SEC Adopts Key Cross-Border Security-Based Swap Rules, Anticipates Further Rulemaking
On June 25, 2014, the Securities and Exchange Commission (SEC) adopted final rules (the SEC Final Rules) that will form the cornerstone of its cross-border rules governing security-based (SB) swap transactions.1 The SEC Final Rules are notable not only for what they provide, but also for what they promise – namely, that the SEC will undertake a series of measured steps in the course of rolling out the SB swap equivalent2 of last year’s cross-border swap guidance (the CFTC Guidance) from the Commodity Futures Trading Commission (CFTC).3
Here are the highlights of the SEC Final Rules and the related adopting release (the SEC Adopting Release):
- Subject Matter. The SEC Final Rules focus on (i) which entities must register as SB swap dealers or major SB swap participants (SB MSPs) in a cross-border context, and (ii) the procedures that will apply to, but not the substantive standards that will be used to evaluate, substituted compliance applications. They also include a rule delineating broad anti-fraud jurisdiction.
- Relation to CFTC Guidance. Generally speaking, the SEC Final Rules close but do not eliminate the gap, in relevant part, between the CFTC Guidance and the cross-border rules that the SEC first proposed in May 2013 (the SEC Proposed Rules).4 Unlike the CFTC, which took an interpretive approach to its cross-border jurisdiction, the SEC has acted via formal rulemaking.
- More to Come. Substantive cross-border SB swap issues remain to be addressed, as the SEC Final Rules cover only a small but key part of the ground covered by the SEC Proposed Rules. Unlike the CFTC, the SEC has decided that domestic and cross-border formulations of its rules will arrive hand-in-hand (rather than the domestic formulation coming first, accompanied by a series of actions providing temporary cross-border relief). Thus, unlike the CFTC Guidance, neither the SEC Final Rules nor the SEC Adopting Release addresses how specific entity-level requirements (e.g., reporting and recordkeeping requirements) or transaction-level requirements (e.g., mandatory clearing or trade execution requirements) will apply in a given cross-border context.
- Issues Addressed. The principal issue addressed by the SEC Final Rules is which SB swaps a non-U.S. person will need to count against SB dealer and SB MSP thresholds when the non-U.S. person is determining whether it must register with the SEC as an SB swap dealer or SB MSP under rules previously adopted by the SEC.5 For this purpose, the SEC Final Rules define “U.S. person” and prescribe the treatment of SB swaps with non-U.S. persons that either are guaranteed by, or act as “conduit affiliates” for, one or more U.S. persons. This definition will also be used in the future as the SEC rolls out the domestic and cross-border formulations of its substantive SB swap rules.
- Definition of U.S. Person. The SEC Final Rules’ definition of U.S. person was broadened from that proposed last year to pick up (as does the CFTC’s definition) certain offshore funds that are managed by U.S. investment managers (i.e., that are deemed to have their principal place of business in the United States rather than in, say, the Cayman Islands). However, the SEC (unlike the CFTC) does not extend its jurisdiction to collective investment vehicles that are majority-owned by U.S. persons.
- Definition of Guarantee. The SEC’s approach to guarantees focuses on recourse and consequently is narrower than the CFTC’s. Commissioner Stein criticized the rule for not extending the guarantee treatment to keepwells and implicit guarantees. In this respect, the SEC is viewing its jurisdiction under Dodd-Frank narrowly (relative to how the CFTC views its own jurisdiction).
- Conduit Affiliates. The SEC Final Rules include the concept of a “conduit affiliate” despite its absence from the SEC Proposed Rules. In part, the change responded to comments the SEC received to a question in the proposing release concerning whether it should adopt the CFTC’s approach. In taking the approach, the SEC developed a jurisdictional analysis that relies on an interpretation of the anti-evasion element of the Dodd-Frank statutory text that provides the SEC’s SB swap jurisdiction.
- Conduct-Based Jurisdiction over Non-U.S. Persons. The SEC Final Rules do not address conduct-based jurisdiction per se – i.e., jurisdiction over swap transactions executed by non-U.S. persons having a jurisdictional nexus to the United States (e.g., involvement by NYC-based front-office personnel of a non-U.S. swap dealer when it trades with a non-U.S. customer). This issue will be subject to further consideration and rulemaking by the SEC.
- Effectiveness and Relation to Substantive Requirements. Although the SEC Final Rules will be effective September 7, 2014 (60 days after publication in the Federal Register), they will not have practical effect until the underlying substantive rules (e.g., the base SB swap dealer registration requirements themselves) are adopted and become effective.
This Update describes the SEC Final Rules in greater detail below and contrasts them with their analogues in the CFTC Guidance. It ends with related observations regarding how the SEC perceives its jurisdiction, including in the context of the enforcement of anti-fraud statutory provisions.
U.S. Person Definition
The lynchpin definition for application of the SEC Final Rules is “U.S. person,” which is defined as follows:
- a natural person resident in the United States;
- a 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;6
- an account (whether discretionary or non-discretionary) of a U.S. person; or
- an estate of a decedent who was a resident of the United States at the time of death.
