Derivatives Regulation Update: Latest U.S. Developments · Julian Hammar, Of Counsel, Morrison &...

Derivatives Regulation Update: Latest U.S. Developments

Teleconference

Tuesday, October 18, 2016

12:00 PM – 1:30 PM EDT

Presenters:

Julian Hammar, Of Counsel, Morrison & Foerster LLP James Schwartz, Of Counsel, Morrison & Foerster LLP

1. Presentation

2. Morrison & Foerster Client Alert – “CFTC Releases Its Final Staff Report on the Swap Dealer De Minimis Exception”

3. International Financial Law Review – “A Step Closer”

4. International Financial Law Review – “Setting the Scene”

5. Futures and Derivatives Law Report, Volume 36, Issue 8 –

“The Federal Reserve’s Proposed Rules for Financial Contracts of Global Systemically Important Banking Organizations and ISDA’s Resolution Stay Jurisdictional Modular Protocol”

6. Morrison & Foerster Client Alert – “CFTC Approves Supplemental Proposal

on Position Limits to Permit Exchanges to Recognize Non-Enumerated Bona Fide Hedges”

7. Morrison & Foerster Client Alert – “CFTC Issues Final Rules Regarding the Cross-Border Application of its Uncleared Swaps Margin Requirements”

8. Morrison & Foerster Client Alert – “SEC Issues Business Conduct Rules for Security-Based Swap Entities”

9. Morrison & Foerster Client Alert – “SEC Adopts Rule Amendments Addressing

Dealing Transactions Between Non-U.S. Persons that are ‘Arranged, Negotiated, or Executed’ in the United States”

https://www.mofo.com/resources/events/161018-derivatives-regulation-update.html

https://www.mofo.com/people/julian-hammar.html

https://www.mofo.com/people/james-schwartz.html

© MORRISON & FOERSTER LLP 2016 | mofo.com

Derivatives Regulation Update:

Latest U.S. Developments

October 18, 2016

Julian Hammar

James Schwartz

NY2-777738

• With more than six years having passed since the enactment of Dodd-Frank, regulatory agencies and market participants are still grappling with Title VII

• Questions as to the amount of swap dealing activity that will be permitted before an entity is required to register as a swap dealer

• Margin requirements now in process of being phased in

• Position limits for swaps still not set

• CFTC has recently proposed relief for certain foreign entities that is necessary because Dodd-Frank added swaps to the definition of commodity interest

• SEC requirements for security-based swaps and security-based swap dealers are still not finalized

Introduction and Overview

2

• Recent proposed regulations not required by Title VII of Dodd-Frank have also raised questions relating to the treatment of derivatives

• The SEC has proposed to limit significantly investment companies’ use of derivatives

• The Federal Reserve has proposed to limit significantly the commodities activities of financial holding companies

• Banking regulators have proposed rules that, when finalized, will likely require many market participants to waive certain termination rights in connection with many derivatives

Introduction and Overview,

cont’d. 3

• Our topics today will reflect these developments

• Topics will include:

• CFTC De Minimis Exception Developments

• Uncleared Swaps Margin Rules Update

• New CFTC Cross Border Proposal

• New CFTC Mandatory Clearing Determinations

• CFTC Position Limits Supplemental Proposal

• CFTC Proposed Registration Relief for Certain Foreign Persons and Annual Reports for Commodity Pool Operators;

• SEC Title VII Implementation

• SEC Proposal Regarding Investment Companies’ Use of Derivatives

• Federal Reserve’s Proposal to Further Limit FHCs’ Commodities Activities

• Federal Reserve and OCC Proposed Rules for Financial Contracts of Banking Institutions and Related Matters

Topics to be Covered

4

• The de minimis threshold is the measure of how much swap dealing activity a market participant can engage in without being required to register as a swap dealer

• In 2012 the CFTC set the threshold at $3 billion in notional amount of swap dealing activity over the course of a year, but with a phase-in period, during which the threshold is $8 billion

• That phase-in period is still ongoing

• However, under the rule, at the end of 2017 the threshold would automatically drop from $8 billion to $3 billion

• Last month, CFTC Chairman Timothy Massad announced that he would recommend a one-year extension of the date on which the swap dealer de minimis threshold is scheduled to drop, until December 31, 2018

• Chairman Massad stated that the extension would be through a CFTC order and that, given the importance of the issue, a delay was the sensible and responsible thing to do

• On October 13, 2016, the CFTC issued its extension order

CFTC De Minimis Exception Developments

5

• The extension order establishes December 31, 2018 as the termination date for the de minimis threshold phase-in period and is effective upon issuance (Oct. 13, 2016)

• The CFTC notes that it may take further action regarding the de minimis threshold prior to the new termination date

• The order states that it is prudent to extend the phase-in period by one year in order to provide additional time for more information to become available to reassess the de minimis exception, noting that reliable data was not yet available for several asset classes of swaps as found in the CFTC staff report on the de minimis exception, although data quality is improving

• The order also notes that a capital regulation for non-bank swap dealers has not been adopted, and implementation of the uncleared swaps margin rules is underway – a delay would allow the CFTC to finalize the capital rule and assess margin implementation, which should provide helpful information in further assessing the impact of changing the de minimis threshold

• A delay also provides clarity to market participants for when they need to begin preparing for a change in the de minimis exception

CFTC De Minimis Exception

Developments, cont’d 6

• The CFTC order follows the CFTC’s release, on August 15 of this year, of the final report of the CFTC Staff on the de minimis exception

• CFTC regulations require the CFTC Staff to draft such a report, and provide that nine months after publication of such report, and after giving due consideration to that report and associated public comment, the CFTC may either terminate the phase-in period, thus reducing the de minimis threshold to $3 billion, or determine that it is in the public interest to propose an alternative to the $3 billion de minimis threshold amount

• The final report, like the preliminary report that preceded it, notes numerous deficiencies with its underlying data

• That data lacked, among other things

• Detail regarding which swaps constitute dealing activity and

• For certain swaps, reliable notional amount data or information regarding the identities of the counterparties



• Such issues with data quality forced the Staff to make numerous assumptions to interpret the data, and limited the Staff’s ability to assess with precision the potential results of changes to the de minimis threshold

• Significantly, however, notwithstanding these difficulties with data quality, the final report finds that only a very material increase or decrease in the de minimis threshold would have a significant impact on the amount of interest rate and credit default swap activity covered by swap dealer regulation, whether measured by number of transactions, number of counterparties, or notional amount

• The final report finds that, if the de minimis threshold were lowered to $3 billion, as currently contemplated, approximately 84 additional entities trading in interest rate swaps and credit default swaps might be required to register as swap dealers



• However, as compared with the current $8 billion de minimis threshold, with a $3 billion threshold “less than 1% of additional notional activity and swap transactions and less than 4% of additional unique counterparties would potentially be covered by swap dealer regulation,” and thus “additional regulatory coverage” would be “insignificant”

• Similarly, if the de minimis threshold were raised to $15 billion, while approximately 34 fewer entities trading in interest rates and credit might be subject to registration as swap dealers, overall coverage would decrease by less than 1%, whether measured by notional amounts, number of transactions or unique counterparties.



• While these numbers appear to provide a ready justification for keeping the de minimis threshold at its current $8 billion level, the final report gives little indication of how the CFTC will ultimately address the de minimis exception

• Apart from its finding that only a large change in the de minimis threshold would have a material impact on the amount of interest rate and credit default swap activity covered by swap dealer regulation, the final report seems somewhat perfunctory



• In its discussion of alternatives to the current de minimis exception and its inventory of key issues, the final report suggests the CFTC may wish to consider, among other things, whether to:

• Keep the de minimis notional threshold at its current $8 billion level, allow it to drop to $3 billion as scheduled, or delay its reduction while the CFTC continues its efforts to improve data quality;

• Exclude from the de minimis threshold, after further study, as the CFTC staff did not have sufficient time to study the matter, swaps that are traded on a swap execution facility or designated contract market, or cleared;

• Maintain a single de minimis threshold based on notional amounts, rather than a threshold based on additional factors, such as counterparty or transaction counts;

• Maintain the current single gross notional de minimis exception rather than adopting an asset class-specific approach; and

• Request the staff to obtain further information to continue to assess the insured depository institution (“IDI”) exclusion, which allows an IDI to exclude from its de minimis calculations certain swaps that it enters into with its borrowing customers, to determine whether the conditions of that exclusion are overly restrictive.



