the Extraterritorial Reach of Dodd-Frank
The following are considerations of the extraterritorial reach:
the nature of connections to the U.S. that would require a person to register as a swap dealer or major swap participant (MSP)
how the requirements of Dodd-Frank should be applied to non-U.S. registered swap dealers and MSPs, their branches, agencies and affiliates
how the requirements of Dodd-Frank should be applied to the non-U.S. branches, agencies and affiliates of U.S. registered swap dealers and MSPs
how Dodd-Frank should be applied to swaps where one party is not a U.S. person
the circumstances under which a non-U.S. person or non-U.S. branch of a U.S. person may be permitted to substitute compliance with U.S. law by complying with home country law or the law of its jurisdiction of residence
the definition of a U.S. person
The information in this alert focuses on all of the above, except the criteria for qualification as a registered swap dealer or MSP.
Highlights of the CFTC Proposed Regulatory Regime
Certain Dodd-Frank requirements are proposed to apply to non-U.S. swap dealers and MSPs as a whole ("Entity Level Requirements") and others are proposed only to apply on a swap-by-swap basis ("Transaction Level Requirements").
In certain circumstances in which the CFTC determines that a non-U.S. person must comply with Entity Level Requirements or Transaction Level Requirements, it proposes to permit substituted compliance with the laws of the home country jurisdiction or jurisdiction of residence (in the case of branches or agencies). Such substituted compliance will only be permitted (on a category of regulation by category of regulation basis) if the CFTC determines that the laws, rules and enforcement regime of the relevant foreign jurisdiction are comparable to the Commodity Exchange Act (CEA) and CFTC rules and regulations.
Non-U.S. swap dealers are subject to all Entity Level Requirements (with substituted compliance permitted) and all Transaction Level Requirements for all swaps with U.S. persons.
Non-U.S. branches and agencies of U.S. swap dealers and MSPs are treated as part of the U.S. registrant, and so Entity Level Requirements are required to be satisfied by the registrant. Most Transaction Level Requirements apply to all the swaps of such entities but substituted compliance is permitted for swaps with non-U.S. persons. The External Business Conduct Rules do not apply to swaps between foreign branches and non-U.S. persons.
Swaps between a non-U.S. person and a U.S. person, where there is no swap dealer or MSP, are subject to clearing, trade execution, real-time public reporting and LTR reporting without substituted compliance. SDR reporting and swap data record keeping are required on a substituted compliance basis.
Non-U.S. affiliates of U.S. swap dealers may independently be required to be registered as swap dealers based on the level of their activity with U.S. persons.
The CFTC has granted time-limited relief until July 12, 2013, for non-U.S. swap dealers and non-U.S. MSPs for most Entity Level Requirements and all Transaction Level Requirements with non-U.S. persons.
The CFTC has granted time-limited relief until July 12, 2013, for non-U.S. branches of U.S. swap dealers and MSPs whereby such entities when dealing with non-U.S. counterparties (or with other such entities) may comply only with local law.
Dodd-Frank Defines the CFTC's Extraterritorial Authority
Section 722(d) of the Dodd-Frank Act2 (enacted as Section 2(i) of the CEA) defines the authority of the CFTC with respect to swaps as not applying to activities outside the U.S. unless those activities:
have a direct and significant connection with activities in, or effect on, commerce of the U.S., or
contravene such rules or regulations as the CFTC may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of Dodd-Frank
The Proposed Guidance
On July 12, 2012, the CFTC published a proposed interpretive guidance and policy statement titled Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act3 (the "Proposed Guidance") which sets forth the CFTC's proposed scheme for cross-border regulation.
Entity Level and Transaction Level Requirements
The Proposed Guidance includes analysis of when an entity's swap dealing activities or swaps positions with the U.S. merit required registration as a swap dealer or MSP. The CFTC states that the provisions of Title VII of Dodd-Frank apply equally to swap dealers and MSPs, regardless of where they reside. On the other hand it notes that it is constrained by statutory construction of its authority as well as principles of international comity. Accordingly, and in response to the requests of commentators, the CFTC divides the regulatory requirements applicable to non-U.S. registered swap dealers and MSPs into Entity Level Requirements and Transaction Level Requirements.
