On May 10, 2019, the U.S. Securities and Exchange Commission (SEC) proposed rule changes and interpretive guidance (the Proposal) related to the treatment of security-based swaps (SB swaps) that have certain cross-border characteristics.1 Most important, the SEC is reconsidering the treatment of SB swaps that are “arranged, negotiated or executed” by U.S.-based personnel of non-U.S. dealers. The SEC had addressed that subject through rulemaking in February 2016.2
Under the Proposal:
- New guidance would exclude certain market-facing activity that is U.S. based from being considered “arranging” or “negotiating” if certain conditions were met.
- The SEC’s existing “de minimis exception” to SB swap dealer registration requirements would be modified to permit a non-U.S. SB swap dealer to exclude certain SB swaps from its de minimis calculations.
- Certain SB swap dealer requirements would be subject to conditional exceptions.
- Additional new guidance and modifications would apply in the case of a limited number of other rules that relate to non-U.S. SB swap dealers.
Analogous cross-border rules and guidance apply to swaps over which the U.S. Commodity Futures Trading Commission (CFTC) exercises primary jurisdiction (non-SB swaps). The CFTC’s last formal action in that regard was a rule proposal in October 2016 (CFTC Cross-Border Proposal),3 which remains outstanding; more recently, the CFTC’s Chairman addressed the subject in a white paper (CFTC Chairman White Paper).4
In this Sidley Update, we will discuss the SEC’s Proposal and how it relates to the SEC’s existing SB swap rules and guidance; we will also discuss how the Proposal relates to certain aspects of the CFTC’s existing and proposed non-SB swap rules and guidance.
The Proposal is a step toward the SEC’s long-delayed completion of rulemaking for SB swap dealers, as required under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.5 Before its SB swap dealer registration requirements come into effect,6 the SEC must determine when and how its rules will apply to an SB swap between a dealer and a counterparty where each is a non-U.S. person and the swap is “arranged, negotiated or executed” by U.S.-based personnel of the non-U.S. dealer (or of its agent).7 The SEC previously provided guidance, which the Proposal is revisiting, regarding which activities are covered by the phrase “arranged, negotiated or executed” (ANE Activities). Once a non-U.S. dealer’s SB swaps with non-U.S. counterparties are identified as having resulted from ANE Activities of U.S.-based personnel (ANE Transactions), the question remains which SB swap requirements will apply to those SB swaps (ANE Requirements).
In the Proposal, the SEC addresses ANE Activities and then certain ANE Requirements that will apply to resulting ANE Transactions. The Proposal first proposes additional interpretive guidance regarding the “market-facing” actions of U.S.-based personnel that will be deemed ANE Activities of a non-U.S. dealer. The Proposal then offers two alternative means by which the SEC’s existing “de minimis exception” to SB swap dealer registration requirements may be expanded with respect to ANE Transactions. The Proposal also seeks comment regarding whether certain other SB swap dealer requirements should be subject to conditional exceptions related to ANE Activities; those requirements include (i) SB swap reporting and public dissemination requirements and (ii) SB swap business conduct requirements.
After addressing ANE-related matters, the Proposal proposes supplemental guidance and specific rule changes with respect to (i) SEC Rules 15Fb2-1 and 15Fb2-4, regarding certain certification and opinion of counsel requirements, (ii) SEC Rule of Practice 194, regarding associated persons who are subject to a statutory disqualification and (iii) proposed SEC Rule 18a-5, regarding recordkeeping for an SB Swap Entity8 that either (A) has a prudential regulator or (B) does not have a prudential regulator and is registered with the SEC only as an SB Swap Entity (and not also as a broker-dealer).
Comments regarding the Proposal must be submitted to the SEC no later than 60 days after the Proposal’s publication in the Federal Register.
In the balance of this Sidley Update, we will address the elements of the Proposal in turn. With respect to those elements that address ANE Activities and ANE Requirements, we will also briefly consider the analogous requirements and proposals of the CFTC as they apply to non-SB swaps.
