On October 11, 2016, the Commodity Futures Trading Commission (the CFTC) proposed a rule (the Proposed Rule)1 that addresses the cross-border application of certain of its swaps rules. The Proposed Rule, if adopted, would supersede, in important respects, the cross border interpretive guidance that the CFTC originally published in 2013 (the Cross-Border Guidance),2 which sets forth the CFTC’s initial approach to the cross-border application of its swaps rules. The Proposed Rule would extend the cross-border application of CFTC swap rules in some ways, but would limit it in others. In doing so, the Proposed Rule would generally reinforce the approach that the CFTC took earlier this year when it adopted its final rule for the cross border application of margin requirements for non-cleared swaps (the Cross-Border Margin Rule).3
Rather than following the Cross-Border Guidance, the Proposed Rule defines “U.S. person” in the same manner that the Cross-Border Margin Rule defined the term. The Proposed Rule also includes a definition for “foreign consolidated subsidiary” (or FCS), which is borrowed from the Cross-Border Margin Rule. The Proposing Release includes additional defined terms that, although not used in the Proposed Rule itself, capture important concepts supporting the Proposed Rule, such as those related to non-U.S. persons that trade with guarantees provided by U.S. persons.
The Proposed Rule would apply the new definitions (and concepts captured in the additional defined terms) in only two limited, albeit important, areas: registration thresholds for swap dealers and major swap participants (MSPs), and external business conduct standards for non-U.S. swap dealers and MSPs. However, the Proposing Release suggests that the new definitions and supporting concepts will have a broader application in the future, as the CFTC more generally revisits the subject of the cross-border application of its swaps rules.4 In particular, the CFTC indicated that it might apply the new definitions and supporting concepts when it considers whether transaction-level requirements (such as the swap clearing requirement) should apply when a non-U.S. swap dealer transacts with a non-U.S. person in a swap that is “arranged, negotiated or executed” by personnel in the United States.5 That subject is sometimes referred to as the “elevator rule” (based on comments made by former CFTC Chairman Gary Gensler).6
Comments regarding the Proposed Rule must be submitted to the CFTC by December 17, 2016.
This Sidley Update describes important elements of the Proposed Rule, highlighting key differences from the Cross-Border Guidance, and key similarities to the Cross-Border Margin Rule. Tables A, B and C below reproduce the three tabular summaries that were included in the Proposing Release.
“U.S. person”
The Proposed Rule includes a definition of “U.S. person” that is substantially the same as the definition in the Cross-Border Margin Rule. Thus, unlike the definition the CFTC put forward in the Cross-Border Guidance, the Proposed Rule’s definition does not cover collective investment vehicles that are majority-owned by U.S. persons, and it does not include a catch-all phrase (“include, but not be limited to”) that would give the CFTC broad leeway to interpret the definition beyond its enumerated component parts. However, like both the Cross-Border Guidance and the Cross-Border Margin Rule, the Proposed Rule’s definition of “U.S. person” includes a prong tied to the “principal place of business” of an entity. That prong retains its Cross-Border Guidance interpretation, which may result, for example, in a fund vehicle that is organized outside the United States but managed by a U.S. investment manager to be considered a U.S. person.7
“U.S. Guaranteed Entity” and “Guarantee”
The Proposed Rule does not include a definition of “U.S. Guaranteed Entity,” but the Proposing Release creates that defined term to capture related concepts in the Proposed Rule. The Proposing Release uses the term “U.S. Guaranteed Entity” to refer to a non-U.S. person whose obligations under the relevant swap are guaranteed by a U.S. person.8 That concept would apply under the Proposed Rule on a swap by-swap basis, depending on the presence or absence of a U.S. person’s guarantee for a particular swap. Thus, a non-U.S. person may be treated under the Proposed Rule as a U.S. Guaranteed Entity as to some transactions, but not as to others.9
The Proposed Rule also does not define “guarantee,” but the Proposing Release states that the term is used in the Proposed Rule as it is defined in the Cross-Border Margin Rule. That usage of the term depends on the presence of “rights of recourse.”10 Accordingly, “guarantee” is a narrower concept under the Proposed Rule than under the Cross-Border Guidance, where “guarantee” is interpreted broadly “to include not only traditional guarantees of payment or performance of the related swaps, but also other formal arrangements that, in view of all the facts and circumstances, support the non-U.S. person’s ability to pay or perform its swap obligations with respect to its swaps.”11