The Entity Level Requirements relate to: (i) capital adequacy; (ii) chief compliance officer; (iii) risk management;, (iv) swap data record keeping; (v) swap data reporting ("SDR Reporting"); and (vi) physical commodity swaps reporting ("LTR Reporting"). The CFTC further subdivides (i) through (iv) as Category A of the Entity Level Requirements, and as being particularly important to be applied uniformly to U.S. and non-U.S. parties.
The Transaction Level Requirements consist of: (i) clearing and swap processing; (ii) margining and segregation for uncleared swaps; (iii) trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct rules. The CFTC further subdivides (i) through (viii) as Category A of the Transaction Level Requirements. External business conduct rules are Category B.
Delay in Implementation of the Entity Level Requirements and Transaction Level Requirements. On January 7, 2013, the CFTC issued a Final Exemptive Order Regarding Compliance with Certain Swap Regulations4 (the "Final Order") which provides, among other things, for delayed compliance until July 12, 2013, by non-U.S. swap dealers and MSPs and foreign branches with certain Entity Level Requirements and Transaction Level Requirements. The Final Order is a stop gap until the CFTC is in a position to take further action with respect to the Proposed Guidance. The CFTC stated in the Final Order that it believes that it will be beneficial to have further consultations with domestic and international regulators in an effort to harmonize cross-border regulatory approaches before taking action with respect to the Proposed Guidance. The CFTC leaves open the possibility of an extension of the time-limited relief granted in the Final Order.
Application of the Entity Level Requirements. The CFTC proposes that the Category A Entity Level Requirements apply to U.S. and non-U.S. swap dealers and U.S. and non-U.S. MSPs without regard to the counterparty or the location of the swap. It then states that non-U.S. registrants may satisfy these requirements by means of substituted compliance (discussed below). It also proposes to permit substituted compliance for SDR Reporting (if the CFTC has direct access to swap data) and LTR Reporting.
Pursuant to the Final Order, delayed compliance until July 12, 2013, is permitted for non-U.S. swap dealers and MSPs for Category A Entity Level Requirements, but compliance with SDR Reporting and LTR Reporting with U.S. counterparties is required on the respective compliance dates. Moreover, if the non-U.S. swap dealer or MSP is part of an affiliated group in which the ultimate parent is a U.S. swap dealer, U.S. MSP, U.S. bank, U.S. financial holding company or U.S. bank holding company, SDR Reporting and LTR Reporting with non-U.S. counterparties is required on the respective compliance dates. However, non-U.S. swap dealers and non-U.S. MSPs that are not part of such affiliated groups may delay such reporting during the pendency of the Final Order.
For swaps entered into by foreign branches or agencies of U.S. swap dealers or MSPs, or solicited or negotiated by a foreign affiliate but executed by a U.S. entity, the U.S person must comply with all of the Entity Level Requirements.
Application of the Transaction Level Requirements
Category A Requirements
The CFTC proposes that all non-U.S. swap dealers and MSPs comply with all Transaction Level Requirements for all of their swaps with U.S. persons (except for swaps with foreign branches of U.S. persons).
In general, for swaps between non-U.S. swap dealers and MSPs and non-U.S. persons, the Transaction Level Requirements do not apply. However, the CFTC expressed concern with respect to swaps between non-U.S. swap dealers and MSPs and non-U.S. persons, where the swaps are guaranteed by U.S. persons, or where the non-U.S. person is acting as a "conduit"5 for a U.S. person. Where non-U.S. swap dealers or MSPs enter into such a swap, Transaction Level Requirements apply, but substituted compliance is permitted.
Pursuant to the Final Order, non-U.S. swap dealers and non-U.S. MSPs, when dealing with non-U.S. counterparties during the pendency of the Final Order, may comply only with local law, but when dealing with U.S. counterparties, must comply as in the second preceding paragraph.
Non-U.S. branches and agencies of U.S. swap dealers and MSPs are treated as part of the U.S. registrant, and so Transaction Level Requirements apply to all swaps of such entities. The CFTC proposes to permit substituted compliance for swaps between foreign branches of a U.S. swap dealer or MSP and a non-U.S. entity (whether or not the swaps of the non-U.S. entity are guaranteed by a U.S. person). Pursuant to the Final Order, non-U.S. branches and agencies of U.S. swap dealers and MSPs, when dealing with non-U.S. counterparties (including non-U.S. swap dealers and MSPs), may comply with local requirements only; and with respect to swaps between branches or agencies of non-U.S. swap dealers or non-U.S. MSPs, may comply only with those requirements as may be required by local law.6
Category B Requirements
The External Business Conduct Rules apply to all swaps: (i) between U.S. swap dealers and U.S. and non-U.S. persons; and (ii) between foreign branches or agencies of U.S. swap dealers and MSPs and U.S. persons; and (iii) between non-U.S. swap dealers and MSPs and U.S. persons.