As discussed below, there is a range of regulatory consequences when U.S. personnel of a non-U.S. dealer engage in ANE Activities in connection with an SB swap with a non-U.S. counterparty. The Proposal focuses on the first two kinds of ANE Activities: the “arranging and negotiating” of SB swaps.9 The Proposal notes that the SEC has previously focused on those activities because they are “market-facing” activities that, if undertaken in the United States, properly trigger SB swap dealer regulation.10 However, the Proposal states that the SEC
has come to recognize that there are significant variations among the types of market-facing activity that may occur in connection with security-based swap transactions, and that U.S. personnel in some circumstances may engage in activity that, although market-facing, reasonably may not be characterized as “arranging” or “negotiating” a security-based swap transaction — as those terms are understood generally and in the context of the relevant regulatory interests.11
As a consequence, the SEC is proposing guidance that would permit U.S. personnel to provide “market color” in connection with SB swap transactions without such personnel’s engaging in ANE Activities. For that purpose, “market color” would mean
background information regarding pricing or market conditions associated with particular instruments or with markets more generally, including information regarding current or historic pricing, volatility or market depth, and trends or predictions regarding pricing, volatility or market depth, as well as other types of information reflecting market conditions and trends.12
U.S. personnel providing market color would not be engaged in ANE Activities if two conditions were met:
- No client responsibility — The U.S. personnel have not been assigned, and do not otherwise exercise, client responsibility in connection with the transaction.
- No transaction-linked compensation — The U.S. personnel do not receive compensation based on or otherwise linked to the completion of transactions on which the U.S. personnel provide market color.13
The CFTC Cross-Border Proposal sets forth the CFTC’s own proposed interpretation of the scope of ANE Activities as applied to non-SB swaps. Like the Proposal, the CFTC’s proposed interpretation distinguishes between “market facing activity normally associated with sales and trading” and “back-office activities, such as ministerial or clerical tasks, performed by personnel not involved in the actual sale or trading of the relevant swap.”14 However, the CFTC’s proposed interpretation, unlike the Proposal, does not separately address the provision of “market color.”
De Minimis Exemption From Dealer Registration Requirements
Non-U.S. dealers may engage in a “de minimis” level of SB swaps activity in the United States without triggering an obligation to register with the SEC as an SB swap dealer. Under Rule 3a71-3, a non-U.S. dealer would currently be required to include in its de minimis calculation SB swaps to the extent they are part of its dealing activity and are entered into with non-U.S. counterparties through U.S.-based ANE Activities — that is, the SB swaps are “arranged, negotiated, or executed” by personnel of the non-U.S. dealer located in a U.S. branch or office or by personnel of an agent of the non-U.S. dealer located in a U.S. branch or office.
If Rule 3a71-3 were amended in accordance with the Proposal, certain SB swaps that currently would be includable for de minimis calculations would be excluded if certain conditions are met. The Proposal sets forth those conditions in two alternative proposed rule amendments, referred to in the Proposal as “Alternative 1” and “Alternative 2.” Under Alternative 1, an SB swap that was otherwise includable because of ANE Activity in the United States would be excluded if all of the following conditions were met:
- All such ANE Activity is conducted by personnel located in a U.S. branch or office in their capacity as associated persons of a “majority-owned affiliate” that is registered with the SEC as an SB swap dealer.
- The registered SB swap dealer affiliate complies with certain specified SB swap requirements “as if” the affiliate were itself trading with the non-U.S. person’s counterparty.
- The SEC is able to access relevant books, records and testimony of the non-U.S. dealer, and the registered SB swap dealer affiliate is required to maintain records related to the transaction.
- The non-U.S. dealer consents to service of process for any civil action brought by or proceeding before the SEC.
- The registered SB swap dealer affiliate provides certain disclosures to the non-U.S. person’s counterparty.
- The non-U.S. dealer is subject to the margin and capital requirements of a “listed jurisdiction.”
As the SEC acknowledges in the Proposal, the conditions described above are similar to, in certain respects, the conditions set forth in SEC Rule 15a-6(3), which permits non-U.S. (securities) broker-dealers to operate in the United States without registering with the SEC if their activities meet certain conditions.15
For purposes of the Alternative 1 exclusion, an entity will be a “majority-owned affiliate” of another entity if
the entity directly or indirectly owns a majority interest in the other, or if a third party directly or indirectly owns a majority interest in both entities, 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.
Alternative 1 would require that the registered SB swap dealer affiliate comply with specified requirements “as if” the affiliate were acting as principal in the transaction (and not merely arranging and/or negotiating the transaction for the non-U.S. dealer). Accordingly, the affiliate would need to take steps necessary to comply with risk disclosure requirements, suitability requirements related to recommendations, requirements related to fair and balanced communications, trade acknowledgement/confirmation requirements and portfolio reconciliation requirements (but only in connection with the first time reconciliation is required).