“Foreign Consolidated Subsidiary”
“Foreign Consolidated Subsidiary” (or FCS) is defined under the Proposed Rule. The definition is taken directly from the Cross-Border Margin Rule; the concept is not found in the Cross-Border Guidance. FCS means:
a non-U.S. person in which an ultimate parent entity that is a U.S. person (“U.S. ultimate parent entity”) has a controlling financial interest, in accordance with U.S. generally accepted accounting principles, such that the U.S. ultimate parent entity includes the non-U.S. person’s operating results, financial position and statement of cash flows in the U.S. ultimate parent entity’s consolidated financial statements, in accordance with U.S. generally accepted accounting principles.12
As discussed below, this term may eventually have a broad application under the CFTC’s swap rules, and may, in particular, eliminate differences in treatment between non-U.S. swap dealer subsidiaries of U.S. banking organizations that have been based on whether or not a U.S. parent guarantee is present. Thus, FCS status is not dependent on the existence of a U.S. parent guarantee.
“Other Non-U.S. Person”
“Other Non-U.S. Person” is another term defined in the Proposing Release but not in the Proposed Rule. It means a non-U.S. person that is neither an FCS nor a U.S. Guaranteed Entity.
“ANE Transactions”
The Proposing Release defines the term “ANE Transactions” to mean “swap transactions [that] are arranged, negotiated, or executed using personnel located in the United States.”13 The Proposing Release makes clear that relevant “personnel” may be those of a party’s agent, as well as those of the party itself.14 The Proposing Release then sets forth a “proposed interpretation” of the scope of ANE Transactions, which distinguishes “market facing activity normally associated with sales and trading” from “back-office activities, such as ministerial or clerical tasks, performed by personnel not involved in the actual sale or trading of the relevant swap.”15
The defined term ANE Transaction contrasts with the phraseology used by the CFTC’s staff in its November 2013 Advisory 13-69 (the Advisory). The Advisory extended an interpretation that the CFTC put forward in the Cross-Border Guidance. Footnote 513 of the Cross-Border Guidance indicates that “a U.S. branch of a non-U.S. swap dealer or MSP would be subject to transaction-level requirements, without substituted compliance available.” The Advisory suggested that such requirements would apply more broadly; they would apply to non-U.S. swap dealers “regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute a swap with a non-U.S. person.” The definition of ANE Transaction in the Proposing Release does not include the word “regularly,” which qualified the staff’s position under the Advisory. However, the Proposing Release makes clear that incidental contacts with the United States by swap dealer personnel would not trigger ANE Transaction status.16
The Proposing Release states that ANE Transactions may result from algorithmic or other automated electronic trading, if personnel located in the United States are responsible for the trading strategy or technique; however, the defined term is not triggered if the role of personnel located in the United States is limited to technical coding.17
As discussed below, ANE Transactions would not be required to be counted by a non-U.S. swap dealer against its de minimis threshold, but they would trigger a limited application of the external business conduct standards (those targeting fraudulent and deceptive practices). The definitional concept, once refined, will also play into the CFTC’s determinations regarding which transaction-level requirements should apply to given swap transactions — for example, whether a swap between a non-U.S. swap dealer and a non-U.S. counterparty (where neither party is a U.S. Guaranteed Entity or an FCS) should be subject to U.S. clearing requirements because it is arranged by personnel located in the United States.18
Application of Swap Dealer De Minimis Threshold
The Proposed Rule’s provisions regarding the swap dealer de minimis threshold, once finalized, will replace the analogous provisions of the Cross-Border Guidance.19 Under both the Cross-Border Guidance and the Proposed Rule, the principal question concerns how non-U.S. swap market participants determine whether their dealing activity exceeds the de minimis threshold for CFTC swap dealer registration. However, as discussed below, the Proposed Rule targets swap dealing transactions in two circumstances that are not captured by the Cross Border Guidance: where an FCS is the non-U.S. swap market participant’s counterparty, and where a non-U.S. branch of a U.S. swap dealer is its counterparty.
