On April 29, 2015, the U.S. Securities and Exchange Commission (SEC) proposed a rule that addresses the extent of its jurisdiction over non-U.S. persons that use U.S. personnel to arrange, negotiate or execute security-based swap (SBS) dealing transactions (SEC Proposed Rule).1 Last year, the SEC adopted several final rules setting out its cross-border SBS jurisdiction (SEC Final Rules).2 However, when it did so, the SEC tabled for further consideration the subject now addressed by the SEC Proposed Rule.3 This subject was first considered in 2013 when the SEC originally proposed rules related to its SBS cross-border jurisdiction (SEC Original Proposal).4 The comment period for the SEC Proposed Rule will end on July 13, 2015.
An analogous jurisdictional issue created some controversy for the U.S. Commodity Futures Trading Commission (CFTC) in the context of its own swaps regulations, culminating in the CFTC’s decision in early 2014 to review an advisory that the CFTC staff had published in November 2013 (CFTC Staff Advisory).5 SEC Chair Mary Jo White, in her written statement regarding the SEC Proposed Rule, emphasized that the SEC staff had “spent significant time with CFTC staff discussing how to address concerns raised by dealing activity in the United States.”6 The coordination between the agencies suggests the potential importance of the SEC Proposed Rule in the overall evolution of Title VII of Dodd-Frank, which fundamentally altered the regulation of both swaps and SBS in the United States, and in the process has had significant consequences beyond U.S. borders.
The SEC Proposed Rule would designate which SBS dealing transactions of a non-U.S. person would constitute the non-U.S. person’s “U.S. business” (and would thus be subject to certain SBS requirements of the SEC) and which would constitute its “foreign business” (and would thus not be subject to those requirements). On the basis of this distinction, the SEC Proposed Rule would require the following with respect to SBS dealers (SBSDs):
- De Minimis Calculations. When a non-U.S. SBSD evaluates its SBS dealing transactions in light of the de minimis SBS dealing threshold for SBSD registration, it would be required to count only SBS transactions that are part of its U.S. business.
- SBSD Business Conduct Standards. In most cases, an SEC-registered SBSD, whether a U.S. person or a non-U.S. person, would not be subject to SBS business conduct standards with respect to its foreign business.
- Reporting Requirements. Only SBS transactions that are part of a non-U.S. SBSD’s U.S. business would be subject to SBS data repository (SDR) reporting requirements and SBS public dissemination requirements. The requirements would apply whether or not the non-U.S. SBSD were registered with the SEC.
Notably, the SEC Proposed Rule Release states that SBS requirements related to clearing and trade execution would not apply to SBS transactions entered into by a non-U.S. SBSD with a non-U.S. person counterparty even if they are part of the SBSD’s U.S. business. The SEC stated:
[W]e are not proposing to subject transactions between two non-U.S. persons to the clearing requirement (and, by extension, to the trade execution requirement) on the basis of dealing activity in the United States, including transactions that are arranged, negotiated, or executed by personnel located in a U.S. branch or office.7
This represents a substantial change from the SEC Original Proposal, and varies from the analogous position taken in the CFTC Staff Advisory.
We provide additional detail regarding these various matters below.
U.S. Business vs. Foreign Business
The SEC Proposed Rule defines “U.S. business” and “foreign business” with respect to both U.S. and non-U.S. SBSDs.8 For non-U.S. SBSDs, U.S. business includes any SBS dealing transaction that is either:
[E]ntered into, or offered to be entered into, by or on behalf of such non-U.S. SBSD, with a U.S. person (other than a transaction conducted through a foreign branch of that person); or
Arranged, negotiated or executed by personnel of the non-U.S. SBSD located in a U.S. branch or office, or by personnel of an agent of the non-U.S. SBSD located in a U.S. branch or office.9
This approach is akin to, but in an important respect differs from, the approach taken in the SEC Original Proposal, which also defined, and distinguished between, an SBSD’s U.S. business and its foreign business. The first prong of the definition above is substantially the same as the analogous definitional element under the SEC Original Proposal. That is not surprising, given the SEC’s foundational view that when non-U.S. SBSDs transact with U.S. persons, the transactions should be subject to the SEC’s SBS rules.