The SEC’s definition can be contrasted with the more detailed definition provided under the CFTC Guidance:7
For purposes of the SEC’s definition, principal place of business means:
- The location from which the officers, partners, or managers of the legal person primarily direct, control, and coordinate the activities of the legal person.
- With respect to an externally managed investment vehicle, this location is the office from which the manager of the vehicle primarily directs, controls, and coordinates the investment activities of the vehicle.
The SEC Adopting Release provides only a limited amount of guidance regarding its conception of principal place of business in the context of an externally managed investment vehicle.8 Most relevantly, the SEC noted as follows:
This definition directs market participants to consider where the activities of an externally managed investment vehicle generally are directed, controlled, and coordinated, even if this conduct is performed by one or more legally separate persons. For an investment vehicle, for example, the primary manager is responsible for directing, controlling, and coordinating the overall activity of the vehicle, such that the business of the vehicle, such as its investment and financing activity, is principally carried out at the location of the primary manager. Such an investment vehicle’s principal place of business under the final rule would be the location from which the manager carries out those responsibilities.9
The most significant difference between the SEC’s and CFTC’s U.S. person definitions concerns collective investment vehicles that are majority-owned by U.S. persons. Although the CFTC definition extends to such vehicles, the SEC expressly declined to follow suit, noting:
We do not believe risks created through ownership interests in collective investment vehicles are the types of risks that Title VII is intended to address with respect to security-based swaps.10
To the extent an offshore hedge fund or other collective investment vehicle is captured by the SEC definition (by virtue of its principal place of business), it will eventually be subject to SEC SB swap requirements to a greater degree than are funds and vehicles that are non-U.S. persons. However, as noted above, the SEC indicated that it intends to adopt various substantive requirements over time through separate rulemakings, at each turn imposing the requirements via the cross-border elements found in the SEC Final Rules at the same time as the requirements are imposed domestically.11 Thus, there are no significant immediate consequences for such funds and vehicles under the SEC Final Rules.
As under the CFTC Guidance, the SEC Final Rules do not treat non-U.S. persons that are guaranteed by, or affiliated with, U.S. persons, as U.S. persons themselves. However, as discussed below, such non-U.S. affiliates are treated similarly to U.S. persons in certain respects (though not as often as they are under the CFTC Guidance). Also similarly, non-U.S. branches of U.S. persons are considered to be U.S. persons (i.e., the non-U.S. branch is not distinguished from its U.S. entity); however, in certain respects (also as discussed below) the non-U.S. branches of certain U.S. persons are treated as though they are non-U.S. persons.
Applying the U.S. Person Definition
For SB swap dealer de minimis calculations, U.S. persons must count all SB swaps connected with their dealing activity regardless of whether the counterparty is a U.S. person or not. Similarly, for SB MSP threshold calculations, U.S. persons must count all SB swaps. As noted above, non-U.S. branches of U.S. persons are considered U.S. persons, and thus SB swaps that they execute must be counted along with all other SB swaps executed by the U.S. person.
By contrast, non-U.S. persons are generally required to count only those SB swaps that they enter into with U.S. person counterparties. There are four principal exceptions to this rule, two permissive (i.e., permitting the non-U.S. person to exclude certain swaps with U.S. persons) and two restrictive (i.e., requiring it to include certain swaps with other non-U.S. persons):
- SB swaps where its U.S. person counterparty is a registered SB swap dealer12 and conducts the transaction through a foreign branch.
- SB swaps that it enters into anonymously on an execution facility or national securities exchange and that are cleared through a clearing agency. (This exclusion applies only for SB swap dealer de minimis calculations, not SB MSP threshold determinations.)13
- SB swaps where its non-U.S. person counterparty “has rights of recourse against” a U.S. person, such as where a transaction guarantee is provided by its U.S. affiliate in favor of the non-U.S. counterparty.14
- SB swaps irrespective of counterparty (whether or not cleared) where it is acting as a “conduit affiliate” for a U.S. person affiliate.15
As discussed below, unlike the CFTC Guidance in respect of swaps, the SEC Final Rules notably do not require that a non-U.S. person count SB swaps that it enters into with other non-U.S. persons that trade with the benefit of guarantees from U.S. affiliates.16
We address the two restrictive inclusions in the sections below headed “Guarantees and Other Recourse” and “Conduit Affiliates.” As to the first permissive exclusion, the SEC specified the following conditions for a determination that a particular SB swap transaction has been “conducted through a foreign branch” of an SB swap dealer and thus may be excluded by a non-U.S. person that is determining whether it has crossed either an SB swap dealer or an SB MSP threshold:
- To qualify as a “foreign branch,” the branch must:
- be a branch of a U.S. bank and be located outside the United States;
- operate for valid business reasons; and
- be engaged in the business of banking and be subject to substantive banking regulation in the jurisdiction where located.