• Compliance with rules requiring the exchange of margin began on September 1, 2016 for the largest swap dealing institutions and their counterparties

• Uncleared margin rules also went into effect in Japan and Canada for large institutions, while compliance with European Union rules has been delayed, although recently the European Commission approved its version of uncleared margin rules to go into effect phased in from Jan. 2017, subject to no objection by the European Parliament and Council

• In general, the roll out went reasonably smoothly, although not without hiccups

• CFTC issued no-action relief on Sept. 1 that expired on Oct. 3, 2016 from the requirement that swap dealers have third party custodial agreements in place for initial margin subject to certain conditions, in response to the high volume of such agreements required and limited number of custodians

• This relief did not apply to prudentially-regulated swap dealers

Uncleared Swaps Margin Requirements Update

12

• CFTC also issued in September its first substituted compliance determination under its rules for the cross-border application of the uncleared swaps margin requirements for Japan, finding that Japanese rules were comparable to CFTC rules, except with respect to margin for inter-affiliate swaps

• This permits compliance with Japanese rules in lieu of CFTC rules in certain circumstances

• It does not apply to prudentially-regulated swap dealers and, to date, the Prudential Regulators have not issued a comparability determination

• An important upcoming date will be March 1, 2017, when variation margin requirements will go into effect for many counterparties other than the largest swap dealing institutions

Uncleared Swaps Margin

Rules Update, cont’d 13

• To facilitate the broader implementation of variation margin, ISDA has published its 2016 Variation Margin Protocol, which is intended to address documentation changes necessary to comply with the variation margin requirements that will apply to a large number of market participants starting in March 2017

• The protocol is considered to be somewhat complex, and some market participants, particularly those with a small number of covered swap entity counterparties, may prefer to amend their agreements bilaterally (to the extent that their counterparties will permit them to do so)

Uncleared Swaps Margin

Rules Update, cont’d 14

• CFTC issued cross-border “guidance” in July of 2013

• Addresses which substantive rules apply to which swaps and which counterparties

• “Guidance,” not rules, but generally treated as rules

• In May of this year, the CFTC issued final rules regarding cross-border application of its uncleared swaps margin rules

• On October 11, 2016, the CFTC proposed new rules regarding cross-border issues

• SEC has not issued comprehensive final rules or guidance

• In general, the SEC is far behind the CFTC in finalizing its rules

• However, the SEC has provided targeted cross-border rules with respect to each substantive rule as it gets finalized (e.g., rules for counting cross-border SBS toward the de minimis threshold, Reg. SBSR, external business conduct standards), and thus appears to be taking a rule-by-rule rather than a comprehensive approach.

Status of U.S. Cross-Border Rules

15

• In May of this year, the CFTC finalized its rules for the cross-border application of its margin requirements for uncleared swaps

• The rules are complex and may be challenging for market participants to implement

• They state the extent to which Covered Swap Entities (“CSEs”) subject to regulation by the CFTC must comply with the CFTC’s margin rules

• They also state the procedures according to which the CFTC will make substituted compliance determinations with respect to margin requirements

• The CFTC will make element-by-element determinations as to comparability, and, as a result, could make substituted compliance determinations for some, but not all, of a foreign jurisdiction’s margin requirements

CFTC Cross-Border Margin Rules

16

• The final rules contain intriguing disparities from the CFTC’s cross-border guidance

• Increased scope for potential substituted compliance determinations

• Narrowing definition of “U.S. Person”

• Narrowing definition of “guarantee”

• These changes appear to indicate that the CFTC is stepping back from certain problematic aspects of its cross-border guidance

• Increased scope for potential substituted compliance determinations

• Under CFTC’s cross-border guidance, transactions between a non-U.S. dealer and a U.S. person are subject to the CFTC’s rules (although substituted compliance may apply to transactions between the non-U.S. dealer and the foreign branch of U.S. swap dealer)

• However, under the proposed cross-border rules applicable to margin requirements, substituted compliance could apply to transactions between a non-U.S. swap dealer and most U.S. persons (other than U.S. swap dealers)

CFTC Cross-Border Margin

Rules, cont’d 17

• Narrowed definition of “U.S. Person” for purposes of margin requirements

• Deletion of “includes, but is not limited to” at beginning of definition

• Provides greater legal certainty

• Deletion of investment vehicles majority-owned by U.S. persons

• Narrowed definition of “guarantee”

• Guarantee is defined specifically, as an arrangement pursuant to which a party to an uncleared swap has rights of recourse against a guarantor with respect to its counterparty’s obligations under the uncleared swap

CFTC Cross-Border Margin

Rules, cont’d 18

• The general rule is that (i) CSEs that are U.S. persons and (ii) non-U.S. CSEs whose obligations under a swap are guaranteed by a U.S. person must comply with the CFTC’s margin rules

• However, a U.S. CSE, or a non-U.S. CSE whose obligations are guaranteed by a U.S. person, may in certain circumstances satisfy its obligation to post initial margin to certain counterparties in accordance with comparable non-U.S. rules

• Specifically, a U.S. CSE, or a non-U.S. CSE whose obligations are guaranteed by a U.S. person, may satisfy its obligation requirement to post initial margin by posting initial margin that its counterparty is required to collect in accordance with a foreign jurisdiction’s margin requirements, but only if, among other things

• The counterparty is neither a U.S. person nor a non-U.S. person whose obligations under the relevant swap are guaranteed by a U.S. person; and

• The CFTC has made a substituted compliance determination with respect to such foreign jurisdiction’s requirements regarding the posting of initial margin

CFTC Cross-Border Margin – U.S. CSEs

19

• With respect to non-U.S. CSEs, the CFTC’s rules provide an exclusion under which a non-U.S. CSE is not required to comply with the CFTC’s margin rules

• Under that exclusion, with respect to each uncleared swap entered into by a non-U.S. CSE whose obligations under the relevant swap are not guaranteed by a U.S. person, such non-U.S. CSE is not required to comply with CFTC’s margin rules if:

• The non-U.S. CSE is not a U.S. branch of a non-U.S. CSE;

• The non-U.S. CSE is not a “Foreign Consolidated Subsidiary” (that is, a non-U.S. CSE whose ultimate parent is a U.S. person that consolidates the non-U.S. CSE for accounting purposes); and

• The counterparty to the uncleared swap is a non-U.S. person (other than a Foreign Consolidated Subsidiary or the U.S. branch of a non-U.S. CSE), whose obligations under the relevant swap are not guaranteed by a U.S. person

CFTC Cross-Border Margin – Non-U.S. CSEs

20

• However, the exclusion does not apply to certain circumstances in which the non-U.S. CSE enters into a swap with an U.S. affiliate that transfers to the affiliate risk arising out of the relevant uncleared swap

• If the exclusion does not apply with respect to an uncleared swap, then substituted compliance may apply

• In relation to an uncleared swap between

• A non-U.S. CSE whose obligations under the relevant swap are not guaranteed by a U.S. person and

• A counterparty that is not a U.S. CSE or a non-U.S. CSE whose obligations under the relevant swap are guaranteed by a U.S. person,

substituted compliance may apply, and thus the non-U.S. CSE may satisfy margin requirements by complying with the margin requirements of a foreign jurisdiction to which such non-U.S. CSE is subject if the CFTC has issued a comparability determination with respect to that foreign jurisdiction

CFTC Cross-Border Margin –

Non-U.S. CSEs, cont’d 21

• This differs from the CFTC’s general cross-border guidance, which would generally apply the CFTC’s margin requirements to swaps between non-U.S. swap dealers and all U.S. persons, with substituted compliance available only for swaps between a non-U.S. swap dealer and a foreign branch of a U.S. swap dealer.

• In addition, in relation to an uncleared swap between

• A non-U.S. CSE whose obligations under the relevant swap are not guaranteed by a U.S. person and

• A counterparty that is a U.S. CSE or a non-U.S. CSE whose obligations under the relevant swap are guaranteed by a U.S. person,

the non-U.S. CSE may satisfy its requirement to collect initial margin by collecting initial margin in accordance with a relevant foreign jurisdiction’s margin requirements if the CFTC has issued a comparability determination with respect to such foreign jurisdiction’s margin requirements

CFTC Cross-Border Margin –

Non-U.S. CSEs, cont’d 22

• With respect to substituted compliance determinations, the CFTC will review foreign margin requirements on an element-by-element basis

• In order to request a comparability determination, a CSE or a foreign regulatory authority must provide the CFTC with, among other things, information regarding numerous elements of the relevant non-U.S. margin rules

• Under the rules, the CFTC may make substituted compliance determinations for certain elements of a non-U.S. margin regime and not others, in which case market participants may be required to comply with certain aspects of the U.S. rules and certain aspects of the non-U.S. rules

CFTC Margin – Comparability Determinations

23

• To request a comparability determination, a CSE or a foreign regulatory authority must provide the CFTC with information regarding the following elements of the relevant non-U.S. rules:

• The products subject to the foreign jurisdiction’s margin requirements;

• The entities subject to the foreign jurisdiction’s margin requirements;

• The treatment of inter-affiliate derivative transactions;

• The methodologies for calculating the amounts of initial and variation margin; and

• The process and standards for approving models for calculating initial and variation margin models.