However, the second prong under the SEC Proposed Rule is significantly more limited than its counterpart under the SEC Original Proposal, which broadly captured, as part of a non-U.S. SBSD’s U.S. business, all “transactions conducted within the United States.” The SEC Proposed Rule, like the SEC Original Proposal, endeavors to delineate the contours of the SEC’s “territorial approach to the application of Title VII.”10 In each case, the SEC has sought to capture front office activity associated with the execution an SBS transaction.11 But under the SEC Proposed Rule, the definitional terms narrow and focus solely on activity of the SBSD. In contrast, the SEC Original Proposal targeted SBS transactions if either the SBSD or its non-U.S. person counterparty engaged in related front office activity in the United States.
The SEC Proposed Rule Release more generally explains the SEC’s intention with respect to the kinds of front office activity the proposal seeks to capture:
[W]e intend, for purposes of the proposed rule, “arrange” and “negotiate” to indicate market-facing activity of sales or trading personnel in connection with a particular transaction, including interactions with counterparties or their agents. Also for purposes of the proposed rule, we intend “execute” to refer 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. “Arranging,” “negotiating,” and “executing” also include directing other personnel to arrange, negotiate, or execute a particular security-based swap.12
The definition expressly covers “personnel of an agent” of the non-U.S. SBSD, which would include personnel of inter-dealer brokers, as well as personnel of an SBSD affiliate, if personnel acting as agent are located in a U.S. branch or office.13 However, the SEC Proposed Rule Release helpfully distinguishes between personnel “located in a U.S. branch or office” and those “assigned to a foreign office who happen to be traveling within the United States,” indicating that the latter would not trigger the U.S. business definition.14 This nonetheless leaves U.S.-based agents, particularly inter-dealer brokers, at a potential disadvantage when arranging SBS transactions from the United States.15
The SEC Proposed Rule Release emphasizes that, whether the non-U.S. SBSD is acting directly via its own personnel or through an agent’s personnel in the United States, the activity targeted concerns the economic terms of a transaction. The SEC distinguishes between determining the economics of a transaction and negotiating related documentation,16 and the SEC Proposed Rule Release states that “a transaction would not be captured under the [the SEC Proposed Rule] merely because a U.S.-based attorney is involved in negotiations regarding the terms of the transaction.”17
As a consequence of the rule’s narrower target—front office activity of SBSDs, but not of their non-U.S. person counterparties—the SEC’s SBS regulation would be narrowed in three contexts: SBSD registration requirements, SBSD business conduct standards and SDR and public dissemination requirements. These are discussed below, followed by brief discussion of the SEC’s proposal to exclude from clearing and trade execution requirements even those SBS transactions executed as part of an SBSD’s U.S. business where the counterparty is a non-U.S. person. We then conclude with observations regarding the CFTC Staff Advisory.
Security-Based Swap Dealer De Minimis Thresholds
Under its rules that determine when registration as an SBSD is required, the SEC permits an SBSD to engage in a “de minimis” level of SBS dealing activity before the registration requirement is triggered. In a cross-border context, an SBSD must determine which SBS dealing transactions must be counted against its de minimis threshold and which may be excluded. Under the SEC Final Rules, a U.S. SBSD must count all dealing transactions, including those that form part of its foreign business, and a non-U.S. SBSD must count all SBS dealing transactions with U.S. person counterparties.18 The SEC Proposed Rule addresses which SBS dealing transactions of a non-U.S. SBSD with non-U.S. person counterparties must be counted against its de minimis threshold. Under the SEC Proposed Rule, a non-U.S. SBSD would count toward its de minimis threshold only those SBS dealing transactions that are part of its U.S. business.
