stroock & stroock & lavan llp

STROOCK

SPECIAL BULLETIN

Non-U.S. Regulators and the CFTCs Proposed Interpretive Guidance on Cross-Border Regulation of Swaps
November 8, 2012

In connection with Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),1 on July 12, 2012, the Commodity Futures Trading Commission (the CFTC) published in the Federal Register proposed interpretive guidance and a proposed policy statement (the Guidance)2 regarding the extraterritorial application of the Dodd-Frank Acts requirements regarding swap dealers (SDs) and major swap participants (MSPs). On the same day, the CFTC issued a proposed exemptive order (the Proposed Order)3 that would allow SDs and MSPs to postpone compliance with certain of the Dodd-Frank Acts swaps requirements. By the time the CFTCs comment period on the Guidance and Proposed Order had expired, the CFTC had received an unusual number of stronglyworded comments from non-U.S. regulatory authorities about the effects that the Guidance and Proposed Order would have in their proposed form. These included comment letters from the Swiss Financial Market Supervisory Authority (FINMA);

the Minister of Economy of France and Chairman of the Autorit de contrle prudential (ACP) and the Autorit des marchs financiers (AMF); the Financial Services Agency of the Government of Japan (FSAJapan) and Bank of Japan (BOJ); the U.K. Financial Services Authority (FSAUK); the European Commission (EC); the Australian Securities and Investments Commission, Reserve Bank of Australia, Hong Kong Monetary Authority, Hong Kong Securities and Futures Commission and Monetary Authority of Singapore (together, the AHS Regulators); and the Hong Kong Secretary for Financial Services and the Treasury (the HKS). These commenters are referred to collectively when applicable in this Stroock Special Bulletin as the International Regulatory Commenters, or IRCs. Non-U.S. authorities have been generally concerned about substantial inconsistencies and duplication between U.S. and non-U.S. regulation of the derivative markets that will result if the CFTC moves ahead with finalizing its interpretations of the Dodd-Frank Acts cross-border reach before other

stroock & s troock & l avan llp new york los angeles mi ami 180 m aiden lane, new york, ny 100 3 8-4982 te l 2 12.806 .540 0 fax 212.8 06. 6006 www.s troock. com

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jurisdictions finalize, in many cases jointly, their own regulation of these markets. These regulatory authorities have also made numerous specific comments about problematic aspects of the CFTCs proposal. This Stroock Special Bulletin summarizes key points of the Guidance and Proposed Order in light of the concerns that non-U.S. regulators have expressed, and includes a discussion of the CFTCs related No-Action Letter of October 12, 2012.

cross-border swaps involving one or counterparties that are not SDs or MSPs. B. The Proposed Order

more

I.

Introduction
A. The Guidance

SDs and MSPs are participants in a global swaps market in which U.S. market participants regularly enter into swaps transactions with market participants domiciled or incorporated in non-U.S. jurisdictions and financial institutions carry out their swaps businesses across an international platform. In recognition of this fact, the CFTC issued the Guidance, which sets forth the CFTCs proposal on the cross-border application of registration and compliance requirements under the Commodity Exchange Act (CEA) as they relate to swap transactions involving non-U.S. SDs and non-U.S. MSPs. Specifically, the CFTC addresses in the Guidance: (i) whether a non-U.S. Persons (as defined below) swap dealing activities or swap positions may require registration as an SD or MSP, respectively; (ii) the application of the related requirements under the CEA to swaps involving non-U.S. SDs and non-U.S. MSPs; (iii) a proposed approach to permitting compliance with a comparable regulatory requirement of a foreign jurisdiction to substitute for compliance with the CEA; and (iv) the application of the clearing, trade execution and certain reporting and recordkeeping provisions under the CEA to

In the more than two years since the Dodd-Frank Act became law, the CFTC has issued numerous rules implementing the Dodd-Frank Acts swaps requirements. Many of these rules have not yet been finalized, and others have not yet taken effect. To facilitate an orderly transition to the new regulatory regime and in response to commenters requests, the Proposed Order would allow SDs and MSPs to delay compliance with some of the Dodd-Frank Acts requirements.4

II.

Non-U.S. Persons as SDs or MSPs

Before determining whether an individual or entity is a non-U.S. SD or non-U.S. MSP that would be subject to requirements under the CEA, such individual or entity would first have to determine whether or not it is a U.S. Person. The definition of a U.S. Person would also be significant, as discussed below, for a non-U.S. Person ascertaining whether it would be required to register as an SD when its level of swaps dealing activity with U.S. Persons exceeds certain thresholds. In defining the term U.S. Person, the CFTC stated that it considered the principles expressed in Section 2(i) of the CEA, which prohibits application of the Dodd-Frank Acts swaps requirements to activities outside the United States, unless those activities (1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or (2) contravene such rules or regulations as the [CEA] may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act that was enacted by the [Dodd-Frank Act].5

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A.

Proposed Definition of U.S. Person

The Guidance defines U.S. Person to include, but not be limited to:

any natural person who is a resident of the United States; any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise, in each case that is either (a) organized or incorporated under the laws of the United States or having a principal place of business in the United States or (b) in which the direct or indirect owners thereof are responsible for the liabilities of such entity and one or more of such owners is a U.S. person; any individual account (discretionary or not) where the beneficial owner is a U.S. Person; any commodity pool, pooled account or collective investment vehicle (whether or not it is organized or incorporated in the United States) of which a majority ownership is held, directly or indirectly, by a U.S. person(s); any commodity pool, pooled account or collective investment vehicle the operator of which would be required to register as a commodity pool operator under the CEA; a pension plan for the employees, officers, or principals of a legal entity with its principal place of business inside the United States; and an estate or trust, the income of which is subject to United States income tax regardless of source.6 SDs and MSPs should note that this list is not exclusive and that the CFTC could determine that an entity not on the list is a U.S. Person.