CFTC Margin – Comparability

Determinations, cont’d 24

• On September 8, 2016, the CFTC issued its first comparability determination with respect to the uncleared swaps margin requirements under Japanese rules, finding that the Japanese rules were, for the most part, comparable to CFTC rules.

• The determination generally permits CSEs that are subject to both the CFTC’s and Japan Financial Services Agency’s (“JFSA’s”) uncleared swaps margin rules to comply with the CFTC’s rules through substituted compliance with Japan’s uncleared swaps margin rules that have been found comparable, as provided for under the Cross-Border Margin Rules.

CFTC Issues Comparability Determination for Japan

25

• The CFTC did not find Japanese rules comparable with respect to margin for uncleared inter-affiliate swaps because the JFSA does not have any margin requirements for inter-affiliate swaps, while CFTC rules require exchange of VM and, in some cases, IM with respect to such swaps.

• Accordingly, a CSE entering into an uncleared swap with an affiliate will have to comply with CFTC rules.

• For the requirements that the CFTC found comparable, it did not insist that Japanese requirements be identical to its requirements.

• Rather, it adopted a more outcomes-based approach, assessing whether JFSA requirements were comparable to the CFTC’s in purpose and effect.

Japan Comparability Determination

26

• Thus, for example, under CFTC rules, all IM posted or collected by a CSE must be held by an independent third-party custodian.

• While not a requirement under JFSA rules, JFSA rules do require that IM must be held in a trust structure, which the CFTC found comparable because property deposited to a trust account under Japanese law is recognized as segregated from the property of the trustor, property of the trust bank, and other trust property.

• Similarly, although JFSA rules do not have as high a haircut for certain equities posted as collateral that are not contained in the S&P 500, they have a higher haircut (and thus are more stringent) for corporate bonds than the CFTC’s rules.

• Commissioner Bowen dissented from these and certain other comparability determinations, arguing that third party custodianship is an important safeguard in the event of bankruptcy.

Japan Comparability

Determination, cont’d. 27

• Another concern she raised was that the Prudential Regulators have not issued a comparability determination, so, for example, Japanese swap dealers registered with the CFTC that are subject to the Prudential Regulators’ rules will not be able to substitute compliance with Japanese rules in the same way as those Japanese swap dealers that are subject to the CFTC’s rules.

• Despite these concerns, the CFTC’s approach appears to be a pragmatic one, recognizing that some flexibility is need if an international framework is to be implemented, and that, other than with respect to inter-affiliate swaps for which the JFSA has no rule, its other rules achieve comparable outcomes to CFTC rules.

• The determination became effective on September 15, 2016.

Japan Comparability

Determination, cont’d 28

• On October 11, 2016, the CFTC issued proposed rules to address certain cross-border issues.

• Specifically, the proposed rules define key terms for purposes of applying the CEA on a cross-border basis, including definitions of U.S. person and foreign consolidated subsidiary.

• The proposal also includes an interpretation regarding transactions “arranged, negotiated or executed” in the United States.

• In addition, the proposal addresses the cross-border application of swap dealer and major swap participant registration thresholds and the cross-border applicability of the external business conduct standards, including the extent to which they would apply to swap transactions that are arranged, negotiated, or executed using personnel located in the United States. These rules, if adopted, would supersede the CFTC’s Cross-Border Guidance.

• The proposal will be open for public comment until 60 days after publication in the Federal Register.

CFTC Cross-Border Proposal

29

• The proposed rules would define the terms “U.S. Person” and “Foreign Consolidated Subsidiary” (“FCS”) in line with the definitions in the cross-border uncleared swaps margin rules.

• These definitions would be used for purposes of the other rules contained in the proposal, and for purposes of any subsequent rulemakings addressing the cross-border application of Dodd-Frank requirements.

CFTC Proposal – Definitions

30

• The proposal contains an interpretation regarding the scope of transactions that are “arranged, negotiated, or executed” in the United States (“ANE”) that would be subject to Dodd-Frank.

• The proposed interpretation of ANE is substantively identical with the interpretation adopted by the SEC defining these terms earlier this year in connection with cross border security-based swap dealing.

• The interpretation provides that the terms “arrange” and “negotiate” 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. The terms would not encompass activities such as swap processing, preparation of the underlying swap documentation (including negotiation of a master agreement and related documentation), or the mere provision of research information to sales and trading personnel located outside the United States.

• The term “executed” would refer to the market-facing act of becoming legally and irrevocably bound to the terms of a swap under applicable law.

Proposed Interpretation

31

Under the proposed rule, in making its swap dealer de minimis calculation:

• A U.S. person would include all of its swap dealing transactions.

• A non-U.S. person would include all swap dealing transactions with respect to which it is a “U.S. Guaranteed Entity.” For purposes of the proposed rules, “guarantee” has the same meaning as in the cross-border margin rules.

• An FCS would include all of its swap dealing transactions.

• A non-U.S. person that is neither an FCS nor a U.S. Guaranteed Entity (“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 designated contract market, swap execution facility, or foreign board of trade and cleared.

• Other Non-U.S. Persons would not, however, include any of their swap dealing transactions with Other Non-U.S. Persons, even if they constitute ANE transactions.

• This differs from the SEC approach, which requires that ANE transactions be included in a Non-U.S. person’s security-based swap dealing de minimis calculation.

Cross-Border Application of Swap Dealer

Registration Thresholds

32

• Notably, the Proposal does not address “conduit affiliates,” which, under the Cross-Border Guidance, are required to count all of their swaps transactions toward the de minimis threshold, although it includes a series of questions requesting comment regarding conduits.

• Consistent with the approach taken in the Cross-Border Guidance, the proposed rules provide that potential swap dealers, whether U.S. or non-U.S. persons, would aggregate their swap dealing transactions with those of persons controlling, controlled by, or under common control with the potential swap dealer to the extent that those affiliates are themselves required to include those swaps in their own de minimis thresholds, unless the affiliated person is a registered swap dealer.

Cross-Border Application of Swap

Dealer Registration Thresholds,

cont’d 33

• An entity that is not a swap dealer would count swap positions toward the major swap participant threshold calculations to the same extent as potential swap dealers count swap dealing transactions toward the swap dealer de minimis calculation, with the exception of the aggregation requirement.

• In addition, all swap positions that are subject to recourse would be attributed to a guarantor, whether it is a U.S. person or a non-U.S. person, unless the guarantor, the guaranteed entity, and its counterparty are “Other Non-U.S. Persons.”

Cross-Border Application of Major Swap

Participant Registration Thresholds

34

• The proposed rules would apply the CFTC’s external business conduct (“EBC”) standards to cross-border transactions as follows:

• U.S. swap dealers and major swap participants (SD/MSPs) would comply with applicable EBC standards, without substituted compliance, except with respect to transactions conducted through a foreign branch of the U.S. SD/MSP.

• Non-U.S. SD/MSPs and foreign branches of U.S. SD/MSPs would comply with applicable EBC standards, without substituted compliance, if the counterparty is a U.S. person (other than a foreign branch of a U.S. SD/MSP).

• Non-U.S. SD/MSPs and foreign branches of U.S. SD/MSPs would not be subject to EBC standards for their swaps with non-U.S. persons and foreign branches of a U.S. SD/MSP, except that non-U.S. SDs and foreign branches of U.S. SDs that enter into transactions ANE would be required to comply with CFTC Reg. 23.410 (Prohibition on Fraud, Manipulation, and other Abusive Practices) and 23.433 (Fair Dealing), without substituted compliance.

Cross-Border Application of External Business

Conduct Standards

35

• On September 28, 2016, the CFTC expanded the existing clearing requirement for interest rate swaps to include fixed-to-floating interest rate swaps, basis swaps, forward rate agreements, and overnight index swaps denominated in currencies that were not covered by the CFTC’s first clearing requirement determination.

• Specifically, the expanded interest rate swaps required to be cleared include:

• Fixed-to-floating interest rate swaps denominated in Australian dollar (AUD), Canadian dollar (CAD), Hong Kong dollar (HKD), Mexican peso (MXN), Norwegian krone (NOK), Polish zloty (PLN), Singapore dollar (SGD), Swedish krona (SEK), and Swiss franc (CHF);

• Basis swaps denominated in AUD;

• Forward rate agreements (FRAs) denominated in NOK, PLN, and SEK; and

• Overnight index swaps (OIS) denominated in AUD and CAD, as well as U.S. dollar-, euro-, and sterling-denominated OIS with termination dates up to three years.