This approach represents a significant departure from the approach in the SEC Original Proposal. Under the SEC Original Proposal, a non-U.S. SBSD would have been required to count any “transaction conducted within the United States.”19 The SEC’s focus under the SEC Proposed Rule narrows to front office activities of the non-U.S. SBSD, to the exclusion of any front office activity of its non-U.S. person counterparties. In proposing to eliminate the latter as a jurisdictional factor, the SEC explains:
[O]ur initially proposed approach . . . potentially could have imposed significant costs on, and presented compliance challenges to, market participants. . . . [T]he initially proposed definition of “transaction conducted within the United States” was sufficiently broad that it might have encompassed conduct within the United States by either counterparty to the transaction that could be characterized as “incidental.” In addition, market participants may have incurred costs associated with monitoring the location of relevant personnel acting on behalf of their counterparty and/or obtaining relevant representations from their counterparty on a transaction-by-transaction basis.20
As a consequence, a non-U.S. SBSD would not need to monitor the location of front office activity of its non-U.S. person counterparties for purposes of determining when it must count SBS dealing transactions against its de minimis threshold (or, as discussed below, when it must comply with certain business conduct standards and reporting requirements). It would continue to be required to monitor the location of its own front office personnel (and that of any affiliated or third-party agent) in order to ensure that when they are located in a U.S. branch or office, it counts the relevant SBS dealing transactions (and complies with related SEC requirements).
Business Conduct Standards
The SEC has proposed rules to implement the statutory mandate under Title VII that SBSDs comply with prescribed business conduct standards in connection with their SBS dealing activities. Those requirements include counterparty eligibility standards, various counterparty disclosure and communication requirements, making available to counterparties mark-to-market information, know-your-counterparty practices and transaction suitability requirements.21
Even under the SEC Original Proposal, the business conduct standards would have applied only to the U.S. business of registered SBSDs. However, as discussed above, the original definition of U.S. business, as applied to non-U.S. SBSD, was tied to the SEC Original Proposal’s broad conception of “transactions conducted within the United States.” Under the SEC Proposed Rule, because U.S. business is defined in a more limited fashion and, in this more limited form, continues to function as a trigger for business conduct standard requirements, the requirements themselves would be applied in a more limited manner.
The SEC stated a desire to maintain consistency between business conduct standard elements of its cross-border rules and the provisions that determine when SBSD registration is required:
[I]t is desirable that the types of activities in the United States that trigger application of the external business conduct requirements to transactions of a registered foreign security-based swap dealer with another non-U.S. person should be identical to those that require a transaction to be included in a non-U.S. person’s de minimis threshold calculations.22
It is worth noting that, although the SEC Proposed Rule most significantly concerns non-U.S. SBSDs engaged in front office activity in the United States, it would also determine when registered U.S. SBSDs would be relieved of the SEC business conduct standard requirements in connection with their activity outside the United States, because, as with a registered non-U.S. SBSD, the requirements would not apply to a U.S. SBSD’s foreign business. A U.S. SBSD’s foreign business would consist of SBS transactions conducted through a foreign branch of the U.S. SBSD with a non-U.S. person (or with a U.S. person counterparty acting through its own foreign branch). In this regard, the SEC Proposed Rule is largely consistent with the SEC Original Proposal, though is potentially at odds with CFTC swap regulation.23
SBS Transaction Reporting
The SEC Proposed Rule addresses two kinds of SBS transaction reporting requirements: SDR reporting and public dissemination. It treats each the same way, requiring in both cases that reporting occur in connection with SBS transactions that are part of a non-U.S. SBSD’s U.S. business. This approach represents a further narrowing of requirements set out in the SEC Original Proposal, which would have imposed reporting requirements on SBS “transactions conducted within the United States.” The SEC Proposed Rule would require reporting where both counterparties are non-U.S. persons but, in contrast to the SEC Original Proposal, only in cases where an SBSD is one of the parties and engages in U.S. front office activity in connection with the transaction.