The CFTC stated that a foreign branch or agency of a U.S. Person would generally be covered under this interpretation of U.S. Person because a branch or agency is a part, or an extension, of a U.S. person. On the other hand, a foreign subsidiary or affiliate of a U.S. Person would be considered a nonU.S. Person whether or not such subsidiary or affiliate has certain or all of its swap-related obligations guaranteed by the U.S. Person. The AHS Regulators have commented that the definition of U.S. Person could be further clarified, noting in particular that the proposed definition is high-level and different from that used in other regulations, such as Regulation S of the Securities and Exchange Commission (the SEC), that [m]arket practitioners havealso highlighted that it is not easy to identify if a counterparty is a U.S. Person, and that such uncertainty will increase the risk for, and costs of, market participants in assessing the full impact of the Guidance. The ACP and AMF have asked the CFTC to develop a strict and objective definition of the concept of US person without criteria that would be excessively subtle and difficult to implement and that could finally undermine the effectiveness of our common action to regulate OTC derivatives. The EC has noted that the CFTCs proposed definition was based on a non-exclusive list of entities, and that it is important for the CFTC to provide further clarification about the process for determining any other types of entities that it deems to be U.S. Persons in the future and how and when it intends to apply regulatory requirements to those entities.

III.

Definitions and Registration Threshold

On April 18, 2012, the SEC and CFTC issued a joint rulemaking (the Joint Rulemaking), which,

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among other things, defined SD and MSP and set forth the activities that would cause a person to be an SD and the level of swap positions that would cause a person to be an MSP. In the Guidance and Proposed Order, the CFTC then proposed how these requirements could be applied in a cross-border context. A. Swap Dealers

Under the Proposed Guidance, the CFTC would require non-U.S. Persons who engage in more than the de minimis level of swap dealing with U.S. Persons to register as SDs. The CFTC stated that levels of swap dealing above the de minimis threshold, when conducted by a non-U.S. Person with U.S. persons, constitute a direct and significant connection with U.S. activities under Section 2(i)(1) of the CEA. The de minimis threshold is initially $8 billion measured over a 12-month period, which will be reduced to $3 billion at the end of a phase-in period.7 In calculating the threshold, a non-U.S. Person would not need to include the notional value of dealing transactions with foreign branches of registered U.S. SDs, as swaps with such foreign branches would be covered by Dodd-Franks transactional requirements so that there would be little concern that this exclusion could be used to engage in swap activities outside the Dodd-Frank Act. Under the Joint Rulemaking, calculation of the de minimis threshold will require that swap dealings of all affiliates be aggregated. Under the Guidance, a nonU.S. Person engaged in swap dealings would be required to include the aggregate notional value of (i) any swap dealing transactions between U.S. Persons and any of its non-U.S. affiliates under common control and (ii) any swap dealing transactions of any of its non-U.S. affiliates under common control where the obligations of such non-

U.S. affiliates are guaranteed by U.S. Persons. Transactions conducted by a non-U.S. Persons U.S. affiliates would not need to be included in the calculation, as the CFTCs focus is on the impact of non-U.S. Persons swap dealing activities on U.S. commerce. In accordance with the Joint Rulemaking, under the Proposed Guidance, a non-U.S. Person without a guarantee from a U.S. Person that determines it is not engaged in swap dealing as part of a regular business with respect to U.S. Persons as counterparties would not be required to apply the de minimis test or to register as an SD, whether or not the non-U.S. Person was engaged in swap dealing as part of a regular business with respect to nonU.S. Persons as counterparties.8 B. Major Swap Participants

Taking a stance similar to that for SDs, the CFTC stated that the level of swap positions substantial enough to require a person to register as an MSP when held by a U.S. Person also constitutes a direct and significant connection with U.S. activities within the meaning of Section 2(i)(1) of the CEA when such positions are held between a nonU.S. Person and a U.S. Person. To determine whether a non-U.S. Person is an MSP, the Guidance proposed that non-U.S. Persons would be required to count the following categories of swaps in the de minimis calculation:

Swaps between it and a U.S. Person (unless the non-U.S. Persons obligations are guaranteed by a U.S. Person, as these swap positions would be attributed to the U.S. Person when determining whether either person is an MSP); and Swaps between another non-U.S. Person and a U.S. Person, where it guarantees the

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obligations thereunder.

of

the

non-U.S. Person

With respect to both SDs and MSPs, the CFTC set out in its Guidance the reasoning behind its approach to guarantees made by U.S. Persons. Where a non-U.S. Person engages in swap dealings with a non-U.S. counterparty whose obligations are guaranteed by a U.S. Person, such U.S. Person is exposed to potential adverse consequences by being liable for such obligations in the event of a default or insolvency by the guaranteed non-U.S. Person.9 Such exposure may lead to disruptions in U.S. commerce and the U.S. financial system. Therefore, the CFTC has expressed a strong regulatory interest in providing protections for U.S. guarantors of nonU.S. SDs and MSPs. The CFTCs treatment of guarantees given by U.S. Persons differs slightly for SDs than for MSPs. With respect to SDs, the CFTC would require a non-U.S. Person to register as an SD when the aggregate notional value of its swap dealing activities with U.S. Persons, or of its swap dealing activities with non-U.S. Persons where the dealing nonU.S. Persons obligations are guaranteed by a U.S. Person, exceeds the de minimis level of swap dealing as set forth in section 1.3(ggg)(4) of the CFTCs regulations. With respect to MSPs, however, the Joint Rulemaking provides that in determining whether a person is an MSP, a persons swap positions are attributed to a parent, other affiliate or guarantor to the extent that the counterparties to those positions would have recourse to the other entity in connection with the position unless the first person is itself subject to capital regulation by the CFTC or SEC (e.g., including where the first person is a swap dealer or MSP) or is a U.S. entity regulated as a bank in the United States. Accordingly, the CFTC proposes to require non-