- An SB swap transaction is defined as having been “conducted through a foreign branch” if:
- the foreign branch is the counterparty to the SB swap transaction; and
- the SB swap transaction is arranged, negotiated, and executed on behalf of the foreign branch solely by persons located outside the United States.
This exclusion is narrower than the exclusion proposed originally in the SEC Proposed Rules, which did not limit the exclusion to registered SB swap dealers (and thus would have applied to transactions conducted through the foreign branches of U.S. persons generally). The SEC noted that even though it was narrowing the exclusion, it was preserving the exclusion because:
[R]equiring non-U.S. persons to count transactions with foreign branches “could limit access of U.S. banks to non-U.S. counterparties when they conduct their foreign security-based swap dealing activity through foreign branches because non-U.S. persons may not be willing to enter into transactions with them in order to avoid being required to register as a security-based swap dealer.”17
The SEC further noted that the exclusion in the SEC Final Rules is consistent with the similar exclusion in the CFTC Guidance.18
Aggregation and Attribution Rules
The SEC Final Rules addressing thresholds for SB swap dealer and SB MSP calculations include aggregation and attribution elements that require a given person to count SB swap transactions to which the person is not a party when considering whether a given threshold is met. However, these requirements differ depending on which of the two calculations – SB swap dealer or SB MSP – is at issue. In the case of SB swap dealer calculations, the focus is on aggregating dealing activities across affiliates (irrespective of any guarantee or other recourse feature); by contrast, in the case of SB MSP calculations, the attribution requirement depends upon certain guarantee and recourse features (irrespective of any affiliation).
- SB swap dealer aggregation: If a person (whether U.S. or non-U.S.) engages in any level of SB swap dealing activity that is addressed by the basic rule (described above), then it must also aggregate for its own calculations all SB swap dealing activity of any affiliate19 that is:
- a U.S. person;
- a non-U.S. person that is a conduit affiliate; or
- a non-U.S. person that is not a conduit affiliate but that nonetheless engages in SB swap dealing activity that it must count toward its own SB swap dealer de minimis threshold (e.g., SB swap dealing transactions with U.S. persons).
If the affiliate falls into the third category above – i.e., a non-U.S. person that is not a conduit affiliate – aggregation is not required for swaps that are entered into anonymously by the affiliate on an execution facility or national securities exchange and are cleared through a clearing agency. By contrast, aggregation will pick up anonymous swaps if executed by an affiliate that is either a U.S. person or a conduit affiliate. Effectively, the aggregation captures those dealing transactions of affiliates that the affiliates themselves are required to count against their own de minimis thresholds.
However, the dealing activity of any affiliate that is registered with the SEC as an SB swap dealer may be excluded.20 This effectively permits – as does the analogous portion of the CFTC Guidance – a corporate group to engage in SB swap dealing activity as long as the aggregate activity outside of the group’s registered SB swap dealer(s) does not exceed the de minimis threshold. Although the SEC Proposed Rules included a condition that the registered SB swap dealer be “operationally independent” before its SB swaps could be excluded from aggregation, the SEC Final Rules do not.21
- SB MSP attribution: When a person determines whether it meets the SB MSP thresholds, it must attribute to itself certain SB swaps to which it is not a party but in respect of which it provides a guarantee or otherwise has recourse obligations (without regard to the presence or absence of any affiliation). This is discussed in the section immediately below.
The differing requirements for SB swap dealer aggregation and SB MSP attribution relate to the SEC’s perception of the different kinds of risks that are presented by SB swap dealers, on the one hand, and SB MSPs, on the other. In the former case, the focus is on dealing activity; in the latter, it is on economic exposure to particular SB swap transactions.22
Guarantees and Other Recourse
Under the SEC Final Rules, the presence of a guarantee or other recourse obligation may, given the circumstances, influence how either the guarantor or the guaranteed party (but not the counterparty) is required to calculate its position in respect of SB swap dealer de minimis thresholds or SB MSP thresholds. The SEC Final Rules do not use the term “guarantee” per se; instead, they speak of “rights of recourse.” As discussed below, the SEC acknowledged that its treatment of this subject results in an approach that is more targeted than the “guaranteed affiliate” approach found in the CFTC Guidance. The SEC cautioned, however, that the “recourse” provisions of its rules are not triggered only by the presence of formal guarantees.
Typical recourse arrangements for an SB swap transaction can be graphically represented in this simple way (where we use a guarantee structure as the recourse example):
In the two subsections below, we address first the treatment of guaranteed parties and then the treatment of guarantors. Before turning to the rules as applied from these alternative perspectives, we describe two important general differences between how the SEC and the CFTC respectively addressed guarantees.