Thus, under proposed amendments to the SEC’s SBS reporting rules (Regulation SBSR), SDR and public dissemination reporting would not be required for an SBS transaction between two non-U.S. counterparties if neither is an SBSD (even if one or both of the counterparties engage in front office activity in the United States in connection with the SBS transaction). Moreover, if a non-U.S. SBSD transacts from outside the United States (i.e., the SBS transaction in question is not part of its U.S. business), the transaction would not be reportable even if the SBSD’s non-U.S. counterparty transacts from within the United States. However, the reporting requirements would apply to a non-U.S. SBSD transacting as part of its U.S. business whether or not it is registered as an SBSD with the SEC. In other words, if a non-U.S. SBSD’s dealing activity remains under the SEC de minimis threshold for SBSD registration despite its having a U.S. business (as defined under the SEC Proposed Rule), it would nonetheless be required to report SBS transactions when they represent part of its U.S. business. The SEC explained:
We recognize that some commenters suggested that . . . reporting and public dissemination requirements . . . should not apply to transactions between two non-U.S. persons even if they involve activity in the United States because of operational complications or potential regulatory overlap or duplication. . . . We do not believe, however, that reporting a security-based swap . . . is likely to pose significant challenges, as the burden is borne under our rules only by one side of the transaction, and at least one counterparty to any transaction arranged, negotiated, or executed by a non-U.S. person, in connection with its dealing activity, using personnel located in a U.S. branch or office is already likely to have infrastructure in place to report transactions to a registered SDR.24
Clearing and Trade Execution Requirements
Under the SEC Original Proposal, clearing and trade execution requirements would have applied to “a ‘transaction conducted within the United States’ involving at least one registered foreign security-based swap dealer.”25 The SEC Proposed Rule reflects a different, narrower approach. As the SEC Propose Rule Release explains:
[W]e are not proposing to subject transactions between two non-U.S. persons to the clearing requirement (and, by extension, to the trade execution requirement) on the basis of dealing activity in the United States, including transactions that are arranged, negotiated, or executed by personnel located in a U.S. branch or office.26
In effect, the clearing and trade execution requirements would not apply where an SBS transaction does not give rise to counterparty risk in the United States, even though there exists a significant territorial nexus in the form of front office activity on the part of a registered SBSD related to the transaction. The SEC indicated that it did not believe that the burdens associated with the clearing and trade execution requirements would be justified by the marginal additional protection that those requirements would afford in circumstances where both counterparties are non-U.S. persons (even where one is a registered SBSD operating from the United States). The SEC explained:
Given that, under our proposed approach, a non-U.S. person that engages in significant security-based swap activity using personnel located in a U.S. branch or office is likely to be required to register and be subject to Title VII capital and margin requirements with respect to all of its transactions, we preliminarily do not believe that subjecting a subset of these persons’ activities to the clearing requirement is likely to provide a significant additional reduction in counterparty credit risk in the United States.27
Interplay with CFTC Swap Rules and Related Actions
As noted above (and at various places in the SEC Proposed Rule Release), the SEC staff consulted with CFTC staff regarding related issues arising under CFTC swap regulation. In preparing the SEC Proposed Rule, the SEC reviewed the letters that the CFTC received in response to its request for public comment regarding the CFTC Staff Advisory. Although the SEC indicated that its proposal should not be viewed as indicative of any future CFTC action in respect of the CFTC Staff Advisory,28 we believe it is instructive that the SEC nonetheless emphasized its consultation with the CFTC in that regard. Presumably the CFTC will also consult with the SEC before it takes final action to address the CFTC Staff Advisory. Such coordination could include consideration of comment letters that the SEC receives in respect of the SEC Proposed Rule; it would also seem reasonable for the CFTC to propose for public comment—rather than to finalize without further public input—its jurisdictional approach to swap trading circumstances that are similar to the SBS trading circumstances addressed in the SEC Proposed Rule.
We addressed the CFTC Staff Advisory at some length, in a previous Sidley Update.29 For present purposes, we observe that the positions taken in the CFTC Staff Advisory regarding the extent of the CFTC’s swap jurisdiction differ in significant ways from analogous positions taken in the SEC Proposed Rule and SEC Proposed Rule Release. Most notably, the CFTC Staff Advisory indicates that the CFTC’s swap clearing and trade execution requirements (along with all other “Transaction-Level Requirements” as described in the CFTC Staff Advisory) would apply when a non-U.S. CFTC-registered swap dealer enters into a swap with another non-U.S. person if personnel or agents of the non-U.S. registered swap dealer who are located in the United States are regularly used to arrange, negotiate or execute swaps with non-U.S. persons. Also of interest is the SEC Proposed Rule’s focus on front office personnel “located in a U.S. branch or office,” which can be contrasted with the CFTC Staff Advisory’s potentially broader formulation: any “non-U.S. [swap dealer] . . . regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute a swap with a non-U.S. person” (without regard to the existence of a U.S. branch or office).30
The final regulatory actions of both the SEC and the CFTC with respect to the cross-border activity addressed in the SEC Proposed Rule and the CFTC Staff Advisory will have important implications for the international swaps and SBS markets and will likely bear on related actions and positions taken by non-U.S. regulators.