CFTC Expands Clearing Requirement

36

• The end-user exception may be elected with respect to the expanded set of swaps subject to mandatory clearing, just as with the initial set.

• Also as under the first mandatory clearing determination, market participants will not be required to clear swaps subject to the determination entered into before the applicable compliance date.

• The compliance schedule differs from that for the first clearing determination, which was phased in based on the type of market participant.

• Instead, the phased-in compliance schedule is based on when analogous clearing requirements have taken, or will take, effect in non-U.S. jurisdictions for each type of swap subject to the determination.

• There is a two-year time limit after the determination is published in the Federal Register.

CFTC Expands Clearing

Requirement, cont’d 37

• On May 26, 2016, the CFTC approved a proposed supplement (“Supplemental Proposal”) to its December 2013 proposal to establish position limits on 28 core physical commodity contracts and economically equivalent futures, options, and swaps (“2013 Position Limits Proposal”).

• The Supplemental Proposal would provide for a new process for exchanges to recognize certain positions in commodity derivatives contracts as “non-enumerated” bona fide hedges (not already enumerated in CFTC regulations) or enumerated anticipatory bona fide hedges, as well as to exempt from CFTC position limits certain spread positions, in each case subject to CFTC review.

CFTC Position Limits Supplemental Proposal -

Overview

38

• In addition, the Supplemental Proposal would amend the definition of the term “bona fide hedging position” for physical commodities and certain other definitions contained in the 2013 Position Limits Proposal.

• It would also delay the requirement that designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) establish and monitor position limits on swaps where the DCM or SEF lacks access to sufficient swap position information.

• Comment period on the Supplemental Proposal closed on July 13, 2016.

Overview

39

• Under the 2013 Position Limits Proposal, the CFTC limited the definition of the term bona fide hedging position to an enumerated list of hedging strategies.

• A hedging strategy not on the list would not qualify as a bona fide hedge, and, in order to exceed an applicable position limit, a market participant would either have to request an interpretive letter from CFTC staff that would recognize the proposed hedging strategy as a bona fide hedge or seek exemptive relief from the CFTC.

• Some commenters expressed the concern that the 2013 Position Limits Proposal’s narrow definition of enumerated hedges would exclude legitimate hedging transactions commonly used by commercial enterprises.

• Also, the processes for obtaining relief, which could only be obtained from the CFTC or its staff, did not provide for deadlines or standards, which raised concerns about whether a response could be obtained in a commercially reasonable time.

Background

40

• In response to these concerns, the CFTC issued the Supplemental Proposal, which provides for:

• Exchange recognition of bona fide hedges and exemption of spread positions,

• Makes amendments to the definition of the term bona fide hedging position, and

• Delays exchange-set position limits for swaps.

Supplemental Proposal

41

• The Supplemental Proposal includes three proposed regulations that would permit exchanges to submit to the CFTC rules pursuant to which the exchange could, respectively:

• Recognize non-enumerated bona fide hedging positions (“NEBFHs”),

• Grant exemptions to position limits for certain spread positions, and

• Recognize enumerated anticipatory bona fide hedging positions.

• Market participants would be required to apply for recognition as bona fide hedges or spread exemptions prior to exceeding any applicable position limit, which would include both exchange-set and CFTC-set limits.

• Any recognition of a bona fide hedge or grant of a spread exemption by the exchange would apply for one year, after which a market participant would be required to reapply.

Exchange Recognition of Hedges and Spread Exemptions

42

• The CFTC would review an exchange’s actions through these processes under its rule enforcement review program.

• It also would retain the ability to review an exchange’s determination to recognize any non-enumerated hedge position as bona fide (or an enumerated anticipatory bona fide hedging position) or grant of a spread exemption, either before or after an exchange makes a determination or grants an exemption.

• If after such a review the CFTC determines to reverse a determination or revoke an exemption granted by the exchange, the recipient of the determination or exemption would be afforded a commercially reasonable amount of time to reduce its position below the applicable position limit.

CFTC Review of Exchanges’ Actions

43

• In order for an exchange to process applications for recognizing bona fide hedges or granting spread exemptions, it would have to meet certain requirements that are generally similar under the three proposed regulations.

• For example, an exchange may process NEBFH applications only if (i) the commodity derivative is a “referenced contract,” (ii) the exchange lists the commodity derivative contract for trading, (iii) the commodity derivative contract is actively traded on the exchange, (iv) the exchange has established position limits for the commodity derivative contract, and (v) the exchange has at least one year of experience and expertise administering position limits for the commodity derivative contract.

• Exchanges would not be permitted to recognize an NEBFH or grant a spread exemption involving a commodity index contract and one or more futures contracts subject to position limits (i.e., risk management exemptions).

Requirements for Exchanges

44

• If an exchange recognizes an NEBFH or grants a spread exemption, the Supplemental Proposal would require that the exchange post a summary of the general hedging strategy or spread position to its website (without revealing the identity of the hedger) that would be subject to CFTC review.

• With regard to NEBFHs only, an exchange would be permitted to establish separate application processes under its rules for persons to demonstrate why a position constitutes an NEBFH under novel facts and circumstances and under facts and circumstances substantially similar to a position for which a summary has been published.

• In the latter case, the process may be less expansive.

• Exchanges also would have certain recordkeeping and reporting requirements.

Requirements for Exchanges,

cont’d 45

• Each of the three processes includes detailed application requirements for market participants, including any additional information necessary for the exchange to process the application.

• In addition, an exchange would be required to have rules requiring that applicants file a report (that must be kept updated) with the exchange when such applicants own or control a position that has been recognized as a bona fide hedge (or granted a spread exemption).

• Such applicants would be required to report the offsetting cash position (in the case of a spread exemption, applicants must report each component of the spread).

Requirements for Market Participants

46

• The Supplemental Proposal also would amend the definition of the term bona fide hedging position, which the exchanges must follow in recognizing non-enumerated bona fide hedges.

• The amended definition essentially tracks the definition of bona fide hedging in Section 4a(c)(2) of the CEA.

• The 2013 Position Limits Proposal had defined the term bona fide hedging position to include two requirements in addition to those included in the statutory definition: (i) the “orderly trading requirement” and (ii) the “incidental test,” which were contained in the CFTC’s regulatory definition of bona fide hedging.

• Under the orderly trading requirement, a bona fide hedging position would have to be established and liquidated in an orderly manner in accordance with sound commercial practices.

• The incidental test would have required that the risks offset by a commodity derivatives position must be incidental to the position holder’s commercial operations.

Amendments to the Definition of Bona Fide Hedging

47

• The Supplemental Proposal would eliminate the orderly trading requirement and the incidental test from the definition of the term bona fide hedging position.

• With regard to the orderly trading requirement, the CFTC stated that it is not aware of a denial of a bona fide hedge due to a lack of orderly trading on an exchange and notes that disruptive trading activity by a commercial entity engaged in establishing or liquidating a hedging position would generally appear to be contrary to its economic interests.

• Moreover, the CFTC noted that market participants would remain subject to other provisions within the CEA in any event, such as restrictions on disruptive trading and manipulation, and thus the orderly trading requirement is unnecessary.

Amendments to the Definition

of Bona Fide Hedging, cont’d 48

• With respect to the incidental test, the CFTC states that it interprets the incidental test similarly to the requirements of the statutory requirement that bona fide hedges be “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise,” rendering the incidental test unnecessary.

• The CFTC also confirmed that it continues to read the statutory “economically appropriate” test to refer to price risk only (consistent with its interpretation of the “incidental test’) and does not include other risks, such as execution, logistics, or credit risk.

Amendments to the Definition

of Bona Fide Hedging, cont’d 49

• The Supplemental Proposal also proposes to temporarily delay the requirement for an exchange to establish position limits on swaps where the exchange lacks access to sufficient swap position information.

• The CFTC states that it believes that most exchanges do not have access to sufficient swap position information at this time to effectively monitor swap position limits.

• The Supplemental Proposal includes proposed guidance that would provide that DCMs or SEFs need not demonstrate compliance with the position limit core principles applicable to swaps until they have access to sufficient swap position information, after which the guidance would no longer be applicable.

• While providing for this delay in exchange-set limits, CFTC-set position limits would apply to swaps that are economically equivalent to referenced futures contracts subject to federal limits.