Treatment of U.S. Persons and U.S. Guaranteed Entities. Like the Cross-Border Guidance, the Proposed Rule would require swap market participants that are U.S. persons or U.S. Guaranteed Entities to count all dealing transactions against their de minimis threshold. And like the Cross-Border Guidance, the Proposed Rule would require non-U.S. swap market participants that are not U.S. Guaranteed Entities or FCSs — in the parlance of the Proposing Release, “Other Non-U.S. Persons” — to count all dealing transactions with counterparties that are U.S. persons or U.S. Guaranteed Entities.
Treatment of FCSs. The Proposed Rule would treat FCSs differently from how the Cross-Border Guidance treats such parties regarding CFTC swap dealer registration in two ways: first, with respect to which dealing transactions an FCS must count against its own threshold; and second, with respect to whether a non-U.S. swap market participant must count one of its own dealing transactions with an FCS (whether or not the FCS is itself a swap dealer).
Under the Proposed Rule, an FCS is required to count all of its swap dealing activity against its threshold, “without exception.”20 In effect, it would be treated (as to CFTC registration) in the same manner as a market participant that is a U.S. person or U.S. Guaranteed Entity. By contrast, under the Cross-Border Guidance, an FCS is not required to count dealing transactions with non-U.S. persons unless the FCS’s swap obligations are guaranteed by a U.S. person or it is considered a “conduit affiliate” under the Cross-Border Guidance.
If an FCS is a counterparty to a non-U.S. market participant that in turn is measuring its dealing activity against its own threshold, the Proposed Rule would require the non-U.S. market participant to count any dealing transaction with the FCS against its threshold. By contrast, under the Cross-Border Guidance, the non-U.S. market participant counts its dealing transactions with an FCS only if the FCS is guaranteed by a U.S. person.
The new FCS provisions of the Proposed Rule are intended, in part, to close a “loophole” that was perceived to have arisen when non-U.S. subsidiaries of U.S. banking organizations de-guaranteed themselves.21 Thus, a non-U.S. subsidiary of a U.S. banking organization would be required to count all of its dealing transactions in connection with de minimis determinations (whether or not its obligations are guaranteed by a U.S. parent). Perhaps more important, non-U.S. swap market participants that wish to remain below the de minimis threshold (to avoid swap dealer registration with the CFTC) would no longer be able to exclude dealing transactions with such subsidiaries (whether or not they are guaranteed).
Treatment of Non-U.S. Branches of U.S. Swap Dealers. In a similar vein, the Proposed Rule would encompass transactions with non-U.S. branches of U.S. swap dealers. Under the Cross-Border Guidance, non-U.S. swap market participants are not required to count transactions with such non-U.S. branches. However, under the Proposed Rule, they would be required to do so. The Proposing Release explains:
[The] exception [for non-U.S. branches of U.S. swap dealers under the Cross-Border Guidance] was primarily driven by concerns that, absent such an exception, non-U.S. counterparties would avoid transacting with U.S. SDs. Upon further consideration, however, the Commission believes that incorporating a similar exception into the Proposed Rule could create a substantial regulatory loophole.22
Treatment of ANE Transactions. As noted above, a swap market participant that is an Other Non-U.S. Person (i.e., neither an FCS nor a U.S. Guaranteed Entity) is not required to count, against its swap dealer de minimis threshold, dealing transactions with counterparties that are themselves Other Non-U.S. Persons. The Proposed Rule would not change that result even if the swap qualifies as an ANE Transaction. In other words, under the Proposed Rule, a non-U.S. swap market participant that is not an FCS or U.S. Guaranteed Entity would not be required to count an ANE transaction against its de minimis threshold unless its counterparty is a U.S. person, a U.S. Guaranteed Person or an FCS.23 An Other Non-U.S. Person would be required to include all of its swap dealing transactions with U.S. persons, U.S. Guaranteed Entities and FCSs.