1 See Securities Exchange Act of 1934 Release No. 74834 (April 29, 2015), 80 Fed. Reg. 27443 (May 13, 2015) (SEC Proposed Rule Release), available at: http://www.gpo.gov/fdsys/pkg/FR-2015-05-13/pdf/2015-10382.pdf.
2 See Securities Exchange Act Release No. 72472 (June 25, 2014), 79 Fed. Reg. 39068 (July 9, 2014) (SEC Final Rules Release), available at: http://www.gpo.gov/fdsys/pkg/FR-2014-07-09/pdf/2014-15337.pdf. A previous Sidley Update discussed the SEC Final Rule and the SEC Final Rule Release in detail. See Sidley Update, SEC Adopts Key Cross-Border Security-Based Swap Rules, Anticipates Further Rulemaking (July 21, 2014), available at: http://www.sidley.com/news/07-21-2014derivativesupdate.
3 See SEC Final Rules Release at 39069-70.
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 See CFTC Staff Advisory No. 13-69 (November 14, 2013); see also 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), available at: http://www.gpo.gov/fdsys/pkg/FR-2014-01-08/pdf/2014-00080.pdf.
6 Chair White also stated: “In developing this proposal, we have been keenly aware of the important steps that the CFTC has already taken in this area and the compliance implications that differences in our final approaches may create for market participants. The staff has carefully considered not only comments submitted to us in response to our Cross-Border Proposing Release but also the views that the CFTC received regarding a November 2013 Staff Advisory that addressed similar issues. See White, M., Statement at Open Meeting on Cross-Border Security-Based Swap Rules Regarding Activity in the United States and Pay Versus Performance (April 29, 2015), available at: http://www.sec.gov/news/statement/statement-at-open-meeting-april-29-2015.html.
7 SEC Proposed Rule Release at 27481.
8 This Sidley Update uses the terms “U.S. SBSD” and “non-U.S. SBSD” in place of the SEC Proposed Rule’s lengthier formal definitions: “U.S. security-based swap dealer” (meaning “a security-based swap dealer [as defined in the Exchange Act and related rules] that is a U.S. person) and “Foreign security-based swap dealer” (meaning “a security-based swap dealer [as defined in the Exchange Act and related rules] that is not a U.S. person). In all cases, however, the term applies whether or not the SBSD in question is registered with the SEC.
We assume throughout this Sidley Update, when speaking of a “non-U.S. person” or a “non-U.S. SBSD,” that such person or SBSD is not guaranteed by a U.S. person and is not a “conduit affiliate” of a U.S. person (which would result in different treatment of such person or SBSD under the SEC Final Rules).
9 SEC Proposed Rule Release at 27510. The SEC Proposed Rule then defines an SBSD’s “foreign business” simply as SBS transactions “other than the U.S. business of [the SBSD].”
10 SEC Proposed Rule Release at 27463.
11 Although the SEC does not use the phrase “front office,” both the SEC Original Proposal and the SEC Proposed Rule address activities commonly considered “front office.” See SEC Original Proposal at 31207 (defining “transaction conducted within the United States” as a transaction “that is solicited, negotiated, executed, or booked within the United States, by or on behalf of either counterparty to the transaction, regardless of the location, domicile, or residence status of either counterparty to the transaction” (emphasis added)); SEC Proposed Rule Release at 27510 (defining “U.S. business” in relevant part to include a transaction that is “arranged, negotiated, or executed by personnel of the [non-U.S. SBSD] located in a U.S. branch or office, or by personnel of an agent of the [non-U.S. SBSD] located in a U.S. branch or office” (emphasis added); see also SEC Proposed Rule Release at 27467 note 173 (explaining that the word “solicit” in the SEC Original Proposal was replaced by “arrange” in the SEC Proposed Rule “in recognition of the fact that a dealer, by virtue of being commonly known in the trade as a dealer, may respond to requests by counterparties to enter into dealing transactions, in addition to actively seeking out such counterparties”; and explaining why the word “booked” was dropped from the litany).