First, provisions of the SEC Final Rules related to guarantees are not triggered unless under the given guarantee the counterparty has a right of recourse against the guarantor in respect of the underlying SB swap. In other words, unlike the CFTC Guidance provisions related to guarantees,23 the SEC Final Rules are not triggered by keepwell agreements or related arrangements unless those agreements or arrangements meet the rules’ standards for recourse. The SEC Adopting Release explained:
[A] recourse guarantee is present if, in connection with the security-based swap, the counterparty itself has a legally enforceable right to payment or collection from the U.S. person, regardless of the form of the arrangement that provides such a legally enforceable right to payment or collection.24
The SEC Adopting Release makes it clear that recourse obligations other than those created by traditional written guarantees – e.g., the obligation of a general partner with unlimited liability for the obligations of a partnership – will satisfy this standard if the counterparty has recourse in respect of the underlying SB swap.25 The touchstone, repeated twice in the SEC Final Rules (in the two different contexts where it serves), is whether “the counterparty has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, the [guarantor] in connection with the security-based swap.”26
As to the difference between this approach to guarantees and other recourse arrangements and the CFTC’s approach, the SEC Adopting Release notes:
Our final rule is more targeted than the CFTC approach, in that our final rule requires a non-U.S. guaranteed affiliate to count only those dealing transactions for which the counterparty to the security-based swap has recourse against a U.S. person that is affiliated with the non-U.S. person. This reflects our decision to focus the application of the de minimis exception on recourse arrangements involving security-based swaps, while recognizing that some non-recourse arrangements could influence a U.S. person to provide financial support to non-U.S. persons and thereby present risk to the U.S. person and potential risk to the U.S. financial system.27
The second general difference between the SEC and CFTC treatments of guarantees concerns which of the parties to a given guaranteed transaction are affected by the presence of the guarantee. As discussed below, the SEC adopted detailed rules related to guarantees and other recourse arrangements, but these rules focus on persons that either provide guarantees (a “Guarantor” in the graphic above) or that trade with the benefit of a guarantee (a “Guaranteed Party” in the graphic). Unlike the CFTC Guidance, the SEC Final Rules do not flip the perspective and alter the calculations of a counterparty when it trades with a guaranteed party (the “Counterparty” in the graphic). To be specific: The CFTC Guidance requires a non-U.S. person to count not only swaps with U.S. persons, but also swaps with non-U.S. persons that are guaranteed by U.S. person affiliates. The SEC Final Rules do not; they look at this circumstance from the perspective of the guarantor and the guaranteed party; they do not require a non-U.S. person counterparty to count an SB swap where the other party is another non-U.S. person even if that other non-U.S. person trades with a guarantee from a U.S. person.28
Guaranteed Parties and SB Swap Dealer and SB MSP Thresholds
Normally a non-U.S. person is not required to count SB swaps with other non-U.S. persons. However, where the non-U.S. person trades SB swaps with the benefit of a recourse guarantee provided by a U.S. person, additional requirements may be triggered for the non-U.S. person’s SB swap dealer calculations and SB MSP calculations. The additional requirements are similar, but not the same, for the two types of calculations. In both cases:
- The additional requirement is triggered when a U.S. person guarantees (or otherwise provides rights of recourse in respect of) the obligations of a non-U.S. party under an SB swap when the non-U.S. party trades with a non-U.S. counterparty.
- The non-U.S. party that is guaranteed must count the SB swap against its own SB swap dealer threshold29 and SB MSP threshold, whether or not its counterparty is a U.S. person (whereas in the absence of a U.S. person guarantor – or conduit affiliate arrangement (discussed below) – a non-U.S. party would be required to count only SB swaps with U.S. persons).
However, the guarantee-related requirement is narrower in the context of SB swap dealer calculations than in the context of SB MSP calculations, inasmuch as guaranteed SB swaps are counted for SB swap dealer de minimis purposes only where the U.S. guarantor is an affiliate of the non-U.S. party. By contrast, a guaranteed non-U.S. party must count the guaranteed SB swaps against SB MSP thresholds whether or not the U.S. guarantor is affiliated.30
Guarantors and SB MSP Thresholds
We focus now on guarantors (rather than guaranteed parties as just discussed). Where a person provides a recourse guarantee in respect of SB swap transactions, it may be required to count those SB swap transactions when determining whether it is an SB MSP. These are the SB MSP attribution rules referenced above. There is no equivalent for SB swap dealer de minimis calculations.
The results under the SB MSP attribution rules differ depending on whether the guarantor in question is a U.S. person or a non-U.S. person (but, as noted above, the rules apply without regard to affiliation). In effect, any recourse guarantee arrangement will trigger the attribution rule for the guarantor unless the guarantor is a non-U.S. person, the guaranteed party is a non-U.S. person and the counterparty either is a non-U.S. person or is a registered SB swap dealer that conducted the SB swap transaction through a foreign branch (subject to the exclusion noted below for guaranteed parties that are subject to regulatory capital requirements). Specifically, guarantors must count SB swaps that they guarantee in the following circumstances:
- U.S. person guarantor: SB swaps of any guaranteed party31 where the counterparty (whether U.S. or non-U.S.) has rights of recourse against the U.S. person.
- Non-U.S. person guarantor: SB swaps of any guaranteed party that is:
- a U.S. person where the counterparty (whether U.S. or non-U.S.) has rights of recourse against the non-U.S. person,32 or
- a non-U.S. person where the counterparty is a U.S. person and has rights of recourse against the non-U.S. person (other than where the U.S. person is a registered SB swap dealer and has conducted the SB swap transaction through a foreign branch in the manner described above).