However, the Proposing Release notes that the analogous SEC rule concerning registration of security-based swap dealers takes a different approach and, in effect, requires ANE Transactions of non-U.S. security-based swap market participants to be counted against their de minimis thresholds for SEC registration. The Proposing Release also includes a specific question asking whether that aspect of the Proposed Rule should be harmonized with the SEC rule.24
Treatment of Conduit Affiliates. The Cross-Border Guidance applies the term “conduit affiliate” to certain non-U.S. persons and treats the category in many respects in the same manner as it treats U.S. persons and non-U.S. persons that trade with U.S. guarantees.25 However, the term is not used in the Proposed Rule. In part, this omission may be a corollary to the introduction of the FCS category in the Proposed Rule and the resulting expanded coverage of CFTC swap rules to certain non-U.S. subsidiaries of U.S. corporate groups in the Proposed Rule.
CFTC Commissioner Sharon Bowen, however, expressed concern over the absence of the concept from the Proposed Rule.26 Moreover, the Proposing Release (but not the Proposed Rule itself) defines the term “SD conduit” and then poses a number of related questions that address circumstances where an Other Non-U.S. Person (e.g., a UK-based bank) might act as a conduit for a U.S. dealing operation undertaken by a U.S. subsidiary that was not registered as a dealer with the CFTC.27
The Proposing Release includes a tabular representation of the cross-border application of the swap dealer de minimis threshold (see Table A below).
Application of MSP Registration Thresholds
The provisions of the Proposed Rule governing which swap transactions that a potential non-U.S. MSP must count against its MSP registration threshold generally follow the swap dealer de minimis threshold requirements of the Proposed Rule described above. Thus, U.S. persons, U.S. Guaranteed Entities and FCSs would be required to count all swap transactions in determining whether they are required to register as MSPs with the CFTC.
Other Non-U.S. Persons, however, would be required to count transactions only with U.S. persons, U.S. Guaranteed Entities and FCSs. They would not be required to count transactions with counterparties that are also Other Non-U.S. Persons (even if one of the parties arranges, negotiates or executes the transaction through personnel located in the United States).
The Proposing Release includes a tabular representation of the cross-border application of the MSP registration threshold (see Table B below).
Application of External Business Conduct Standards
The Proposed Rule would apply the CFTC’s rules regarding external business conduct standards to the following swap dealers and MSPs, without the possibility of substituted compliance:
- swap dealers and MSPs that are U.S. persons: when they transact with any counterparty, except transactions concluded through the swap dealer’s or MSP’s own non-U.S. branches
- other swap dealers and MSPs: when they transact with U.S. person counterparties, except transactions with counterparties that are non-U.S. branches of U.S. person swap dealers and MSPs
The second group would include not only swap dealers and MSPs that are Other Non-U.S. Persons, but also those that are U.S. Guaranteed Entities and FCSs and those that are U.S. persons when they conclude transactions through a non-U.S. branch. When those swap dealers and MSPs transact with non-U.S. person counterparties (including U.S. Guaranteed Entities and FCSs) or with U.S. person counterparties that are trading through a non-U.S. branch, the external business conduct standards would generally not apply. However, in the case of an ANE Transaction (i.e., when the swap dealer uses its own or an agent’s personnel in the United States to arrange, negotiate or execute the transaction), the anti-fraud and fair dealing requirements of the CFTC’s external business conduct standards would apply. The Proposing Release explains:
By limiting application of the external business conduct standards to ANE transactions to the antifraud and fair dealing requirements, the Proposed Rule is tailored to ensure a basic level of counterparty protections while, consistent with the principles of international comity, recognizing the supervisory interests of the relevant foreign jurisdictions in applying their own sales practices requirements to transactions involving counterparties that are non-U.S. persons or foreign branches of a U.S. SD/MSP. This approach recognizes the supervisory interests of the local jurisdiction with respect to swaps conducted within that jurisdiction and that broadly imposing U.S. external business conduct standards with respect to such transactions would not be necessary to advance the goals of the Dodd-Frank customer protection regime.28
The Proposing Release includes a tabular representation of the cross-border application of the external business conduct standards (see Table C below).