U.S. Persons to register as MSPs when their swaps with U.S. Persons, regardless of whether or not they are guaranteed by U.S. Persons, exceed the relevant MSP threshold set forth in the Joint Rulemaking. C. Foreign Affiliates or Subsidiaries of U.S. Persons

The CFTC noted that a large number of financial institutions employ a central booking model, under which swaps are solicited or negotiated through their branches, agencies, affiliates or subsidiaries, but are booked directly or indirectly in a single legal entity (typically the parent company) for balance sheet and financial reporting purposes. Where a central booking model is used, the CFTC proposes to require the U.S. Person who books the swaps to register as an SD, regardless of whether the swaps were directly booked by the U.S. Person (by directly becoming a party to the swap) or indirectly transferred to the U.S. Person (through a back-toback swap or other arrangement). In either case, the affiliate may also be required to register as an SD if it independently meets the definition of an SD. D. U.S. Branches, Agencies, Affiliates or Subsidiaries of Non-U.S. Persons

Where a U.S. branch, agency, affiliate or subsidiary of a non-U.S. Person engages in solicitation or negotiation in connection with the swap entered into by the non-U.S. Person, such non-U.S. Person would be subject to the registration and other requirements applicable to SDs under the CEA. E. IRC Comments

IRCs have communicated their concerns to the CFTC about requiring non-U.S. Persons to register as SDs or MSPs when they are already subject to substantial regulation in their home countries. IRCs

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are concerned that these registration requirements, and the panoply of additional requirements for SDs and MSPs under the Dodd-Frank Act, could overlap with or contradict the rules to which they are already subject. Many of the IRCs also noted that SD and/or MSP registration would likely be required before these proposed regulations on cross-border activities are finalized, and clarify under what situations a nonU.S. Person would be required to register as a result of its cross-border derivatives activities. In this regard, the CFTC has since determined that as of October 12, 2012, persons must comply with the CFTCs SD registration regulations with respect to their swap activities, and entities that engage in more than the de minimis level of swap dealing activity (measured by aggregate gross notional amount) after October 12, 2012, must register as SDs by no later than two months after the end of the month in which they exceed the de minimis level. Thus, in an October 12, 2012 No-Action Letter, the CFTCs Division of Swap Dealer and Intermediary Oversight (SDIO) has noted that an entity engaged in swap dealing activity must determine whether or not a swap entered into after October 12, 2012 should be included in the calculation of its aggregate gross notional amount of swap dealing activity. With respect to non-U.S. persons engaging in swap dealing transactions, SDIO determined that it: will not recommend that the [CFTC] take enforcement action against any person not described in (i) through (v) below for failure to include a swap executed prior to the earlier of December 31, 2012, or the effective date of a definition of U.S. person in a final Exemptive

Order Regarding Compliance with Certain Swap Regulations, in its calculation of the aggregate gross notional amount of swaps connected with its swap dealing activity for purposes of [CFTC] Regulation 1.3(ggg)(4), so long as the counterparty to such swap is not: (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 organized or incorporated under the laws of 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 exclusively for foreign employees of such entity; (iv) an estate or trust, the income of which is subject to U.S. income tax regardless of source; or (v) an individual account (discretionary or not) where the beneficial owner is a person described in (i) through (iv) above.[T]he position taken herein shall apply where the counterparty to such swap is not a person described in (i) through (v) above whether or not that counterpartys obligations under the swap are guaranteed by a person that is described in (i) through (v) above.

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The SDIO also took the same position with respect to the determination of whether a person is an MSP: [T]he Division will not recommend that the [CFTC] take enforcement action against any person not described in (i) through (v) above for failure to include a swap executed prior to the earlier of December 31, 2012, or the effective date of a definition of U.S. person in a final Exemptive Order Regarding Compliance with Certain Swap Regulations, in its calculation of whether a person is a major swap participant for purposes of [CFTC] Regulation 1.3(hhh), so long as the counterparty to such swap is not a person described in (i) through (v) above. The SDIO also took this position in situations in which the counterparty to a swap described above is a foreign branch of a person described in (i) through (v) above that meets the definition of a swap dealer under Section 1a(49) of the CEA and CFTC Regulation 1.3, and such person represents that it intends to register with the CFTC as a swap dealer by March 31, 2013.10

provided that in certain situations, some of these requirements may be satisfied through substituted compliance, as discussed below, which the CFTC has permitted in order to abide by principles of international comity. The proposed Guidance followed numerous commenters suggestions to conceptually divide the Dodd-Frank Acts swap requirements into two categories based on whether they apply at the entity level, i.e., to the firm as a whole (Entity-Level Requirements) or on a transactional basis, i.e., to the individual swap or trading relationship (Transaction-Level Requirements). The Proposed Order also adopted this categorization.11 A. Entity-Level Requirements

IV.