12 SEC Proposed Rule Release at 27467-68.
13 See SEC Proposed Rule Release at 27464 (“[A] dealer may carry out . . . market-facing activities . . . using either its own personnel or the personnel of an affiliated or unaffiliated agent. . . . Alternatively, the dealer may in some circumstances determine to engage the services of an unaffiliated agent through which it can engage in dealing activity. For example, a dealer may determine that using an inter-dealer broker may provide an efficient means of participating in the inter-dealer market in its own, or in another, jurisdiction, particularly if it is seeking to do so anonymously or to take a position in products that trade relatively infrequently.”)
14 See SEC Proposed Rule Release at 27469 (“The proposed amendment generally would not require a non-U.S. person to consider activity of personnel who are not located in a U.S. branch or office, such as participation in negotiations of the terms of a security-based swap by an employee of the dealer assigned to a foreign office who happens to be traveling within the United States. We preliminarily believe that this type of activity is incidental and therefore not likely to raise the concerns that the proposed approach is intended to address to the same degree as dealing activity carried out by personnel who are located in a U.S. branch or office.”)
15 The SEC recognizes this potential disadvantage, but deems it nonetheless appropriate. See SEC Proposed Rule Release at 27470 footnote 196.
16 See SEC Proposed Rule Release at 27468 (indicating that “preparing underlying documentation for the transaction, including negotiation of a master agreement and related documentation, or performing ministerial or clerical tasks in connection with the transaction as opposed to negotiating with the counterparty the specific economic terms of a particular security-based swap transaction, also would not be encompassed by the proposed approach” (emphasis added)).
17 SEC Proposed Rule Release at 27468 footnote 180.
18 See Rule 3a71-3 (17 CFR 240.3a71-3) (paragraphs (b)(1)(i) and (b)(1)(iii)).
19 See SEC Proposed Rule Release at 27446-47.
20 SEC Proposed Rule Release at 27467.
21 SEC Proposed Rule Release at 27474.
22 SEC Proposed Rule Release at 27473.
23 See SEC Original Proposal at 31016-18; SEC Proposed Rule Release at 27475 footnote 243. The CFTC Staff Advisory indicated that all CFTC “Transaction-Level Requirements” (which would include the external business conduct standards for CFTC-registered swap dealers) would apply to swap transactions described in the advisory.
24 SEC Proposed Rule Release at 27483 footnote 323 (emphasis added).
25 SEC Proposed Rule Release at 27481.
26 SEC Proposed Rule Release at 27481.
27 SEC Proposed Rule Release at 27482.
28 SEC Proposed Rule Release at 27447-48 footnote 27 (stating that “neither our discussions of [the CFTC Staff Advisory and related comments received by the CFTC] nor any preliminary views expressed herein should be interpreted as necessarily reflecting the views of any other agency or regulator, including the CFTC.”)
29 See Sidley Update, CFTC Staff Action Addresses CFTC Cross-Border Jurisdiction, Echoes SEC’s Proposed Territorial Approach (December 6, 2013).
30 The language used in the SEC Proposed Rule is closer to the language that the CFTC originally used in its cross-border guidance (which the CFTC Staff Advisory then expanded upon). See CFTC, Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45291 (July 26, 23013) at 45350 footnote 513 (“[T]he Commission takes the view that a U.S. branch of a non-U.S. swap dealer or MSP would be subject to Transaction-Level requirements.” (emphasis added)), available at: http://www.gpo.gov/fdsys/pkg/FR-2013-07-26/pdf/2013-17958.pdf.
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