A condition to the exclusion in Alternative 1 is that a non-U.S. dealer be subject to the margin and capital requirements of a “listed jurisdiction.” The Proposal suggests that the “listed jurisdictions” may include all or some of Australia, Canada, France, Germany, Hong Kong, Japan, Singapore, Switzerland and the United Kingdom. The Proposal notes that applications for “listed jurisdiction” status “may be expected to raise issues that are analogous to those that would accompany applications for substituted compliance in connection with margin and capital rules.”16 However, the Proposal also indicates that the contexts for evaluating the two kinds of applications — those for “listed jurisdiction” status and those related to substituted compliance — would be “materially distinct” and that the former would present risks to U.S. persons and markets that are more attenuated than the latter.17 That characterization suggests that the standards for “listed jurisdiction” applications will likely be more easily met than the standards for substituted compliance applications.
Alternative 2 mirrors Alternative 1, with one important distinction: The ANE Activities in question could be undertaken by U.S. personnel of a majority-owned affiliate that is either a registered SB swap dealer or an SEC-registered broker-dealer.
In contrast to each of the Proposal’s two alternatives, the CFTC’s own swap dealer de minimis exception simply excludes ANE Transactions without imposing any additional requirements/conditions.18 The CFTC Cross-Border Proposal noted this difference between the CFTC and SEC rules and sought comment as to whether the rules should be harmonized. 19
Reporting and Public Dissemination Requirements
Under Regulation SBSR, non-U.S. dealers (even if not registered with the SEC as SB swap dealers) are required to report and disseminate transaction information for ANE Transactions. The Proposal notes that in adopting Regulation SBSR, the SEC
determined that requiring those transactions to be reported to a registered swap data repository would “enhance the Commission’s ability to oversee relevant security-based swap activity within the United States as well as to evaluate market participants for compliance with specific Title VII requirements” and monitor for fraudulent activity.... [and] that public dissemination of those transactions would “contribute to price discovery and price competition in the U.S. security-based swap market” by providing a “more comprehensive view of activity in the U.S. market.” 20
Nonetheless, the Proposal invites commenters to address the Regulation SBSR requirements that apply only because of the ANE Activities of U.S.-based personnel.
Business Conduct Requirements
The Proposal seeks comment regarding one aspect of the SEC’s business conduct rules for registered SB swap dealers: the relevance of ANE Activities to the cross-border application of those requirements in connection with a registered SB swap dealer’s “foreign business.” The “foreign business” definition references the definition of “U.S. business,” which in part includes transactions of registered non-U.S. swap dealers that involve ANE Activities of the U.S. personnel.21
Other Proposal Matters
SEC Rules 15Fb2-1 and 15Fb2-4 — Opinion and Certification Requirements
SEC Rule 15Fb2-4 requires, among other things, that each nonresident 22 SB Swap Entity registering with the SEC certify that it can, as a matter of law, and will provide the SEC with prompt access to its books and records and submit to on-site inspection and examination by the SEC. It also requires that the nonresident SB Swap Entity obtain and provide the SEC an opinion of counsel to support that certification. These requirements are designed to provide assurances that the SEC will be able to directly access the books and records of a nonresident SB Swap entity and conduct on-site inspections and examinations of those records.
In the Proposal, the SEC proposes guidance related to SEC Rule 15Fb2-4 regarding
- the non-U.S. laws that must be covered by the certification and opinion of counsel
- the scope of the books and records that are the subject of the certification and opinion of counsel (i.e., records that relate to the “U.S. business”23 of the nonresident SB Swap Entity and financial records necessary for the SEC to assess its compliance with capital and margin requirements)
- predication of a firm’s certification and opinion of counsel, as necessary, on the nonresident SB Swap Entity’s obtaining prior consent of the persons whose information is or will be included in the books and records to allow the firm to promptly provide the SEC with direct access to its books and records and to submit to on-site inspection and examination
- applicability of the certification and opinion of counsel requirement to contracts entered prior to the date on which an SB Swap Entity submits an application for registration
- whether the certification and opinion of counsel can take into account approvals, authorizations, waivers or consents provided by local regulators 24
The SEC also proposes to amend SEC Rule 15Fb2-1 to provide additional time for a nonresident SB Swap Entity to submit the certification and opinion of counsel. Specifically, a nonresident applicant that is unable to submit the certification and opinion of counsel at the time that it applies for registration would be conditionally registered for up to 24 months (from the compliance date under amended SEC Rule 15Fb2-1) if the applicant has submitted the appropriate registration form and that form is complete in all other respects. Such a firm would remain conditionally registered until the SEC acts to grant or deny registration, but if the firm fails to provide the certification and opinion of counsel within 24 months of the compliance date, the SEC could institute proceedings to determine whether ongoing registration should be denied.