Cross-Border Application of Dodd-Frank Requirements

Title VII of the Dodd-Frank Act establishes a comprehensive regulatory framework for SDs and MSPs. Persons that meet the definition of SDs and MSPs are required to register as such and, once registered, to comply with all of the requirements applicable to SDs and MSPs for all of their swaps (not just the ones that made them an SD or MSP),

In the Guidance, the Entity-Level Requirements are further broken down into two subcategories: those that address and manage firms operational risks (Internal Control Requirements), and those relating to the CFTCs market surveillance program (Market Surveillance Requirements).12 The Internal Control Requirements are designed to address and manage risks arising from a firms operation as an SD or MSP and to serve as a first line of defense against financial, operational and compliance risks that could lead to a firms default or failure. The Internal Control Requirements include specific measures regarding the following: Capital adequacy:13 In an effort to reduce the likelihood and cost of an SDs or MSPs default by requiring SDs and MSPs to maintain a certain level of financial cushion, SDs and MSPs not subject to the capital requirements of prudential regulators (NonBank SDs or MSPs) would be required to hold a minimum level of adjusted net capital based on whether the Non-Bank SD or MSP is: (i) also a futures commission merchant (FCM); (ii) not an FCM but a non-bank subsidiary of a bank holding

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company; (iii) neither an FCM nor a non-bank subsidiary of a bank holding company. Chief compliance officers:14 SDs and MSPs would be required to appoint an individual as its chief compliance officer responsible for administering the firms compliance policies and procedures, reporting directly to the board of directors or a senior officer of the SD or MSP and preparing and filing with the CFTC a certified report of compliance with the CEA. Risk management:15 SDs and MSPs would be required to establish internal policies and procedures designed to address risk management, monitor compliance with position limits, prevent conflicts of interest and promote diligent supervision, and maintain business continuity and disaster recovery programs. Swap data recordkeeping:16 SDs and MSPs would be required to maintain books and records for all activities related to their business, including complete transaction and position information for all swap activities, including documentation on which trade information is originally recorded. Within the Market Surveillance Requirements, SDR Reporting (as defined below) is intended to provide the CFTC with a better understanding of market risks and allow it to monitor risk profiles of market participants in the swaps market. Large Trade Reporting (as defined below) is intended to allow the CFTC to conduct surveillance of the futures market and their economically equivalent swaps. Swap data reporting (SDR Reporting):17 SDs and MSPs would be required to report certain transaction data to a registered SDR and comply with recordkeeping requirements for pre-enactment swaps and data relating to transition swaps in accordance with Parts 45 and 46 of the CFTCs regulations. Physical commodity swaps reporting (Large Trader Reporting):18 SDs would be required to

submit routine position reports on certain physical commodity swaps and swaptions. B. Application of the Entity-Level Requirements.

The CFTC proposed to require non-U.S. SDs and non-U.S. MSPs to comply with all of the Internal Control Requirements and the SDR Reporting requirement. Non-U.S. SDs would also be required to comply with Large Trader Reporting requirements. The CFTC noted that in consideration of the principles of international comity, it would permit substituted compliance with comparable foreign regimes for each of the foregoing requirements. C. Transaction-Level Requirements

The Transaction-Level Requirements (with the exception of the external business conduct requirements) generally relate to both risk mitigation and market transparency. The Transaction-Level Requirements include specific measures regarding the following: Clearing and swap processing:19 SDs and MSPs are required to submit swaps promptly to a derivatives clearing organization (DCO) for clearing and comply with certain standards for swap processing. The AHS Regulators and the HKS objected strongly to the proposed blanket requirement that non-U.S. SDs be required to centrally clear their swap transactions with U.S. counterparties (or nonU.S. counterparties guaranteed by U.S. Persons unless Substituted Compliance has been permitted) through CFTC-registered, or exempt from registration, DCOs, rather than making provisions for clearing through non-U.S. central clearing platforms satisfying certain standards that provide liquidity in particular non-U.S. markets.

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Margining and segregation for uncleared swaps:20 SDs and MSPs that trade in swaps that are not cleared are required to comply with the CFTCs margin requirements, including notifying the counterparty of its right to require segregation of funds provided as margin and upon such request, to segregate the funds with a third-party custodian for the benefit of the counterparty. Trade execution:21 SDs and MSPs are required to execute swaps subject to a clearing requirement on a designated contract market (DCM) or swap execution facility (SEF) unless no such DCM or SEF makes the swap available to trade. Swap trading relationship documentation:22 SDs and MSPs are required to establish, maintain and enforce written policies and procedures to ensure that the SD or MSP executes written swap trading relationship documents covering all of their swaps. The documents must include, among other things: all terms governing the trading relationship between the SD or MSP and its counterparty; credit support arrangements; investment and re-hypothecation terms for assets used as margin for uncleared swaps, and custodial arrangements. Portfolio reconciliation and compression:23 SDs and MSPs would be required to perform portfolio reconciliation, a post-execution risk management tool designed to ensure accurate confirmation of a swaps terms and resolve discrepancies in the valuation of the swap, and portfolio compression, a post-trade mechanism used to ensure timely and accurate processing and netting of swaps. Real-time public reporting:24 SDs and MSPs are subject to the CFTCs requirement that all publicly reportable swap transactions be reported and publicly disseminated on a real-time basis. Trade confirmation:25 SDs and MSPs would be required to timely and accurately confirm all swaps and life cycle events for existing swaps.

Daily trading records:26 SDs and MSPs are required to maintain daily trading records, including information related to pre-execution, execution and post-execution data and any cash or forward transactions used to hedge, mitigate the risk of, or offset any swap held by the SD or MSP. External business conduct standards:27 Under the business conduct rules, SDs and MSPs will be required to conduct due diligence on their counterparties to verify eligibility to trade, provide disclosure of material information about the swap to their counterparties, provide a daily mid-market mark for uncleared swaps and, when recommending a swap to a counterparty, make a determination as to the suitability of the swap for the counterparty based on reasonable diligence concerning the counterparty. D. Application of the Transaction-Level Requirements