However, an exception is provided for attribution (in the case of both U.S. person and non-U.S. person guarantors) where the guaranteed party is subject to specified regulatory capital requirements.33
A conduit affiliate is defined under the SEC Final Rules as a person, other than a U.S. person, that:
- is directly or indirectly majority-owned34 by one or more U.S. persons; and
- in the regular course of business enters into security-based swaps with one or more other non-U.S. persons, or with foreign branches of U.S. banks that are registered as security-based swap dealers, for the purpose of hedging or mitigating risks faced by, or otherwise taking positions on behalf of, one or more U.S. persons (other than U.S. persons that are registered as security-based swap dealers or major security-based swap participants) who are controlling, controlled by, or under common control with the person, and enters into offsetting security-based swaps or other arrangements with such U.S. persons to transfer risks and benefits of those security-based swaps.
The treatment of conduit affiliates in the SEC Final Rules is straightforward: even though they are non-U.S. persons by definition, they must count swaps against their SB swap dealer and SB MSP thresholds in the same fashion as U.S. persons – i.e., they must count all SB swap dealing activity in the former instance, and all SB swaps in the latter.35 Similarly, when a person is determining which affiliate transactions it must aggregate for purposes of its own swap dealer de minimis calculations, it must count affiliates that are either U.S. persons or conduit affiliates.
Although a conduit affiliate is treated like a U.S. person in the two regards noted above, it is not treated like a U.S. person when non-U.S. persons that trade with it measure their own activity against applicable SB swap dealer and SB MSP thresholds. As is the case when a non-U.S. person deals with guaranteed affiliates,36 it does not need to count conduit affiliates.37
As noted above, the concept of a “conduit affiliate” was not included in the SEC Proposed Rules, although the release accompanying the SEC Proposed Rules included a specific question regarding whether the SEC should adopt the CFTC’s conduit affiliate approach.38
Conduct Within the United States
The SEC Proposed Rules would have extended the SEC’s jurisdiction to certain SB swaps conducted within the United States whether or not a U.S. person was involved in the transaction in one manner or another. The related element of the SEC Proposed Rules defined “transactions conducted within the United States.”
In the SEC Adopting Release, the Commission indicated that it was tabling this issue for further consideration:
While we continue to preliminarily believe that the cross-border application of the security-based swap dealer definition should account for activities in the United States related to dealing – even when neither party to the transaction is a U.S. person – we also believe that the final resolution of this issue can benefit from further consideration and public comment. Accordingly, we anticipate soliciting additional public comment regarding approaches by which the cross-border application of the dealer definition appropriately can reflect activity between two non-U.S. persons where one or both are conducting dealing activity within the United States.39
A similar subject has created some controversy for the CFTC in the context of its own swap regulation, and the CFTC has requested comment regarding prior action in this area.40 It is not clear whether the CFTC and the SEC will coordinate their efforts so that conduct-based jurisdiction over non-U.S. persons is the same for swaps and SB swaps.
The SEC Final Rules include a procedural provision setting out how the SEC will address and act on applications for substituted compliance orders. Perhaps most significantly, the provision requires that the SEC publish notice of these applications in the Federal Register and seek public comment (for a period of no fewer than 25 calendar days following publication of notices). The SEC drew a careful distinction between the rule adopted – which concerns process – and the substantive standards that will apply to its determinations regarding substituted compliance applications:
[W]e expect to address issues regarding the availability of substituted compliance as part of future rulemakings, in conjunction with considering the cross-border application of the relevant substantive rules. As discussed above, we believe that it is appropriate to address issues regarding the cross-border application of the substantive requirements under Title VII in conjunction with considering the final rules to implement those substantive requirements, as substituted compliance potentially will constitute an integral part of the final approach toward cross-border application. At this time, however, we believe that it is appropriate to adopt a final rule to address the procedures for submitting substituted compliance requests.41
SEC Jurisdiction Generally
Dodd-Frank Section 772 added Section 30(c) to the Securities Exchange Act of 1934. It provides, among other things, that “[n]o provision of [Title VII] . . . shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States,” unless that business is transacted in contravention of rules prescribed to prevent evasion of Title VII.42
As noted above,43 Commissioner Stein was critical of the view taken by the SEC regarding its jurisdiction, and commented at some length in this regard during the meeting at which the SEC Final Rules were approved. She believes the SEC has broader jurisdiction than it has claimed in the rulemaking. The SEC’s General Counsel defended the jurisdictional interpretation by reference to the Supreme Court’s recent Morrison decision44 and, more generally, to the limits of the SEC’s territorially-based jurisdiction. For example, the General Counsel indicated that in the absence of recourse, the territorial condition for the SEC’s jurisdiction is not satisfied for a keepwell arrangement. This appears to have caused the SEC to take a more limited position than the CFTC in the context of different intercompany support arrangements.