Delay of Exchange-Set Limits for Swaps

50

• This summer the CFTC proposed rules that would expand an existing exemption for certain foreign entities from registration as a commodity pool operator, commodity trading adviser, introducing broker or futures commission merchant

• The proposed rules would largely codify existing no-action relief that the CFTC has previously given to foreign entities that are

• Engaged in activities for persons outside of the U.S. or

• Acting for International Financial Institutions (“IFIs”)

• CFTC rule 3.10 currently provides exemptions for foreign entities that might otherwise be required to register as CPOs, CTAs, IBs or FCMs, but by their terms, those exemptions require that, in order for such exemptions to apply, the related commodity interest transactions must be submitted for clearing

CFTC Proposed Relief for Foreign Persons

51

• Dodd-Frank amended the term “commodity interest transaction” to include swaps, and not all swaps are cleared or available for clearing

• Accordingly, the CFTC has proposed to amend the exemptions to omit the clearing requirement

• Under the proposed amended regulations, a person located outside the United States, its territories, or possessions engaged in activity that meets the definition of an FCM is not required to register as an FCM if such activity is either

• Solely that of a foreign broker (defined to solicit or accept orders only from persons located outside the United States, its territories, or possessions) or

• Solely on behalf of IFIs

CFTC Proposed Relief for

Foreign Persons, cont’d 52

• Similarly, under the proposed amended regulations, a person located outside the United States, its territories, or possessions that is engaged in activity that meets the definition of an IB, CTA or CPO is not required to register as such if its activity is solely on behalf of either

• persons located outside the United States, its territories, or possessions or

• IFIs

• The proposed regulations define IFI to include numerous institutions, as well as any other institution that the CFTC might designate

• IFIs listed in the proposed regulations include, among others, the International Monetary Fund, the International Bank for Reconstruction and Development, the European Bank for Reconstruction and Development, the International Development Association, the International Finance Corp., the Multilateral Investment Guarantee Agency, the African Development Bank, the African Development Fund, the Asian Development Bank and the Inter-American Development Bank

CFTC Proposed Relief for

Foreign Persons, cont’d 53

• The CFTC on August 5, 2016, issued a proposal to amend its rules governing commodity pool annual reports, which, if adopted, would permit CPOs of a pool located outside the United States to use accounting standards established in certain enumerated non-U.S. jurisdictions in lieu of U.S. Generally Accepted Accounting Principles (“GAAP”) when preparing the pool’s financial statements.

• The proposal would also exempt a newly formed commodity pool from the audit requirement covering the first fiscal year when the period from pool formation to the fiscal year end is three months or less, under certain conditions.

• The comment period on the proposal, which generally would codify no-action relief previously granted by CFTC staff, closed on September 6, 2016.

CFTC Proposal Rules governing CPO Annual Reports

54

• The proposal would expand the conditional exemption in CFTC Reg. 4.22(d)(2) from using U.S. GAAP in preparing a non-U.S. pool’s financial statements, which currently applies to the International Financial Reporting Standards (“IFRS”), to accounting standards or practices followed in the United Kingdom, Ireland, Luxembourg and Canada, provided that the jurisdiction under whose laws the pool was organized follows such standards or practices.

• Currently, Reg. 4.22(d)(2) is not self-executing and requires the CPO to file a notice with the National Futures Association (“NFA”), which would remain the case under the proposal.

Expansion of Exemption from using U.S. GAAP

55

• The proposal would also amend CFTC Reg. 4.22(g)(2) to exempt from the audit requirement applicable to the Annual Report for a commodity pool’s first fiscal year when the period from pool formation to the end of the pool’s first fiscal year is three months or less.

• In these circumstances, the cost of an audit for the short period of time of the pool’s operation would be unduly burdensome relative to the pool’s size.

• To rely upon the exemption, the pool would have to have no more than 15 participants and no more than $1.5 million in capital contributions during the period from the formation of the pool to the end of the pool’s first fiscal year.

• For this purpose, the following persons and their capital contributions would not be counted: (i) the pool’s CPO, its commodity trading advisor, and any of their principals; (ii) a child, sibling, or parent of the participants described in (i); (iii) the spouse of any of the participants described in (i) or (ii); (iv) any relative of one of the participants described in (i) through (iii); and (v) an entity that is wholly owned by one or more of the participants described in (i) through (iv).

Exemption from Audit Requirement

• To rely on the exemption, a CPO would be required to obtain, prior to the date on which the annual report for the first fiscal year is due, a specified written waiver from each pool participant of the right to receive an audited annual report and include a specified legend on an unaudited annual report and the pool’s first audited annual report.

• The pool’s first audited annual report would be required to cover the period from the formation of the pool to the end of the pool’s first 12-month fiscal year. In addition, the CPO would be required to file a notice with the NFA along with a certification that the CPO had received the written waiver from each of the pool’s participants.

• Finally, the proposal would make a conforming amendment to CFTC Reg. 4.22(c) making exemptive relief from the annual report audit requirement under that regulation unavailable for pools that cease operation when a CPO has not previously distributed an audited annual report or filed an audited annual report with NFA, such as the case where the CPO has claimed relief under proposed CFTC Reg. 4.22(g)(2), and the pool ceases operations before the end of its first 12-month fiscal year.

Exemption from Audit

Requirement, cont’d 57

• The Dodd-Frank Act divides regulatory responsibility for the derivatives market between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC)

• The CFTC regulates swaps and swap dealers

• The SEC regulates security-based swaps and security-based swap dealers

• Also major swap participants and major security-based swap participants

• The swaps markets are larger than the security-based swaps markets

• The CFTC is generally understood to regulate about 90-95 percent of the overall market and the SEC about 5-10 percent of the overall market

• There are expected to be fewer SBSDs than there are SDs

• Currently there are approximately 104 registered swap dealers (and very few major swap participants)

• The SEC estimates that there will be about 50 SBSDs

SEC Title VII Implementation

58

• The CFTC and the SEC have taken significantly different approaches to their regulatory responsibilities under Title VII

• CFTC: aggressive timing, requirements phased in over time, no-action relief granted when requirements prove impracticable

• SEC: much less aggressive timing, looks like more of a “big bang” approach

• More than six years after Dodd-Frank was enacted, very few of the SEC’s rulemakings regarding security-based swaps require compliance, though the SEC has proposed all of its major rules under Title VII and has finalized a growing number of them

• Although there are still questions about implementation, it appears that many of the SEC’s SBS regulations will go live at the time when SBS dealers are required to register, so when registration will be required is an important question

SEC vs. CFTC

59

• In late 2012, when the CFTC required registration of swap dealers, a number of the CFTC’s rules had not yet gone into effect and the CFTC had not yet finalized its guidance on the cross-border application of its regulations

• In contrast, it appears that substantially all of the SEC’s SBSD rules may be final by the time when SBSD registration is required

• Accordingly, SBSD registration should be a more predictable process than swap dealer registration was

• SBSD applicants should be able, to a significant degree, to model their SBSD policies, procedures and processes after their swap dealer policies, procedures and processes

• On the other hand, the burden will be heavier on SBSD applicants to think through a greater number of rules than swap dealers had to think through by the time when they registered, including margin rules and the cross-border application of the SEC’s regulatory regime

SEC vs. CFTC, cont’d 60

• Among the major compliance issues and challenges facing swap dealer registrants are:

• Policies and procedures: developing the required policies and procedures to demonstrate compliance with all relevant laws and regulations

• Applicable substantive requirements: determining which substantive requirements apply to which transactions and to which market participants, especially, for non-U.S. registrants, in light of the SEC’s rules for cross-border transactions

• Supervision and CCO compliance: demonstrating that a strong supervisory system is in place, with skilled supervisory personnel along with a qualified CCO

• IT and related infrastructure: the ability to comply with the required policies and procedures will demand IT and infrastructure development

Big Picture Considerations

61

• The SEC’s final rules for the registration of SBSDs, released last year, set out the formal requirements for SBSD registration

• Timing for SBSD registration is difficult to predict, but at this point the best guess is in the second half of 2017

• Under the SEC’s registration rules, the compliance date, when SBSD registration will be required, will occur only after the occurrence of several events that, taken together, have not yet occurred, cannot occur for a minimum of six months, and still seem relatively unlikely to occur until after significantly more than six months have passed

SEC Registration Rules for SBSDs

62

• Specifically, the compliance date will occur on the latest of:

• Six months after the date of publication in the Federal Register of a final rule release adopting rules establishing capital, margin and segregation requirements for SBSDs;

• The compliance date of final rules establishing recordkeeping and reporting requirements for SBSDs;

• The compliance date of final rules establishing business conduct requirements for SBSDs; and

• The compliance date for final rules establishing a process for a registered SBSD to make an application to the SEC to allow an associated person who is subject to a statutory disqualification to effect or be involved in effecting security-based swaps on the SBSD’s behalf

SEC Registration Rules – Timing

63

• First timing requirement: six months after the date of publication of a final rule release adopting rules establishing capital, margin and segregation requirements for SBSDs

• The SEC proposed margin and capital rules in October 2012

• After the SEC proposed those rules, in September 2013 the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published their framework for margin for non-centrally cleared derivatives