1 See CFTC, Cross-Border Application of the Registration Thresholds and External Business Conduct Standards Applicable to Swap Dealers and Major Swap Participants; Proposed Rule, Interpretations, 81 Fed. Reg. 71946 (October 18, 2016) (the Proposing Release), available at: http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016-24905a.pdf.
2 See CFTC, Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45292 (July 26, 2013), available at: http://www.gpo.gov/fdsys/pkg/FR-2013-07-26/pdf/2013-17958.pdf. See Sidley Update, CFTC Adopts Final Cross-Border Guidance and Exemptive Order; Announces “Path Forward” with EU (July 19, 2013).
3 See CFTC, Margin Requirements for Non-cleared swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements; Agency Information Collection Activities: Proposed Collection, Comment Request: Final Rule, Margin Requirements for Non-cleared swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements; Final Rule and Notice, 81 Fed. Reg. 34817 (May 31, 2016), available at: https://www.gpo.gov/fdsys/pkg/FR-2016-05-31/pdf/2016-12612.pdf; see also Sidley Update, CFTC Adopts Cross-Border Margin Rule for Non-Cleared Swaps (August 4, 2016), available at: http://www.sidley.com/news/2016-08-04-derivatives-update.
4 See, e.g., Proposing Release at 71951, footnote 41 ("Although the Proposed Rule is focused on the
cross-border application of the registration thresholds and external business conduct standards for SD/MSPs, the Commission expects to address how other substantive Dodd-Frank swap requirements (including the trading and clearing mandates and reporting requirements) would apply to FCSs in
cross-border transactions in subsequent rulemakings.").
5 See, e.g., Proposing Release at 71953 (“[T]he Proposed Rule addresses the application of the SD registration threshold and external business conduct standards to ANE transactions. The Commission intends to address application of other Dodd-Frank swap requirements to ANE transactions in subsequent cross-border rulemakings as necessary and appropriate.”).
6 Gensler, Gary, Remarks at Swap Execution Facility Conference: Bringing Transparency and Access to Markets (November 18, 2013), available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagensler-152. (“[A] U.S. swap dealer on the 32nd floor of a New York building and a foreign-based swap dealer on the 31st floor of the same building, have to follow the same rules when arranging, negotiating or executing a swap. One elevator bank … one set of rules.”).
7 See Proposing Release at 71949, footnote 25 (“Unless expressly stated otherwise herein, the description of the U.S. person definition in the Cross-Border Margin Rule, including the Commission’s interpretation of the principal place of business test regarding funds, would also apply in the context of the Proposed Rule.”).
8 See, e.g., Proposing Release at 71954.
9 See Proposing Release at 71954, footnote 76 (“The preamble of this release uses the term ‘U.S. Guaranteed Entity’ for convenience only. Whether a non-U.S. person would be considered a U.S. Guaranteed Entity would vary on a swap-by-swap basis, such that a non-U.S. person may be considered a U.S. Guaranteed Entity for one swap and not another, depending on whether the non-U.S. person’s obligations under the swap are guaranteed by a U.S. person.”).
10 See Proposing Release at 71955, footnote 79 ("For purposes of this proposed rulemaking, ‘guarantee’ has the same meaning as defined in [the Cross Border Margin Rule], except that application of the proposed definition of ‘guarantee’ would not be limited to uncleared swaps. Under this definition, a ‘guarantee’ would include arrangements, pursuant to which one party to a swap has rights of recourse against a guarantor, with respect to its counterparty’s obligations under the swap. For these purposes, a party to a swap has rights of recourse against a guarantor if the party has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from the guarantor with respect to its counterparty’s obligations under the swap.") (emphasis added).
11 Cross-Border Guidance at 45320.
12 Proposing Release at 71973.
13 Proposing Release at 71947.
14 See Proposing Release at 71952 ("To the extent that a person uses personnel located in the United States (whether its own personnel or personnel of an agent) to arrange, negotiate, or execute its swap dealing transactions, the Commission believes that such person is conducting a substantial aspect of its swap dealing activity within the United States and therefore, falls within the scope of the Dodd-Frank Act.") (emphasis added).