The CFTC proposes to require non-U.S. SDs and non-U.S. MSPs generally to comply with all of the Transaction-Level Requirements with respect to all of their swaps with U.S. counterparties, other than foreign branches of U.S. counterparties. Substituted compliance generally would not be permitted for swaps between non-U.S. SDs or non-U.S. MSPs and U.S. Persons, as the CFTC has expressed a strong supervisory interest in applying the Dodd-Frank Acts requirements to all SDs or MSPs, regardless of whether or not they are U.S. Persons, in its effort to increase market transparency and mitigate economic risk for SDs, MSPs and their counterparties. Non-U.S. SDs and non-U.S. MSPs who enter into swaps with a non-U.S. counterparty whose obligations are guaranteed by a U.S. Person generally would also be required to comply with the Transaction-Level Requirements. The CFTC would, however, permit substituted compliance in

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these cases. Conversely, swaps between a non-U.S. SD or non-U.S. MSP and a non-U.S. counterparty not guaranteed by a U.S. Person would not be subject to the Transaction-Level Requirements. The CFTC also addressed concerns arising from the use of entities that operate as conduits by U.S. Persons in executing swap transactions. The CFTC noted that while these conduits may be used for legitimate purposes, such as allocating economic risk within a corporate groups swap portfolio, a conduit may also be used to evade the TransactionLevel Requirements. For example, a U.S. SD or U.S. MSP may execute a swap with its foreign affiliate or subsidiary which could then execute a swap with a non-U.S. third party in a jurisdiction lacking comparable transactional requirements. Therefore, the CFTC proposes to require compliance with the TransactionLevel Requirements for swaps in which: (i) a nonU.S. counterparty is majority-owned, directly or indirectly, by a U.S. Person; (ii) the non-U.S. counterparty regularly enters into swaps with one or more other U.S. affiliates or subsidiaries of the U.S. Person; and (iii) the financials of such non-U.S. counterparty are included in the consolidated financial statements of the U.S. Person. However, the CFTC would permit substituted compliance for these Transaction-Level Requirements with respect to swaps between a non-U.S. SD and non-U.S. MSP and an affiliate conduit. With respect to external business conduct rules, the CFTC would not require non-U.S. SDs and nonU.S. MSPs to comply with such rules for swaps with a non-U.S. counterparty, whether or not guaranteed by a U.S. Person, as the sales practices would relate to non-U.S. market participants who would be subject to their own foreign regulatory regimes.

V.

Substituted Compliance With Respect to Particular Requirements

In deference to principles of international comity and the practical limitations on the CFTCs ability and resources to monitor a global swaps market, the Guidance proposes to allow a non-U.S. SD or nonU.S. MSP, in limited circumstances, to satisfy certain of the swaps requirements under the Dodd-Frank Act by complying with comparable regulatory regimes of its home jurisdiction without additional requirements under the CEA (Substituted Compliance).28 A. Entity-Level Requirements

As a general matter, all SDs and MSPs must comply with the Entity-Level Requirements, regardless of whether or not they are U.S. Persons. The Guidance would allow non-U.S. SDs and MSPs to use Substituted Compliance to satisfy the Internal Control Requirements.29 Substituted Compliance would also be available to non-U.S. SDs and nonU.S. MSPs with respect to SDR Reporting if they are transacting with non-U.S. counterparties (whether or not such non-U.S. SDs or non-U.S. MSPs are guaranteed by U.S. Persons) and only if the CFTC has direct access to the swap data for such non-U.S. SD or non-U.S. MSP that is stored at the foreign trade repository. Foreign branches of U.S. Persons may not use Substituted Compliance with respect to the EntityLevel Requirements. Since the CFTC considers foreign branches and agencies of U.S. SDs to be the agents of their U.S. person, a U.S. SD would be responsible for complying with all Entity-Level requirements.30

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B.

Transaction-Level Requirements

A non-U.S. SD or non-U.S. MSP would be permitted to use Substituted Compliance for transactions between it and a non-U.S. Person whose swap obligations are guaranteed by a U.S. Person, as the CFTC states that a foreign jurisdiction would have a strong supervisory interest in regulating the activities of its domiciles occurring within its territory. On the other hand, a non-U.S. SD or non-U.S. MSP is generally not permitted to use Substituted Compliance in transactions with a U.S. counterparty. However, the CFTC would permit Substituted Compliance in a swap transaction between a foreign branch of a U.S. Person and a non-U.S. Person counterparty (whether or not one or both parties obligations under the swap is guaranteed by a U.S. Person). With respect to foreign affiliates or subsidiaries of U.S. SDs, a U.S. SD is subject to all of the requirements applicable to SDs under the CEA in cases where a swap is directly booked in the U.S. SD but the foreign affiliate or subsidiary facing the counterparty engages in swap dealing and independently meets the definition of a swap dealer, even though all exposure to the swaps are transferred to a central booking entity. Conversely, if an affiliate or subsidiary facing the counterparty is acting as a disclosed agent and does not independently meet the definition of an SD, then the affiliate or subsidiary would not be subject to the requirements of the Dodd-Frank Act as long as the agency relationship is properly documented and the principal remains primarily responsible for the actions of the affiliate. The Guidance recognizes that some countries do not have a swap regulatory regime comparable to that

established by the Dodd-Frank Act. In such circumstances, the Guidance nevertheless would allow foreign branches or agencies of U.S. SDs to use Substituted Compliance with respect to the Transaction-Level Requirements, albeit on a limited basis. Foreign branches and agencies of U.S. swap dealers may use this option only if the aggregate notional value of the swaps of all foreign branches and agencies in such countries does not exceed 5% of the total swaps of the U.S. SD. U.S. Persons relying on this exemption would be required to maintain records verifying their eligibility for the exemption as well as identify, define and address any significant risk that may arise from the non-application of the Transaction-Level Requirements.31 The Guidance addresses two specific scenarios involving foreign affiliates and subsidiaries. First, where the counterparty-facing affiliate or subsidiary and the central booking entity are both required to comply with the SD-related requirements under the Dodd-Frank Act, and both entities owe obligations to a third party counterparty, both the affiliate or subsidiary and the central booking entity would be required to satisfy the obligations of such third party (though only one may satisfy the obligations of both). Furthermore, if the obligations are unsatisfied, the responsibility for meeting such obligations would be borne by both entities. In the case where a non-U.S. affiliate or subsidiary enters into a swap that is not directly booked in a U.S. Person, such foreign affiliate or subsidiary would be required to register as an SD, if they individually or in the aggregate meet the definition of an SD. Foreign affiliates or subsidiaries would also be required to comply with the SDR Reporting requirement but would be able to use Substituted Compliance for this requirement.