• The other U.S. regulators that had proposed margin rules prior to the release of the BCBS/IOSCO framework (that is, the CFTC and the prudential banking regulators) re-proposed their rules after the release of the framework

• Although it’s not entirely clear, given the importance and the complexity of the margin rules, it seems likely that the SEC will also re-propose its rules rather than issuing a new set of final rules without an opportunity for full public comment

• Commenters including the Investment Company Institute have urged the SEC to re-propose

SEC Registration Rules –

Timing, cont’d 64

• Second timing requirement: the compliance date of final rules establishing recordkeeping and reporting requirements for SBSDs

• The SEC proposed the relevant recordkeeping and reporting rules in 2014

• The rules have not yet been finalized

• Dodd–Frank itself expressly requires SBSDs to maintain daily trading records of security-based swaps and related records (including records of related cash or forward transactions), including emails, instant messages and recordings of telephone calls

• Proposed rules would require extensive recordkeeping and also extensive financial disclosure, based on broker-dealer reporting rules


Timing, cont’d 65

• Third timing requirement: the compliance date of final rules establishing business conduct requirements for SBSDs

• The SEC finalized its business conduct rules in April 2016

• The release accompanying the final business conduct rules provides that their compliance date will generally be the compliance date of the SEC’s registration rules

• The rules reflect such Dodd-Frank requirements as the designation of the CCO as well as the duties of SBSDs including monitoring of trading, risk management procedures, disclosure of information, providing information to the SEC, and conflicts of interest

• Although there is a great deal of overlap between the SEC’s business conduct rules and the CFTC’s rules, they are not the same in all details

• Not clear what approach the industry will take to compliance with the business conduct standards


Timing, cont’d 66

• Business conduct standards (cont.)

• In particular, not clear SBSDs will be able to rely on information provided by counterparties in connection with ISDA’s existing Dodd-Frank protocols, which have facilitated compliance with the CFTC’s business conduct rules

• The SEC business conduct rules provide that an SBSD may rely on written representations of its counterparties to satisfy its due diligence requirements unless it has information that would cause a reasonable person to question the accuracy of the representation

• However, the SEC expressly rejected a commenter’s suggestion that SBSDs could necessarily rely on a counterparty’s pre-existing written representations with respect to the CFTC’s business conduct rules to satisfy its due diligence requirements under the SEC business conduct rules

• Industry is in the early stages of determining how to address the requirements


Timing, cont’d 67

• Fourth timing requirement: compliance date for final rules establishing a process for a registered SBSD to make an application to the SEC to allow an associated person who is subject to a statutory disqualification to effect or be involved in effecting security-based swaps on the SBSD’s behalf

• The SEC proposed these rules in August 2015

• The rules have not yet been finalized

• Proposed rules state the process by which a SBSD may apply for disqualified associated persons to effect or be involved in effective security-based swaps

• Rules apply to both natural and non-natural persons

• Require a showing that it would be in the public interest to permit the associated person to effect or be involved in effecting security-based swaps

• Require significant amount of information regarding the person and his/her/its responsibilities and regulatory status


Timing, cont’d 68

• Documentation standards

• The SEC recently finalized rules relating to trade acknowledgement and verification of SBS transactions

• The rules provide documentation standards for the timely and accurate acknowledgment and verification of security-based swaps by SBSDs

• “Trade Acknowledgment” is essentially a confirmation

• To be provided by the SBSD promptly, but in any event by the end of the first business day following the day of execution

• Any trade acknowledgment must

• Disclose all the terms of the security-based swap transaction and

• Be provided through electronic means that provide reasonable assurance of delivery and a record of transmittal

• A SBSD must establish, maintain, and enforce written policies and procedures that are reasonably designed to obtain prompt verification of the terms of a trade acknowledgment

Certain Other SBSD Rules

69

• Regulation SBSR

• Relates to reporting and dissemination of security-based swap information

• Issued in final form last year and then amended this year

• Outlines the information that must be reported and publicly disseminated for each security-based swap transaction

• Assigns reporting duties for many security-based swap transactions

• If both sides of a security-based swap transaction are SBSDs, then they choose the reporting side

• If only one side is a SBSD, then that side will be required to report

• Recent amendments to Regulation SBSR require a platform (i.e., a national securities exchange or security-based swap execution facility) or a registered clearing agency to report certain security-based swaps

Certain Other SBSD Rules,

cont’d 70

• SEC Chair Mary Jo White (at an open meeting on July 13, 2016)

• “Title VII assigned the Commission responsibility for security-based swaps, and fully implementing the framework for these products is a key priority for all of the Commissioners and staff. This year, we have continued to finalize these significant rules… Next in line will be to finalize the remaining substantive requirements for dealers — in particular, their requirements for capital, margin, and asset segregation, as well as recordkeeping and statutory disqualification. Our goal is to have completed the regulations for both dealer activity and reporting by the end of this year.”

Completion of SBSD Rules This Year?

71

• In December 2015, the SEC proposed rules regarding the use of derivatives by investment companies and business development companies

• The market’s expectation is that the SEC will adopt final rules by sometime early next year

• The proposed rules, if adopted without substantial modification, would:

• Limit the notional amounts of derivatives into which funds may enter

• Require many funds to adopt comprehensive written derivatives risk management programs, actively overseen by their boards of directors

• Modify and clarify current requirements that a fund segregate assets in connection with derivatives held in its portfolio

• Impose substantial recordkeeping requirements

SEC Proposal on Investment Companies’ Use

of Derivatives

72

• The SEC takes the view that derivatives may constitute “senior securities” for purposes of the Investment Company Act of 1940.

• Section 18 of the 1940 Act generally prohibits an open-end fund from issuing or selling any “senior security” unless the fund maintains 300% asset coverage

• “Asset coverage” is generally the ratio of a fund’s total assets less liabilities and indebtedness not represented by senior securities, to the aggregate amount of the fund’s senior securities

• Section 18 also permits a closed-end fund to issue or sell a senior security subject to asset coverage requirements

SEC Proposal on Investment

Companies’ Use of Derivatives,

cont’d 73

• The Section 18 restrictions on senior securities are intended to prevent funds from exposing themselves and their shareholders to

• Excessive borrowing and unduly increasing the speculative character of a fund’s junior securities

• Operating without adequate assets or reserves

• Potential abuse of the purchasers of senior securities

• In 1979, the SEC issued a general statement of policy known as “Release 10666” which, among other things, made it clear that the term “senior security” may include an instrument that does not constitute a “security” for most purposes under U.S. law but which, for purposes of section 18, represented “evidence of indebtedness”

Investment Companies and Derivatives

74

• Release 10666 did not specifically apply to “derivatives” but to agreements for the purchase or repurchase of securities, including reverse repurchase agreements, firm commitment agreements and standby commitment agreements

• Release 10666 was not limited to these trading practices since the SEC wanted to address “all comparable trading practices” which could affect the capital structure of a fund

• The SEC stated that it would not raise issues under Section 18 with respect to the types of transactions addressed in the release so long as funds segregated an amount of highly liquid assets with a value equal to the full amount of their potential obligations under the relevant transactions

• The segregated account holding such assets would function as a “practical limit on the amount of leverage which the investment company may undertake”

Investment Companies and

Derivatives, cont’d 75

• For the types of transactions specifically addressed in Release 10666, the amount of assets required to be segregated was reasonably clear and based on the purchase price of the relevant security.

• Derivatives, however, raised additional issues

• How to calculate the value of assets to be segregated:

• Based on notional amount, mark-to-market value, or something else?

• Should the amount to be segregated depend on the purpose for which a particular derivative is used?

• Current SEC guidance on segregation of assets in connection with investments in derivatives is contained in more than 30 no-action letters, which address questions on an instrument-by-instrument basis

• Market practice has evolved under which, in relation to certain derivatives, funds segregate the entire notional amount, and in relation to others, they segregate only the mark-to-market value

Investment Companies and

Derivatives, cont’d 76

• The proposed rules would clarify the amounts and nature of the assets that funds are required to segregate in connection with derivatives transactions

• The proposed rules would also offer a middle ground between requiring the segregation of, on the one hand, the entirety of a transaction’s notional amount and, on the other, its current mark-to-market value.