Although the SEC did not claim jurisdictional authority to the extent Commissioner Stein might have preferred, it nonetheless engaged in interpretive analysis to extend the jurisdiction of the SEC Final Rules. For example, at several turns – e.g., the conduit affiliate treatment – the SEC justified a cross-border reach – a reach that encompasses “conduct without the jurisdiction of the United States” – by relying on other elements of Section 30(c), specifically its “anti-evasion” elements. The SEC noted repeatedly that it is permitted to adopt “prophylactic” measures that operate outside the United States, even in the absence of evasive purpose. Thus, the SEC Adopting Release includes the following kinds of statements:
“[S]ection 30(c) of the Exchange Act permits us to impose prophylactic rules intended to prevent possible purposeful evasion, even though such rules may affect or prohibit some non-evasive conduct. Moreover, exercising the section 30(c) authority does not require us to draw a distinction between conduct ‘without the jurisdiction of the United States’ that is purposely evasive as opposed to identical conduct that was motivated by some non-evasive purpose.”45
“Thus, we read the statute to permit us to prescribe such rules to conduct without the jurisdiction of the United States, even if those rules would also apply to a market participant that has been transacting business through a pre-existing market structure, such as a foreign branch or foreign affiliate whose positions are guaranteed by the market participant, established for valid business purposes, provided the proposed rule or guidance is designed to prevent possibly evasive conduct.”46
“We recognize that not all dealing structures involving conduit affiliates may be evasive in purpose. We believe, however, that the anti-evasion authority of section 30(c) permits us to prescribe prophylactic rules to conduct without the jurisdiction of the United States, even if those rules would also apply to a market participant that has been transacting business through a pre¬existing market structure established for valid business purposes, so long as the rule is designed to prevent possible evasive conduct.”47
As noted above, the SEC did not include the concept of a “conduit affiliate” in the SEC Proposed Rules, but asked specifically if the concept should be included.48 It appears that the SEC then engaged in the interpretive effort reflected above, having determined that extending its own rules in this fashion is appropriate as a policy matter.
The SEC also left no doubt regarding the extent of its anti-fraud jurisdiction in the context of SB swap transactions. The SEC Final Rules include a provision confirming that the SEC in this realm, as in others, has broad jurisdiction to enforce anti-fraud laws based either on conduct occurring in the United States or on conduct occurring outside the United States that has a foreseeable substantial effect in the United States.49
1 See Securities Exchange Act Release No. 72472 (June 25, 2014), 79 Fed. Reg. 39068 (July 9, 2014), available at: http://www.gpo.gov/fdsys/pkg/FR-2014-07-09/pdf/2014-15337.pdf.
2 The SEC Final Rules address SB swaps – most notably single-name and narrow-based index CDS and equity swaps – while the CFTC’s jurisdiction covers a much larger part of the swap market.
3 The CFTC Guidance is available at: http://www.gpo.gov/fdsys/pkg/FR-2013-07-26/pdf/2013-17958.pdf. We discussed the CFTC Guidance in a Sidley Update dated July 19, 2013 (“CFTC Adopts Final Cross-Border Guidance and Exemptive Order; Announces ‘Path Forward’ with EU”).
4 See Securities Exchange Act Release No. 69490 (May 1, 2013), 79 Fed. Reg. 39068 (May 23, 2013), available at: http://www.gpo.gov/fdsys/pkg/FR-2013-05-23/pdf/2013-10835.pdf.
5 Rules in respect of the underlying registration requirements were adopted jointly by the SEC and CFTC in 2012. The related release, published at 77 Fed. Reg. 30596 (May 23, 2012) (the Entity Definitions Release), is available at: http://www.gpo.gov/fdsys/pkg/FR-2012-05-23/pdf/2012-10562.pdf. We discussed the entity definitions in a Sidley Update dated May 11, 2012 (CFTC and SEC Finalize Key Dodd-Frank "Entity Definitions”).
6 The SEC Final Rules exclude the following international institutions and entities: 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.
7 We note that the CFTC text set out in the table above is from the “Summary” section of the relevant portion of the CFTC Guidance. See CFTC Guidance at 45316-17. Given the nature of the CFTC Guidance – namely, that it constitutes interpretive guidance rather than formal rules – it is clear that variations on the “Summary” are possible. Indeed, the CFTC wrote: “The Commission continues to include the prefatory phrase ‘include, but not be limited to’ in its interpretation of the term ‘U.S. person,’ . . . to indicate that there may be situations where a person not fully described in the interpretation . . . is appropriately treated as a ‘U.S. person’ for purposes of this Guidance in view of the relevant facts and circumstances and a balancing of the various regulatory interests that may apply.” CFTC Guidance at 45316.
8 The SEC’s discussion of principal place of business is not nearly as detailed as the analogous discussion in the CFTC Guidance, which goes on at some length regarding the concept, citing a relatively recent Supreme Court case (which addressed principal place of business for purposes of federal court diversity jurisdiction) and providing detailed hypotheticals as examples. See CFTC Guidance at 45309-12.