SEC Rule of Practice 194 — Associated Person Prohibition
Under SEC Rule 15F(b)(6), an SB Swap Entity is generally not permitted to allow an associated person who is subject to a statutory disqualification25 to effect or be involved in effecting SB swaps on behalf of the firm. However, the SEC has authority to provide exceptions. For example, SEC Rule of Practice 194 automatically excludes associated persons that are not natural persons, and it also establishes a process by which an SB Swap Entity can apply to the SEC to allow an associated person who is a natural person and who is subject to a statutory disqualification to effect or be involved in effecting SB swaps on its behalf.
In the Proposal, the SEC proposes to amend SEC Rule of Practice 194 to provide an exclusion (from the SEC Rule 15F(b)(6) prohibition) for an associated person of an SB Swap Entity who is a natural person and who (i) is not a U.S. person and (ii) does not effect and is not involved in effecting SB swaps with or for counterparties that are U.S. persons — other than in the case of SB swaps conducted through a non-U.S. branch26 of a counterparty that is a U.S. person.27 However, an SB Swap Entity would generally not be able to rely on the Proposal’s exclusion where the associated person is subject to an order that is described in certain designated subparts of the definition of “statutory disqualification” in the Exchange Act.28
Proposed SEC Rule 18a-5 — Employment Questionnaire and Employment Requirements
In 2014, the SEC proposed recordkeeping requirements for SB Swap Entities, including Rule 18a-5, that would apply to (i) a firm that is registered with the SEC only as an SB Swap Entity and for which there is no prudential regulator (Stand Alone SB Swap Entity) and (ii) an SB Swap Entity for which there is a prudential regulator (Bank SB Swap Entity).29 As part of that rulemaking, the SEC proposed to require an SB Swap Entity to make and keep current a questionnaire or application for employment for each associated person who is a natural person; the questionnaire or application would be required to include, among other things, the associated person’s identifying information, business affiliations for the past 10 years, relevant disciplinary history, relevant criminal record and place of business (the Questionnaire Requirement). The Questionnaire Requirement is intended to serve as a basis for a background check of any associated person who effects or is involved in effecting SB swap transactions on the SB Swap Entity’s behalf to verify that the person is not subject to a statutory disqualification.
Consistent with the proposed amendment to SEC Rule of Practice 194 described above, the Proposal sets out certain modifications to proposed SEC Rule 18a-5 that would provide that any Stand Alone SB Swap Entity or Bank SB Swap Entity would not be required to make and keep current a questionnaire or application for employment that is executed by an associated person if the respective SB Swap Entity is excluded from the statutory disqualification prohibition in SEC Rule 15F(b)(6). The Proposal also includes proposed modifications to proposed SEC Rule 18a-5 that would, regarding an associated person who is not a U.S. person, provide that any Stand Alone SB Swap Entity or Bank SB Swap Entity would not be required to record certain information mandated by the Questionnaire Requirement if either the receipt of that information or the creation or maintenance or records reflecting it would result in a violation of applicable law in the jurisdiction in which the associated person is employed or located.
1 See SEC, Proposed Rule Amendments and Guidance Addressing Cross-Border Application of Certain Security-Based Swap Requirements (May 10, 2019), available at https://www.sec.gov/rules/proposed/2019/34-85823.pdf.
2 See SEC, Security-Based Swap Transactions Connected With a Non-U.S. Person’s Dealing Activity That Are Arranged, Negotiated, or Executed by Personnel Located in a U.S. Branch or Office or in a U.S. Branch or Office of an Agent; Security-Based Swap Dealer De Minimis Exception; Final Rule, 81 Fed. Reg. 8598 (February 19, 2016), available at https://www.sec.gov/rules/proposed/2019/34-85823.pdf.
3 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), available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016-24905a.pdf.