• A fund would be required to identify on its books and records “qualifying coverage assets,” determined daily, with a value equal to the sum of the fund’s

• Aggregate mark-to-market coverage amounts and

• Risk-based coverage amounts

Proposed SEC Rules – Segregation Requirements

77

• “Mark-to-market coverage amount” would mean, for each derivatives transaction, the amount that would be payable by the fund if the fund were to exit the derivatives transaction at the relevant time

• “Risk-based coverage amount” would mean, for each derivatives transaction, an amount representing “a reasonable estimate of the potential amount payable by the fund if the fund were to exit the derivatives transaction under stressed conditions”

• In calculating both “mark-to-market coverage amounts” and “risk-based coverage amounts,” a fund could net transactions under the same netting agreement, thus reducing the amount of assets required to be segregated

• In addition, both “mark-to-market coverage amounts” and “risk-based coverage amounts” could be reduced by the amount of margin pledged by a fund to its counterparty

Proposed SEC Rules –

Segregation Requirements,

cont‘d 78

• The “mark-to-market coverage amount” would be reduced by the value of any variation margin pledged by the fund

• The “risk-based coverage amount” would be reduced by the value of any initial margin pledged by the fund

• The proposed rules would require that the assets identified on a fund’s books and records consist of “qualifying coverage assets”

• For derivatives, such assets would consist of cash and cash equivalents, or the particular asset that may be deliverable under a derivatives transaction


Segregation Requirements,

cont‘d 79

• The proposed rules would also limit the notional amounts of derivatives that funds could transact

• Portfolio limitations are a relatively blunt measurement, because derivatives can be put to many uses, and their risk profiles can vary dramatically

• The SEC is interested in finding a reasonably practicable test, even if it may not be the most refined test possible

• In order to transact derivatives, a fund would be required to conform to one of two portfolio limitations, each intended to prevent a fund from becoming excessively leveraged or speculative

• Board approval would be required for the portfolio limitation under which the fund would operate

Proposed SEC Rules – Portfolio Limitations

80

• The first portfolio limitation would be based on a fund’s “exposure,” a term defined to include, but not be limited to, the notional amounts of a fund’s derivatives

• The first portfolio limitation would require that a fund’s aggregate exposure not exceed 150% of the value of the fund’s net assets

• Exposure for these purposes would equal the sum of

• The notional amounts of a fund’s derivatives (subject to netting for directly offsetting derivatives)

• The fund’s aggregate obligations, whether conditional or unconditional, under financial commitment transactions (such as reverse repurchase agreements, firm commitment agreements and standby commitment agreements)

• Aggregate indebtedness under other senior securities transactions


Portfolio Limitations, cont’d 81

• The limitation at 150% is based on the SEC’s view that exposure levels higher than that level “could be used to take on additional speculative investment exposures that go beyond what would be expected to allow for hedging arrangements”

• Further, limiting exposure to 150% of net assets would allow a fund “to obtain a level of indirect market exposure solely through derivatives transactions that could approximate the level of market exposure that would be possible through securities investments augmented by borrowings as permitted under section 18”

• The second, risk-based, portfolio limitation would permit greater exposure, up to 300% of a fund’s net asset value, but would also require that a fund’s derivatives transactions decrease the fund’s overall market risk, as measured by “Value-at risk” or “VaR”

• The proposed rules define VaR as “an estimate of potential losses on an instrument or portfolio, expressed as a positive amount in U.S. dollars, over a specified time horizon and at a given confidence interval”



• For a fund to comply with this second limitation, its “full portfolio VaR” – that is, the VaR of the fund’s entire portfolio, including derivatives – would need to be less than the fund’s “securities VaR,” the VaR of the fund’s portfolio excluding any derivatives transactions

• Requirements for VaR models must take into account all relevant risk factors, must have a minimum 99% confidence interval, must have a time horizon of not less than 10 and not more than 20 trading days and, if using historical simulation, a minimum of three years of historical data



• Under the proposed rules, many funds using derivatives would be required to adopt and implement a written derivatives risk management program

• The requirement to adopt such a program would apply to any fund that either

• Entered into a “complex derivatives transaction” or

• Did not implement and comply with a portfolio limitation under which the notional amount of its derivatives could not exceed 50% of its net asset value

• For these purposes, a “complex derivatives transaction” is defined as one under which an amount payable by either party upon settlement, maturity or exercise

• Is dependent on the value of the underlying reference asset at multiple points in time during the term of the transaction (e.g., an Asian option or barrier option) or

• Is a non-linear function of the value of the underlying reference asset, other than due to optionality arising from a single strike price (e.g., a variance swap)

Proposed SEC Rules – Risk Management Programs

84

• Risk management programs must be reasonably designed to

• Assess the risks associated with a fund’s derivatives transactions, including an evaluation of potential leverage, market, counterparty, liquidity, and operational risks and any other risks considered relevant

• Manage the risks associated with the fund’s derivatives transactions including by:

• Monitoring whether the fund’s use of derivatives transactions is consistent with any investment guidelines established by the fund or its investment adviser, the portfolio limitations applicable to the fund, and disclosure to investors; and

• Informing persons responsible for portfolio management of the fund or the fund’s board of directors, as appropriate, regarding material risks arising from the fund’s derivatives transactions

• The proposed rules would require a fund to segregate the functions associated with the program from the fund’s portfolio management

• The program would be required to be reviewed and updated at least annually

Proposed SEC Rules – Risk

Management Programs,

cont’d 85

• Under the proposed rules, a fund’s board of directors, including a majority of directors who are not interested persons of the fund, must

• Approve the program and any material changes to it

• Approve the designation of an employee or officer of the fund or the fund’s investment adviser (who may not be a portfolio manager of the fund) responsible to administer the program

• Review, at least quarterly, a written report prepared by a person designated to administer the program that describes the adequacy of the fund’s program and the effectiveness of its implementation

• Under the proposed rules, a fund would be required to maintain, generally for a period of at least five years, extensive written records relating to, among other things, the policies and procedures adopted by the fund

Proposed SEC Rules – Risk

Management Programs,

cont’d 86

• On September 23, 2016, the Board of Governors of the Federal Reserve System (the “Board”) issued proposed rules for public comment that would impose significant capital and other prudential regulatory requirements and limitations regarding the physical commodity activities of financial holding companies (“FHCs”).

• The Board believes the proposed rules are necessary because of the potential environmental catastrophe and other risks associated with certain physical commodity activities of FHCs.

• The proposal follows a 2014 advance notice of proposed rulemaking that requested comment on whether additional prudential requirements or restrictions should be imposed on the physical commodity activities of FHCs, and a report recently submitted to Congress by the Board and other banking agencies recommending repeal of certain physical commodity-related authorities.

• The comment period closes on December 22, 2016.

Fed’s Proposal Regarding FHCs’ Commodities

Activities

87

In general, the proposed rules would:

• Significantly increase FHC’s risk-based capital requirements applicable to certain physical commodity activities and merchant banking investments in companies engaged in such activities;

• Require an FHC to include in the 5% of tier 1 capital limit imposed on physical commodities under “complementary authority,” subject to certain exceptions, all covered physical commodity activities of the FHC and its subsidiaries conducted under any authority;

• Rescind the Board’s approvals of energy management and energy tolling activities previously authorized under “complementary authority” for certain FHCs;

• Eliminate copper from the list of precious metals that bank holding companies are permitted to own and store; and

• Impose a new public reporting requirement that includes disclosures regarding the FHC’s physical commodity holdings and activities.

Proposed Rules Summary

88

• On May 11, 2016, the Board of Governors of the Federal Reserve System (the “Board”) published in the Federal Register proposed new rules intended to reduce the potential risks posed to the U.S. financial system by too-big-to-fail banks

• In addition, on August 19, 2016, the Office of the Comptroller of the Currency (“OCC”) published in the Federal Register proposed rules, substantively identical to the Board’s proposed rules, for entities that the OCC supervises

• The proposed rules have two primary goals, both aimed at facilitating the orderly liquidations of systemically important financial institutions, including under the orderly liquidation process created by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)

Proposed Rules for Financial Contracts

89

• The first goal is to assure the cross-border application of U.S. special resolution regimes to certain transactions between a counterparty outside of the U.S. and a banking entity covered by the proposed regulations

• While it is clear that existing U.S. special resolution regimes provide the U.S. regulatory agencies with the powers to prevent counterparties from exercising contractual termination rights in certain circumstances, it is not entirely clear what might happen if a court outside of the U.S. were to disregard such powers.

• The proposed rules, if adopted, will require parties to add to their contracts provisions to make clear that the U.S. special resolution regimes will apply to cross-border transactions and will thus bind authorities and parties outside of the U.S.

Proposed Rules for Financial

Contracts, cont’d 90

• The second goal is to facilitate the resolution of a covered banking entity under a “single point of entry” strategy, in which only the top-tier holding company would enter into a resolution proceeding while its subsidiaries would continue to operate and meet their financial obligations

• The regulatory agencies take the view that, to facilitate such a resolution, they must ensure that operating subsidiaries of a covered entity are not parties to contracts containing cross-default rights that their counterparties could exercise based on the entry into resolution of an affiliate of such operating subsidiaries

• The proposed rules designate both the Federal Deposit Insurance Act and the “Orderly Liquidation Authority” or “OLA” provisions contained in Title II of Dodd-Frank as “U.S. special resolution regimes”



• Both of the U.S. special resolution regimes in certain circumstances limit the contractual rights of counterparties facing certain bank entities to terminate contracts with those banks

• In addition, under both its OLA authority and the FDI Act, the Federal Deposit Insurance Corporation (“FDIC”) has the right, among other things, to transfer certain contracts to a bridge financial company, which, as contemplated by the special resolution regimes, will be capable of performing under the transferred contracts.