9 SEC Adopting Release at 39100-01 (emphasis added).
10 SEC Adopting Release at 39101.
11 The SEC noted:
We expect to address other [substantive] matters raised by the [SEC Proposed Rules] as part of subsequent rulemakings, to allow us to consider the cross-border application of the substantive requirements imposed by Title VII – including the economic consequences of that cross-border application – in conjunction with the final rules that will implement those substantive requirements. Market participants are not required to comply with certain of those Title VII requirements pending the publication of final rules or other Commission action, and temporarily are exempt from having to comply with certain other requirements added by or arising from Title VII.
SEC Adopting Release at 39069.
12 Until 60 days after the earliest date on which the registration of SB swap dealers is required, this exclusion will apply to SB swaps with all U.S. person bank counterparties conducted through their foreign branches, whether or not the bank counterparties are registered SB swap dealers. See Sections 240.3a67-10(b)(3)(i)(B) and 240.3a71-3(b)(1)(iii)(A)(2).
13 In the absence of an SB MSP exclusion for cleared SB swaps, non-U.S. persons will need to consider how to take into account cleared SB swaps that are executed anonymously. That said, presumably the inclusion of all cleared swaps would not change calculations significantly, since under the rules addressing these calculations generally (whether in a domestic or a cross-border context), the uncollateralized exposure and potential future exposure amounts should be limited. This was discussed in the Entity Definitions Release. See, e.g., Entity Definitions Release at 30668 (“[C]entrally cleared swaps and security-based swaps are subject to mark-to-market margining that would largely eliminate the uncollateralized exposure associated with a position, effectively resulting in the cleared position being excluded from the [current exposure] analysis.”) and at 30670 (“[In light of] the risk-mitigating effects of central clearing, and the additional level of rigor that clearing agencies may have with regards to the process and procedures for collecting daily margin, the final rules further provide that the potential future exposure associated with positions that are subject to central clearing will equal 0.1 . . . times the potential future exposure that would otherwise be calculated.”) See generally supra note 5.
14 As discussed further below in “Guarantees and Other Recourse,” in the context of SB swap dealer de minimis calculations, this additional inclusion applies only where the U.S. guarantor is an affiliate of the non-U.S. person; by contrast, for SB MSP threshold calculations, affiliation or its absence is irrelevant.
15 As discussed further below in “Conduit Affiliates,” in this respect conduit affiliates are treated in the manner as U.S. persons.
16 See infra note 28 and accompanying text.
17 SEC Adopting Release at 39111 (quoting the release accompanying the SEC Proposed Rules).
18 See SEC Adopting Release at 39111.
19 Specifically, any other person controlling, controlled by, or under common control with such person.
20 See Section 240.3a71-4. The exception also applies to affiliates that are temporarily deemed not to be SB swap dealers after they first become subject to a registration requirement (after crossing one of the de minimis exception thresholds) pending their registration with the SEC.
21 See SEC Adopting Release at 39114 and note 406.
22 See SEC Adopting Release at 39081 (“The statutory focus of the major security-based swap participant definition differs from that of security-based swap dealer, in that the security-based swap dealer definition focuses on activity that may raise the concerns that dealer regulation is intended to address, while the major security-based swap participant definition focuses on positions that may raise systemic risk concerns within the United States. Accordingly, a territorial approach to application of the definition of major security-based swap participant involves identifying security-based swap positions that exist within the United States.”).
23 It is interesting to note that the CFTC Guidance is not itself entirely consistent in how it approaches guarantees and other support arrangements. Although its most prominent provisions take an expansive view of the kinds of guarantees and support arrangements (including keepwells) that trigger related cross-border application of CFTC swap rules, in one particular area there appears to be a narrower approach – one that is also based on recourse. In most contexts, the CFTC Guidance’s key definitional element – which incorporates the CFTC’s broadest view of guarantees and support arrangements – is the “guaranteed affiliate.” But when addressing whether certain transaction-level requirements apply when non-U.S. swap dealers and MSPs transact with guaranteed non-U.S. persons, the relevant question becomes not whether the other non-U.S. person is a “guaranteed affiliate,” but whether the guarantee is written by, and provides the non-U.S swap dealer or MSP recourse against, a U.S. person – the phrase “guaranteed affiliate” does not appear in this section of the CFTC Guidance at all. See, e.g., CFTC Guidance at 45355 and note 563.
24 SEC Adopting Release at 39107.
25 See SEC Adopting Release at 39106 (“The terms of the guarantee need not necessarily be included within the security-based swap documentation or even otherwise reduced to writing (so long as legally enforceable rights are created under the laws of the relevant jurisdiction); for instance, such rights of recourse would arise when the counterparty, as a matter of law in the relevant jurisdiction, would have rights to payment and/or collection that may arise in connection with the non-U.S. person’s obligations under the security-based swap that are enforceable.”); SEC Adopting Release at 39098, note 255 (“For example, if a counterparty to a transaction is a general partnership that is not a U.S. person but has a U.S.-person general partner that has unlimited responsibility for the general partnership’s liabilities, including for its obligations to security-based swap counterparties, we would view the general partner’s obligations with respect to the security-based swaps of the partnership as recourse guarantees for purposes of this final rule, absent countervailing factors.”).