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VI.

Substituted Compliance
A. Standard and Review

B.

Application Process

When evaluating whether foreign regulations with respect to foreign SDs and MSPs are comparable to those enacted under the Dodd-Frank Act, the CFTC will use an outcomes-based approach to determine whether a foreign regimes requirements meet the same regulatory objectives as the Dodd-Frank Act. It will accordingly permit Substituted Compliance only where a foreign regimes requirements are comparable and comprehensive to the CEA and CFTC regulations. In making such determination, the CFTC will consider, among other things: (i) the scope, objectiveness and comprehensiveness of the relevant regulatory requirement(s); (ii) the comprehensiveness of the foreign regulators supervisory compliance program; and (iii) the foreign regulators authority to support and enforce its oversight of the non-U.S. SD or non-U.S. MSP applicant.32 Several of the IRCs, including the FSAUK, HKS and AHS Regulators, have criticized these standards as being unclear. During its review, the CFTC may find that a jurisdiction has comparable laws and regulations in some, but not all, of the applicable Dodd-Frank Act provisions and related CFTC regulations.33 In such cases, the CFTC would recognize Substituted Compliance only in those areas that are determined to be comparable to the Dodd-Frank Act provisions and related CFTC regulations. In addition, the CFTC would retain broad discretion to determine that any objectives under the relevant provisions of the Dodd-Frank Act and the CFTCs regulations are met even if the foreign regulations are not identical to those of the CFTC. The CFTC would also retain broad enforcement authority, including anti-fraud and anti-manipulation authority, over these crossborder swaps.

A request for Substituted Compliance would be submitted either by a non-U.S. SD or non-U.S. MSP or by a group of non-U.S. Persons from the same jurisdiction, or a foreign regulator, on behalf of non-U.S. Persons subject to a foreign supervisory regime. Eligible SDs or MSPs would be required to submit an application directly to the CFTC. The CFTC anticipates working closely with the National Futures Association (NFA) to develop procedures for this application process. Applications for Substituted Compliance would need to include, at a minimum: (i) with specificity, the factual basis for requesting that the CFTC recognize comparability with respect to a particular Dodd-Frank Act requirement and include with specificity all applicable legislation, rules and policies; and (ii) a statement that the applicant is licensed and in good standing with its home country supervisors.34 The CFTC may also, as it deems appropriate and necessary, conduct an on-site examination of the applicant, consult with the applicants home country regulator, and request an opinion of counsel on certain matters. C. Findings of Comparability

The CFTC intends to post any findings of comparability on its website. It also intends to rely on past findings of comparability with respect to a particular jurisdiction when reviewing subsequent applications submitted from the same jurisdiction.35 Once the CFTC makes a determination to permit Substituted Compliance, it expects to enter into a memorandum of understanding or similar arrangement with the relevant foreign supervisors to provide for information-sharing and cooperation in ongoing supervision of SDs and MSPs.

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Following CFTC approval of an SDs or MSPs application, such SD or MSP would have a continuing obligation to notify the CFTC of any subsequent material changes to any information submitted in support of a comparability finding, as such changes might render the CFTCs comparability determination invalid. This requirement would cover not only information related to the SD or MSP itself, but also changes in the relevant foreign supervisory or regulatory regime. Finally, as the CFTC updates its swaps regulations in the future, it expects to revisit related findings of comparability.36 Non-compliance with the comparable home country regulations would constitute a breach of the terms and conditions of the SDs or MSPs registration with the CFTC and would potentially lead to de-registration, an enforcement action, or both.37 In other words, SDs or MSPs using Substituted Compliance will be monitored not only by their foreign regulator, but also by the CFTC. D. Clearing

In response to a number of inquiries, the CFTC addressed in the Guidance how it intends to apply Substituted Compliance to swaps covered by a clearing requirement. The CFTC states that it expects to find comparability with foreign regulatory regimes when: (i) the swap is subject to a mandate issued by appropriate government authorities in the home country of the counterparties to the swap, provided that the foreign mandate is comparable and comprehensive to the Commissions mandate; and (ii) the swap is cleared through a DCO that is exempted from registration under the CEA. E. IRC Comments

basis. For example, the FSAJapan and BOJ stated their belief that determinations should be made on a country-by-country basis, and in a comprehensive manner, from the viewpoint of whether or not foreign regulation is broadly in alignment with US regulation. . . .The determination should also take into account such elements as further regulations to be introduced in a phased manner and the necessity of different regulation in light of divergent practices in non-US markets. The FSAUK noted that EU entities will be subject to highly harmonized regulation on derivatives issues. . . . It would therefore seem duplicative to require each EU entity seeking to benefit from substituted compliance to separately demonstrate the equivalence of these EU rules with Dodd-Frank. In the EU, assessments of equivalence will be undertaken at a jurisdictional level. The EC made a similar point, and noted that making assessments at a jurisdictional level would reduce the incremental costs associated with the registration process and alleviate compliance costs. This is similar to the approach adopted in EU legislation. Several of the IRCs, including the FSAUK and the AHS Regulators, also suggested that in making Substituted Compliance determinations, the CFTC consider a countrys compliance with applicable global standards set by international standard-setting bodies like the Committee on Payment and Settlement Systems, International Organisation of Securities Commissioners and the Basel Committee on Banking Supervision.