Application of Dodd-Frank Requirements Where There Is No Swap Dealer or MSP. Pursuant to the Proposed Guidance, the following Dodd-Frank requirements apply to all swaps between U.S. persons and non-U.S. persons (whether or not the swap of the non-U.S. person is guaranteed by a U.S. person, and irrespective of the location of the transaction): (i) clearing; (ii) trade execution; (iii) real-time public reporting; (iv) LTR Reporting; (v) SDR Reporting; and (vi) swap data record keeping.
The CFTC does not permit substituted compliance for clearing, trade execution, real-time public reporting or LTR reporting where one party is a non-U.S. person. The CFTC does permit substituted compliance for SDR reporting (if the CFTC has direct access to the foreign repository) and swap data record keeping.
The CFTC acknowledges in the Proposed Guidance that applying Title VII to swaps conducted outside the U.S. involving a U.S. counterparty (without permitting substituted compliance) may result in two or more jurisdictions asserting authority over these swaps — with the counterparties potentially facing conflicting or duplicative regulatory requirements.
The Final Order does not grant any relief to swaps not involving a swap dealer or MSP.
The CFTC states its approach to determining "comparability" of foreign regulatory regimes will reflect the heightened requirements and expectations under Dodd-Frank. The CFTC states that it will use an outcomes-based approach to determine whether the foreign requirements are designed to meet the same regulatory objectives, and anticipates a robust and ongoing coordination and cooperation between the CFTC and its foreign counterparts. The CFTC anticipates that it will review comparability in most of the categories identified as Entity Level Requirements and Transaction Level Requirements and proposes to recognize substituted compliance in only those categories that it determines to be comparable and comprehensive to the CEA and CFTC regulations.
The CFTC states that its review of a jurisdiction for comparability will be triggered upon the request of: a non-U.S. person; a group of non-U.S. persons from the same jurisdiction; or a foreign regulator. The applicant is required to provide all applicable legislation, rules and policies. The applicant is also charged with keeping the CFTC apprised of material changes in specific categories of requirements. The CFTC expects that it would enter into a memorandum of understanding with the home country supervisor to coordinate information sharing, supervision and enforcement.
Since U.S. regulations are generally further along than those of other jurisdictions, substituted compliance may remain a more theoretical than real option for some time.
Definition of U.S. Person
All questions of extraterritoriality beg the question of who is a U.S. person for the purpose of Title VII of Dodd-Frank. This is because, among other things, swaps between non-U.S. persons (not guaranteed by U.S. persons) are not within the proposed jurisdictional reach of the CFTC, nor do the swaps activities with such entities count towards of requirements to register as a swap dealer or MSP.
The Proposed Guidance includes an eight-prong definition of U.S. person (the "Initial U.S. Person Definition"). The Initial U.S. Person Definition has received substantial comment relating to a perceived sense that it is vague, overly broad and difficult to implement.
On October 12, 2012, the CFTC issued a no-action letter (the "No-Action Letter")7 containing a simplified definition of U.S. person for reliance with respect to swaps entered into prior to December 31, 2012, for the limited purpose of determining the levels of swap dealing or swap positions required swap dealer or MSP registration. The CFTC emphasized the time-limited nature of the relief granted, and cautioned that swaps with entities included in the Initial U.S Person Definition may be required to be counted towards swap dealing and swap positions once that definition is finalized.
The CFTC acknowledged in the Final Order that it would take some time for market participants to implement the Initial U.S. Person Definition. As a result, for the purpose of the Final Order, it adopted a "Phased-in" interim approach to the definition of U.S. person, based on the definition in the No-Action Letter.