4 See J. Christopher Giancarlo, Chairman, CFTC, Cross-Border Swaps Regulation 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation (October 1, 2018), available at https://www.cftc.gov/sites/default/files/2018-10/Whitepaper_CBSR100118.pdf; see also Sidley Update, CFTC Chairman Giancarlo's White Paper: Cross-Border Swaps Regulation 2.0 (October 12, 2018), available at https://www.sidley.com/en/insights/newsupdates/2018/10/cftc-chairman-giancarlos-white-paper.
5 Public Law 111–203, 124 Stat. 1376 (2010).
6 The SEC’s underlying SB swap dealer registration requirements will take effect only after a number of additional rulemakings have been completed (including the establishment of capital, margin and segregation requirements for SB swap dealers).
7 The Proposal states that “the term ‘U.S. personnel’ means personnel located in a branch or office in the United States of an entity that is engaged in security-based swap activity, or by personnel of an agent of that entity.” Proposal at 5 note 2 (emphasis added). We use the term “U.S. personnel” accordingly. The CFTC proposes to address agents similarly. See CFTC Cross-Border Proposal 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 [CFTC] 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).
8 As used herein, the term “SB Swap Entity” refers to SB swap dealers and major SB swap participants.
9 The Proposal does not address the third kind of activity, “executing,” Instead citing prior guidance with respect to such activity: “[T]he term ‘execute’ in the rule ‘refers to the market-facing act that, in connection with a particular transaction, causes the person to become irrevocably bound under the security-based swap under applicable law.” Proposal at 35. The Proposal separately states that “[t]he Commission does not believe there is a reason to revisit its prior guidance regarding the scope of the term ‘execute’; the Commission therefore is not providing any additional guidance regarding the interpretation of that term.” Id. at 37 note 88.
10 See id. at 11 note 16 (citing the SEC’s related 2016 rule release: “[A] non-U.S. person’s market-facing activity in the United States suggests the type of involvement in the U.S. security-based swap market that may raise financial contagion, customer protection, market integrity, and market transparency concerns”).
11 Id. at 38.
13 Id. at 40. The Proposal clarifies that “[u]nder the guidance, U.S. persons could provide market-based information in connection with security-based swap transactions ... in support of non-U.S. persons who actually arrange, negotiate and execute those transactions on behalf of their clients.” Id. at 41.
14 CFTC Cross-Border Proposal at 71953; see also CFTC Chairman White Paper at 76 (“[T]he terms “arranging” and “negotiating” would refer to market-facing activity normally associated with sales and trading as opposed to internal, 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 See Proposal at 83 note 180 and accompanying text.
16 Id. at 73.
17 Id. at 74.
18 However the exception is not available to a non-U.S. dealer if it is a “Foreign Consolidated Subsidiary” (e.g., a non-U.S. subsidiary of a U.S. parent) or is guaranteed by a U.S. person.
19 See CFTC Cross-Border Proposal at 71957 (“The [CFTC] 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?”).
20 Proposal at 97.
21 See id. at 99 note 194 and accompanying text.
22 Under the rule, a swap entity that is a corporation is “nonresident” if it is incorporated, and has its principal place of business, outside the United States.
23 17 C.F.R. § 240.3a71-3(a)(8).
24 The guidance regarding the certification and opinion of counsel requirements would also be relevant to SEC Rule 3a71-6, which allows an SB Swap Entity to comply with certain requirements under Section 15F of the Securities Exchange Act of 1934 (the Exchange Act) through substituted compliance.
25 15 U.S.C. 78o
26 17 CFR 240.3a71(a)(3).
27 The relief would not be relevant, however, to an associated person who effects or is involved in effecting SB swaps to the extent that such person’s functions are solely clerical or ministerial given that such persons are excluded from the definition of associated person in 15 U.S.C. 78c(a)(70)(B).
28 The exclusion would generally not be available if the associated person is subject to any order that is described in either subparagraph (A) or (B) of Section 3(a)(39) of the Exchange Act. See 15 U.S.C. 78c(a)(39)(A),(B). However, with regard to an order by a non-U.S. financial regulatory authority, the limitation would apply only to orders by a non-U.S. financial regulatory authority in the jurisdiction where the associated person is employed or located.
29 See SEC, Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major Security-Based Swap Participants, and Broker-Dealers; Capital Rule for Certain Security-Based Swap Dealers, 79 Fed. Reg. 25194 (May 2, 2014), available at https://www.govinfo.gov/content/pkg/FR-2014-05-02/pdf/2014-09108.pdf.
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