VII.

Many of the IRCs have urged that the CFTC not make Substituted Compliance determinations on an entity-by-entity basis, but rather on a jurisdictional

Cross-Border Application of Swap Provisions to Transactions Involving Other Market Participants

A number of the swap provisions under the CEA apply to cross-border transactions in which neither

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counterparty is an SD or MSP. Taking an approach similar to that for SDs and MSPs, the CFTC stated its belief that U.S. Persons swap activities outside the United States have a direct and significant connection with activities in U.S. commerce and therefore, proposes to apply some of the Dodd-Frank Acts swap requirements to swap transactions by nonU.S. Persons even if such transactions occur outside of the United States. Specifically, in any swap transaction involving at least one U.S. Person counterparty, the CFTC would require the swap to be subject to the Dodd-Frank Act requirements regarding clearing, trade-execution, real-time public reporting, Large Trader Reporting, SDR Reporting and recordkeeping (irrespective of the location of the transaction), and would not permit Substitute Compliance for any of the foregoing requirements aside from the SDR Reporting and swap data recordkeeping requirements, provided that the CFTC has direct access to the swap data for these transactions that is stored at the foreign trade repository. Although the CFTC expressed concern that a non-U.S. affiliate or subsidiary could serve as a conduit for a U.S. Person by executing swaps with counterparties in foreign jurisdictions outside the Dodd-Frank Act regulatory regime, the CFTC did not propose requiring such non-U.S. affiliate or subsidiary to be subject to the swap provisions under the Dodd-Frank Act except pursuant to specific Dodd-Frank Act provisions (or CFTC regulations adopted thereunder) or CFTC orders.38

possible that the SEC will adopt different or even contradictory interpretations of related provisions addressing security-based swap dealers and major security-based swap participants.

IX.

Exemptive Relief under the Proposed Order

A. Availability of Exemptive Relief

VIII. Legal Force of the Guidance

Although the Joint Rulemaking was jointly adopted by the SEC and CFTC, the Guidance was drafted by the CFTC alone. Accordingly, it is

In the interest of facilitating an orderly transition to the Dodd-Frank Acts regulatory regime, the CFTC proposed in its Proposed Order to provide temporary exemptive relief for certain non-U.S. SDs and nonU.S. MSPs. First, the relief would permit non-U.S. SDs and non-U.S. MSPs to delay compliance with the Entity-Level Requirements without being in violation of the CEA, with the exclusion of SDR Reporting requirements for swaps entered into with U.S. Person counterparties. The CFTC would also grant relief to non-U.S. SDs and non-U.S. MSPs and foreign branches of U.S. SDs and U.S. MSPs with respect to Transaction-Level Requirements for swaps entered into with a non-U.S. counterparty so that such parties to the swap would be required to comply only with the foreign regulations of the home jurisdiction of the non-U.S. SD or non-U.S. MSP. Similar relief would not be made available for non-U.S. SDs and non-U.S. MSPs or foreign branches of U.S. SDs and U.S. MSPs entering into swaps with U.S. Person counterparties with respect to Transaction-Level Requirements. The exemptive relief with respect to both the Entity-Level Requirements and Transaction-Level Requirements would become effective on the compliance date for registration of SDs and MSPs and expire on July 12, 2013.

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B.

Conditions to Exemptive Relief

Non-U.S. SDs and non-U.S. MSPs must satisfy two conditions in order to qualify for the Proposed Orders exemptive relief. First, they must register as SDs or MSPs, as appropriate. Second, within 60 days of applying for registration, the non-U.S. applicant would be required to submit a compliance report to the NFA. The report would need to include at a minimum, for each Entity-Level Requirement and Transaction-Level Requirement: (i) whether the non-U.S. applicant plans to comply with the EntityLevel or Transaction-Level Requirement or whether it plans to seek a comparability determination for Substituted Compliance; and (2) if seeking a comparability determination, a description of the requirements of the home jurisdiction. A non-U.S. applicant would need to update its compliance plan periodically with the NFA to maintain compliance with new regulations.

extension would not apply to swap data recordkeeping, SDR Reporting or Large Trader reporting requirements. For non-U.S. SDs and nonU.S. MSPs and foreign branches of U.S. SDs and MSPs, the exemptive relief discussed above would expire on July 12, 2013, subject to the CFTCs discretion to adjust these deadlines when it finalizes the Proposed Order. The CFTC has not yet announced an effective date for the Guidance. ________________________ By Conrad G. Bahlke, Partner in the Corporate Practice Group and Derivatives and Commodities Practice Group of Stroock & Stroock & Lavan LLP, and Anna Cho and David Carlson, associates in Stroocks Corporate Practice Group. This Stroock Special Bulletin is one of a series of articles by Stroocks Derivatives and Commodities Practice Group to keep clients and friends informed of significant developments in this fast-changing area.

X.

Effective Dates of Guidance and Proposed Order

The Proposed Orders exemptive relief would become effective concurrently with the date on which SDs and MSPs must apply to register as such. With respect to U.S. SDs and U.S. MSPs, the CFTC has proposed to permit such registrants to delay compliance with certain Entity-Level Requirements until January 1, 2013. However, this January 1, 2013

For More Information

Conrad G. Bahlke 212.806.6555 cbahlke@stroock.com Scott Le Bouef 212.806.6662 slebouef@stroock.com Marvin J. Goldstein 212.806.5629 mgoldstein@stroock.com Mark N. Rae 212.806.5816 mrae@stroock.com

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1.