The Phased-in definition of U.S. person in the Final Order is as follows:
(i) a natural person who is a resident of the United States
(ii) a 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, in each case that is (A) organized or incorporated under the laws of a state or other jurisdiction in the United States or (B) effective as of April 1, 2013, for all such entities other than funds or collective investment vehicles, having its principal place of business in the United States
(iii) a pension plan for the employees, officers or principals of a legal entity described in (ii) above, unless the pension plan is primarily for foreign employees of such entity
(iv) an estate of a decedent who was a resident of the Untied States at the time of death, or a 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
(v) an 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 (i) through (iv) above
The Final Order was coupled with the Further Proposed Guidance, which reintroduces two categories of entities included in the Initial U.S. Person Definition. First, the CFTC has expressed concern for look-through liability entities in which direct or indirect owners who are U.S. persons have responsibility for the obligations of the entity (which may otherwise not qualify as a U.S. person). In the Initial U.S. Person Definition such an entity would be a U.S. person if even one owner with liability is a U.S. person. In the Further Proposed Guidance, the criteria was changed to majority direct or indirect ownership by U.S. persons bearing unlimited responsibility for the obligations and liabilities of the entity. Second, the CFTC re-proposes the category of entities consisting of commodity pools, pooled accounts, investment funds and other collective investment vehicles. In response to concern about the difficulty of ascertaining ownership of publicly traded partnerships, it proposes that a collective investment vehicle offered directly or indirectly to U.S. persons will be a U.S. person.
Prong (ii) above as proposed by the Further Proposed Guidance would read as follows:
(ii) A 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, in each case that is either (A) 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 or (B) directly or indirectly majority-owned by one or more persons described in prong (i) or (ii)(A) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity (other than a limited liability company or limited liability partnership where partners have limited liability).
The prong of the definition of U.S. person relating to collective investment vehicles would read as follows:
(v) A commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (ii) and that is directly or indirectly majority-owned by one or more persons described in prong (i) or (ii), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly traded but not offered, directly or indirectly, to U.S. persons.
Implications of the Current State of Regulatory Guidance
The current regulatory status of Proposed Guidance together with time-limited relief has created substantial uncertainty for participants in the cross-border swaps market. For example, it is extremely difficult for swap dealers and MSPs to organize their swap businesses, when such a fundamental concept as the definition of U.S. person is evolving, and when it is unclear what criteria the CFTC will require in order to deem a swap to have been executed by a foreign branch.
The extraterritorial reach of the CFTC has a particularly harsh impact on U.S. end-users (i.e., entities that are not swap dealers or MSPs) who when entering into swaps with non-U.S persons are required to comply with U.S. rules and regulations relating to clearing, trade execution, reporting and record keeping without the opportunity for substituted compliance. Such swaps are likely also to be subject to regulation under the laws of the relevant non-U.S. jurisdiction, leaving the possibility of conflicting rules in different jurisdictions. Continuing discussions between U.S. and non-U.S. regulators, together with the development of market solutions, will hopefully in time resolve issues of conflicting regulatory requirements.
1 Further Proposed Guidance Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 909, (Jan. 7, 2013) (the "Further Proposed Guidance").
2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-203, 124 Stat. 1376 (2010).
3 77 Fed. Reg. 41214 (July 12, 2012)
4 78 Fed. Reg. 858 (Jan. 7, 2013)
5 The CFTC defines a "conduit" situation as one in which: (i) a non-U.S. person is majority owned directly or indirectly by a U.S. person, (ii) the non-U.S. person regularly enters into swaps with one or more affiliates of the U.S. person, and (iii) the financials of the non-U.S. person are included in the financials of the U.S. person. The concern is that the U.S. person rather than enter into a swap with third-party X (in a jurisdiction not subject to comparable regulation), will instead enter into swaps with its non-U.S. conduit and the conduit will enter into swaps with party X. The U.S. person will be directly exposed to the risk of its conduit.
6 Since relief for swaps between non-U.S. branches creates the potential for abuse, the CFTC clarifies that it will treat swaps as entered into by the foreign branch of a U.S. person only if: (i) the personnel executing and agreeing to the terms of the swap are located in the jurisdiction of such foreign branch; (ii) the documentation of the swap specifies that that the counterparty or "office" for the U.S. person is such foreign branch; and (iii) the swap is entered into by such foreign branch in its ordinary course of business. The CFTC states that it is considering additional requirements including that the U.S. person treats the swap as a swap of the foreign branch for tax purposes, that the foreign branch operates for valid business reasons and is not only a representative office, and that the branch is engaged in substantive regulation in the jurisdiction in which it operates.
7 CFTC Letter 12-22 (Oct. 12, 2012).