26 See Sections 240.3a67-10(b)(3)(ii) and 240.3a71-3(b)(1)(iii)(B).
27 SEC Adopting Release at 39109.
28 See SEC Adopting Release at 39126, note 488 and accompanying text (“Potential alternatives . . . could be to require non-U.S. persons to count their dealing transactions with counterparties that are guaranteed affiliates of U.S. persons (at least with regard to transactions subject to the guarantees), or their dealing transactions with counterparties that are conduit affiliates. . . . [W]e do not believe that it is necessary to require non-U.S. persons to count their dealing transactions with such non-U.S. counterparties.”). For the SEC’s commentary as to the CFTC requirement to the contrary in respect of guaranteed affiliates, see SEC Adopting Release at 39112, note 384 (related to swap dealer determinations) and SEC Adopting Release at 39135, note 593 (related to MSP determinations).
29 Assuming the SB swap is connected with the non-U.S. person’s dealing activity.
30 Compare Section 240.3a67-10(b)(3)(ii) (no affiliation requirement for SB MSP calculations) and Section 240.3a71-3(b)(1)(iii)(B) (requiring affiliation for SB swap dealer calculations).
31 Although the SEC Final Rules specifically address the case where a non-U.S. person is the guaranteed party, a “Note” that follows this element of the rules indicate, in effect, that the consequence is the same whether the guaranteed party is a U.S. person or a non-U.S. person as long as the guarantor is a U.S. person. See SEC Adopting Release at 39160 (“Note to paragraph (c)(1)(i)”).
32 The SEC noted that this requirement:
may be broader than the CFTC Cross-Border Guidance in this context because the final rule requires the non-U.S. person to attribute to itself all the positions of the U.S. person that are guaranteed by the non-U.S. person, whereas the CFTC Cross-Border Guidance states that the non-U.S. person would generally not attribute to itself positions of the U.S. person that it guarantees where the counterparty is another non-U.S. person that is not guaranteed by a U.S. person. See CFTC Cross-Border Guidance at 45326 (stating that a non-U.S. person would generally consider in its own calculation (i.e., attribute to itself) any swap position (of a U.S. or non-U.S. person) that it guarantees in which the counterparty is a U.S. person or a guaranteed affiliate).
SEC Adopting Release at 39137, note 613.
33 Capital regulation by the SEC or the CFTC; regulation as a bank in the United States; or other capital standards adopted by a home country supervisor that are consistent with the Basel capital accord. See Section 240.3a67-10(c)(2).
34 “The majority-ownership standard . . . is satisfied if one or more [legal entities that are U.S. persons] directly or indirectly own a majority interest in the non-U.S. person, where ‘majority interest’ is the right to vote or direct the vote of a majority of a class of voting securities of an entity, the power to sell or direct the sale of a majority of a class of voting securities of an entity, or the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership.” Section 240.3a71-3(a)(1)(ii).
35 See supra text at note 15.
36 See supra note 28 and accompanying text.
37 As noted above, the CFTC Guidance differs in how swaps with guaranteed affiliates are treated; by contrast, the CFTC Guidance is the same for swaps with conduit affiliates: as under the SEC Final Rules, swaps with conduit affiliates are generally not countable by non-U.S. counterparties.
38 See SEC Proposed Rules at 31024. See also the related discussion of jurisdiction at the end of this Update.
39 SEC Adopting Release at 39069-70.
40 See CFTC, Request for Comment on Application of Commission Regulations to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in the United States, 79 Fed. Reg. 1347 (Jan 8, 2014).
41 SEC Adopting Release at 39148.
42 By contrast, the CFTC’s extraterritorial jurisdiction is provided under Dodd-Frank Section 722(d), which added Section 2(i) of the Commodity Exchange Act, which provides that CFTC swap rules shall not apply to “activities outside the US unless those activities have a direct and significant connection with activities in, or effect on, commerce of the United States.” The CFTC Guidance elaborated on the statutory provision, indicating that the CFTC’s cross-border swap jurisdiction reaches: “activities outside the United States that have either: (1) A direct and significant effect on U.S. commerce; or, in the alternative, (2) a direct and significant connection with activities in U.S. commerce, and through such connection present the type of risks to the U.S. financial system and markets that Title VII directed the [CFTC] to address.” CFTC Guidance at 45300.
43 In the introductory section of this Update, see “Definition of Guarantee.”
44 Morrison v. National Australia Bank, 561 U.S. 247 (2010).
45 SEC Adopting Release at 39081-82 (emphasis added).
46 SEC Adopting Release at 39082 (emphasis added).
47 SEC Adopting Release at 39104, note 316 (emphasis added).
48 See supra note 38 and accompanying text.
49 See Section 250.1 (“Cross-border antifraud law-enforcement authority”).
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