15 Proposing Release at 71953.
16 See Proposing Release at 71953, footnote 66 (“The Proposed Rule would accordingly not capture the activities of personnel assigned to a non-U.S. location if such personnel are only incidentally present in the United States when they arrange, negotiate, or execute a transaction (e.g., an employee of a non-U.S. person happens to be traveling within the United States to attend a conference). Nor would the Proposed Rule include a transaction solely on the basis that a U.S.-based attorney is involved in negotiations regarding the terms of the transaction.”)
17 See Proposing Release at 71953 (“That is, a swap transaction involving algorithmic trading could be viewed as having been arranged, negotiated, or executed using personnel located in the United States if such personnel specify the trading strategy or techniques carried out through algorithmic trading or automated electronic execution of swaps. Therefore, performance of such activity by personnel located in the United States may fall within the scope of the Dodd-Frank Act and trigger the application of certain swap requirements thereunder”); Proposing Release at 71953, footnote 68 (“The activities or location of personnel responsible solely for coding the algorithm, however, as opposed to specifying the trading strategy or techniques that the algorithm is to follow, would not be relevant”).
18 See supra notes 5 and 6 and accompanying text.
19 See Proposing Release at 71954 (“If adopted, the Proposed Rule would supersede the Guidance with respect to the cross-border application of the SD de minimis threshold.”).
20 Proposing Release at 71955.
21 See Proposing Release at 71955 (“The Commission is also concerned that offering FCSs disparate treatment compared to U.S. persons could incentivize U.S. entities to conduct swap activities with non-U.S. counterparties through consolidated non-U.S. subsidiaries in order to avoid application of the Dodd-Frank Act SD requirements, creating the potential for a substantial regulatory loophole.”).
22 Proposing Release at 71956.
23 See Proposing Release at 71957 ("An Other Non-U.S. Person would include all of its swap dealing transactions with counterparties that are U.S. persons, U.S. Guaranteed Entities, or FCSs, unless the swap is executed anonymously on a registered SEF, DCM, or FBOT and cleared. It would not, however, include any of its swap dealing transactions with Other Non-U.S. Persons, even if they constitute ANE transactions.") (emphasis added).
24 See Proposing Release at 71957 (“The Commission invites comment on the appropriateness, necessity, and potential impact of requiring Other Non-U.S. Persons to include ANE transactions in their de minimis threshold calculations. Should the Commission further harmonize with the SEC by requiring Other Non-U.S. Persons to include ANE transactions in their de minimis threshold calculations?”).
25 As noted in the Proposing Release, the Cross-Border Guidance “uses the terms ‘conduit affiliate’ and ‘affiliate conduit’ interchangeably.” Proposing Release at 71956, footnote 82.
26 See Proposing Release at 71974 (“I am concerned that the current proposal does not capture the dealing activity of ‘conduit affiliates.’ A conduit affiliate is (i) a non-US affiliate that is consolidated with a US entity (or where a non-US affiliate and a US entity are consolidated) where there is no ultimate US parent and (ii) which transfers, through back to back swaps, the risk of swaps it enters into with non-US counterparties to that US person. They, in essence, serve as conduits for US entities to engage in, and ultimately assume the risk of, non-US swap activity. One would assume that these conduit affiliates would be captured by our rules and therefore would have to count this activity towards the de minimis threshold. However, this is not the case. That US entity could engage in billions of dollars of swap activity through its conduit affiliate and avoid all of our swap requirements.”).
27 See Proposing Release at 71958 ("Should an Other Non-U.S. Person that is consolidated with an affiliated U.S. SD for financial reporting purposes and that transfers some or all of the risk of a swap with an Other Non-U.S. counterparty, directly or indirectly, to its affiliated U.S. SD (an “SD conduit”) be required to count outward-facing swap as to which it acts as a conduit toward its SD or MSP registration threshold?").
28 Proposing Release at 71962.
Table A
To receive Sidley Updates, please subscribe at www.sidley.com/subscribe.
Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.