President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010, with an effective date of July 16, 2011. Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41,214 (July 12, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregist er/documents/file/2012-16496a.pdf. Exemptive Order Regarding Compliance With Certain Swap Regulations, 77 Fed. Reg. 41,110 (July 12, 2012), available at http://www.cftc.gov/ucm/groups/public/ @lrfederalregister/documents/file/2012-16498a.pdf. See Proposed Order, supra note 3, at 41,111, 12. See Dodd-Frank Act 722(d) (codified as CEA 2(i)). See id. at 41,218. See Entity Definitions, supra note 4, at 30, 626. Swap transactions with special entities would use a lower threshold of $25 million. For this purpose, special entities includes municipalities (including municipal-owned utilities), endowments, and employee benefit plans. Id. at 30,626 n.368. See Guidance, supra note 2, at 41,220. The CFTC notes that for purposes of the Guidance, references to a guarantee refer not only to traditional guarantee of payment or performance of the related swaps but also to other formal arrangements to support the nonU.S. Persons ability to pay or perform its obligations, including, without limitation, liquidity puts and keepwell arrangements.

2012), http://www.cftc.gov/LawRegulation/DoddFrank Act/Dodd-FrankFinalRules/ssLINK/2012-5317a. 16. CEA 4s(f)(1)(B); CFTC Regulations 23.201, .203, 46.1 et seq. 17. CEA 2(a)(13)(G), 21; CFTC Regulations Parts 45, 46. 18. CEA 4t; CFTC Regulation Part 20. See Stroock Special Bulletin: CFTC Adoption of Large Trader Reporting and Recordkeeping Rules for Physical Commodity Swaps, http://www.stroock.com/SiteFiles/Pub1132.pdf. 19. CEA 2(h); CFTC Regulations 23.506, .610; see Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management, 77 Fed. Reg. 21,278 (Apr. 9, 2012), http://www.cftc.gov/LawRegulation/DoddFrankAct/Do dd-FrankFinalRules/ssLINK/2012-7477a. See also Stroock Special Bulletin: CFTC Issues Final Rules on Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management, http://www.stroock.com/SiteFiles/Pub1194.pdf. 20. CEA 4s(e); see Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23,732 (Apr. 28, 2011), http://www.cftc.gov/LawRegulation/DoddFrankAct/Do dd-FrankProposedRules/ssLINK/2011-9598a. See also Overview of Proposed Margin and Capital Rules, supra note 35. 21. CEA 2(h)(8). 22. CEA 4s(i); see Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 6,715 (Feb. 8, 2011), http://www.cftc.gov/LawRegulation/DoddFrankAct/Do dd-FrankProposedRules/ssLINK/2011-2643a. See also Stroock Special Bulletin: CFTC Proposes Regulations on Swap Trading Relationship Documentation Requirements, http://www.stroock.com/SiteFiles/Pub1049.pdf. 23. CEA 4s(i); see Confirmation, Portfolio Reconciliation, and Portfolio Compression Requirements for Swap Dealers and Major Swap Participants, 75 Fed. Reg. 81,519 (Dec. 28, 2010), http://www.cftc.gov/LawRegulation/DoddFrankAct/Do dd-FrankProposedRules/ssLINK/2010-32264a. 24. CEA 2(a)(13); see Real-Time Public Reporting of Swap Transaction Data, 77 Fed. Reg. 1,182 (Jan. 9, 2012), http://www.cftc.gov/LawRegulation/FederalRegister/Fin alRules/2011-33173a. 25. CEA 4s(i); see CFTC Regulation 23.501; see also 75 Fed. Reg. 81,519.

2.

3.

4. 5. 6. 7.

8. 9.

10. CFTC No-Action Letter No. 12-22 (Oct. 12, 2012). 11. See Proposed Order, supra note 3, at 41,114. 12. See Guidance, supra note 2, at 41,22324. 13. CEA 4s(e)(3)(A). See also Stroock Special Bulletin: Overview of CFTCs Proposed Margin Rules and Prudential Regulators Proposed Margin and Capital Rules, http://www.stroock.com/SiteFiles/Pub1067.pdf (Overview of Proposed Margin and Capital Rules). 14. CEA 4s(k); CFTC Regulation 3.3. 15. CEA 4s(j); see CFTC Regulations 23.600.606, .605 .607; see Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rule, Futures Commission Merchant and Introducing Broker Conflicts of Interest Rule, and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 Fed. Reg. 20128 (Apr. 3,

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26. CEA 4s(g)(1); CFTC Regulation 23.202. 27. CEA 4s(h); see Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (Feb. 17, 2012), http://www.cftc.gov/LawRegulation/FederalRegister/Fin alRules/2012-1244a. See also Steven W. Rabitz and Conrad G. Bahlke, Isnt That Special? CFTCs Final Business Conduct Rules, Derivates: Financial Products Report, Apr. 2012, at 1, http://www.stroock.com/SiteFiles/Pub1187.pdf. 28. See Guidance, supra note 2, at 41,22729. 29. See id. at 41,227, 30. 30. See id. at 41,227 n.102. 31. See id. at 41,23031.

32. Id. 33. See id. at 41,229, 33. 34. See id. at 41,233. 35. See id. at 41,233. 36. Id. 37. See id. at 41,233 n.124. 38. Note that this statement appears inconsistent with the CFTCs proposal to require compliance with TransactionLevel Requirements for swaps that meet the three conditions set forth in the third paragraph of Section IV.D of this Bulletin. The CFTC has not addressed in its Guidance how these two statements are to be reconciled.

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____________________________________________________________________________________________________________ This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan llp 2012 Stroock & Stroock & Lavan llp. All rights reserved. Quotation with attribution is permitted. This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome. Stroock & Stroock & Lavan llp is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Senior Director-Legal Publications, at 212.806.5522.