• After such a transfer, the bank’s counterparty no longer has the right to terminate based on events that occurred prior to the transfer

• These provisions of the U.S. special resolution regimes are in accordance with recommendations of the Financial Stability Board (“FSB”).



• After the financial crisis of 2007-09, the FSB recommended that countries put in place special resolution regimes to address failing financial institutions, especially those whose collapse could have systemic consequences

• Many countries that are members of the G20 group of nations have adopted or are in the process of adopting similar resolution regimes

• The proposed rules apply to “covered QFCs,” that is, contracts that constitute “qualified financial contracts” to which a “covered entity” is a party

• The primary difference between the Board’s proposed rules and the OCC’s proposed rules are the entities defined as covered entities.



• “Covered entities,” for purposes of the Board’s proposed rules, include:

• Any U.S. bank holding company that is identified as a global systemically important bank holding company under the Board’s rule establishing risk-based capital surcharges for global systemically important banking organizations (GSIBs);

• Any subsidiary of a U.S. GSIB described in the preceding bullet point that is not a national bank, federal savings association, federal branch or federal agency; and

• A U.S. subsidiary, U.S. branch, or U.S. agency of a non-U.S. GSIB (other than entities subject to regulation by the OCC, such as national banks, federal savings associations, federal branches or federal agencies)

• “Covered entities,” for purposes of the OCC’s proposed rules, include national banks, federal savings associations, federal branches or federal agencies that are subject to regulation by the OCC

• The proposed rules define the term “qualified financial contracts” broadly, in accordance with section 210(c)(8)(D) of the Dodd-Frank Act



• Accordingly, QFCs include many swaps, repurchase (and reverse repurchase) transactions, forward contracts, commodity contracts and securities sale, lending and borrowing transactions

• However, the proposed rules expressly exclude centrally cleared QFCs from their scope

• The “QFC” definition generally includes any master agreement that governs QFCs between parties

• The proposed rules would require covered entities to add two distinct provisions to their QFCs

• One such provision would limit the exercise of default rights under Covered QFCs

• The other provision would permit transfers of QFCs to bridge entities as contemplated by the special resolution regimes



• To clarify the cross-border application of the U.S. special resolution regimes, the proposed rules would require each covered QFC to expressly provide that default rights under such covered QFC “that may be exercised against the covered entity are permitted to be exercised to no greater extent than the default rights could be exercised under the U.S. special resolution regimes,” assuming U.S. law applied and the covered entity were under a U.S. special resolution regime

• Such a provision, if and when inserted into covered QFCs, will make clear that the covered entity’s counterparty, regardless of its jurisdiction, will have no right to terminate a covered QFC to the extent it would not have such right under the applicable U.S. special resolution regime



• The proposed rules would also require each covered QFC to support the U.S. special resolution regimes by permitting transfers of such QFCs to bridge entities as contemplated by the special resolution regimes

• Specifically, the proposed rules would require covered QFCs expressly to provide that the transfer of the covered QFC (and any interest in, or property securing, the covered QFC) from the covered entity will be effective to the same extent as the transfer would be effective under the U.S. special resolution regimes, assuming U.S. law applied and the covered entity were under a U.S. special resolution regime

• The proposed rules also contain provisions intended to support “single point of entry” resolutions of banking organizations, in which only a single legal entity, the top-tier bank holding company, is to enter into a resolution proceeding



• The agencies contemplates that a banking institution may enter into QFCs through operating subsidiaries, and, to the extent that such QFCs cause losses, those losses will be passed up from the operating subsidiaries that incurred them to the holding company, where, by means of the resolution process, the losses will be imposed on the holding company’s equity holders and unsecured creditors

• The “single point of entry” strategy is intended to ensure that the operating subsidiaries will remain adequately capitalized and able to meet their financial obligations without defaulting or entering resolution

• To facilitate this resolution strategy, the agencies believe that they must prevent counterparties facing operating subsidiaries of banking institutions from exercising default rights based on the entry into resolution or insolvency proceedings of the operating subsidiaries’ affiliates



• Accordingly, the proposed rules would provide that a covered QFC may not permit the exercise of any default right with respect to the covered QFC that is related, directly or indirectly, to an affiliate of a covered entity becoming subject to a receivership, insolvency, liquidation, resolution, or similar proceeding

• However, a covered QFC could permit the exercise of default rights based on

• A covered entity itself becoming subject to receivership, insolvency, liquidation, resolution, or similar proceeding, other than under a special resolution regime, or

• A party to a QFC, or an affiliated credit support provider, failing to meet a payment or delivery obligation under the covered QFC



• Contemporaneously with the Board’s release of its proposed rules, ISDA released its Resolution Stay Jurisdictional Modular Protocol (the “JM Protocol”), which is intended to permit market participants to comply with the provisions of the proposed rules (when adopted in their final form) and similar rules of foreign jurisdictions

• By adhering to the protocol, parties agree that their contracts with other adhering parties are amended in accordance with the terms of the relevant protocol

• The heart of the JM Protocol consists of the country-specific modules, a large majority of which ISDA has not yet published

ISDA Resolution Stay Protocols

100

• Market participants other than systemically important banks, such as asset managers, have been concerned about the possibility of breaching their fiduciary duties if they were to expressly relinquish default rights under numerous jurisdictions in the absence of any legal requirement to do so

• The JM Protocol differs from the Universal Stay Protocol and the Resolution Stay Protocol in that, by means of the JM Protocol’s country-specific modules, parties will be able to specify exactly which special resolution regime modules they will opt in to

• So far, the only jurisdictional modules that ISDA has published are the modules for Germany and the UK

• Presumably the U.S. jurisdictional module will not be published until after the Board or the OCC finalizes its proposed rules

ISDA Resolution Stay

Protocols, cont’d 101

Julian Hammar

(202) 887-1679

[email protected]

James Schwartz

(212) 336-4327

[email protected]

Questions?

102

mailto:[email protected]


• We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life sciences companies. We’ve been included on The American Lawyer’s A-List for 13 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights reserved. For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts.

• Because of the generality of this presentation, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

About Morrison & Foerster

103

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1

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Client Alert September 7, 2016

CFTC Releases Its Final Staff Report on the Swap Dealer De Minimis Exception

Last month the Commodity Futures Trading Commission (“CFTC”) released the final report of its staff (the “Staff”) on the de minimis exception to the CFTC’s definition of “swap dealer” (the “Final Report”).1 That exception, which permits a market participant not to register with the CFTC as a swap dealer if it conducts dealing activity in swaps below a specified notional amount threshold, is a key to many market participants’ determinations that they need not register as a swap dealer. Although based on problematic data and limited in its conclusions, the Final Report is part of the process, important to unregistered swap market participants, by which the CFTC will determine whether or not to modify the scheduled implementation of a lower de minimis threshold level. If the de minimis threshold is reduced, as contemplated by CFTC regulations, additional market participants will likely become subject to the swap dealer registration requirement and to the substantial body of CFTC regulations that apply to swap dealers.

CFTC regulations provide for a de minimis threshold of $3 billion in notional amount of dealing activity in swaps over a 12-month period, subject to an initial phase-in period, still ongoing, during which the de minimis threshold is $8 billion in notional amount over a 12-month period.2 However, those regulations also require the Staff to draft a report such as the Final Report, and provide that nine months after publication of such report, and after giving due consideration to that report and associated public comment, the CFTC may either terminate the phase-in period, thus reducing the de minimis threshold to $3 billion, or determine that it is in the public interest to propose an alternative to the $3 billion de minimis threshold amount.3 Accordingly, absent CFTC action amending the regulations’ timeframe, the market will likely4 know on or about May 15, 2017, nine months after the Final Report’s publication, how the CFTC will treat the de minimis threshold.

The Final Report updates the analysis contained in a preliminary report prepared by the Staff (the “Preliminary Report”),5 sets out final findings, and discusses alternatives in approaches to the de minimis threshold in light of additional data and comments received on the Preliminary Report. As required by CFTC rules,6 the Final Report examines topics relating to the de minimis threshold and the definition of “swap dealer,” including, among other things, the potential impact of modifying the de minimis threshold.

The Final Report, like the Preliminary Report before it, notes numerous and significant difficulties with its underlying data. The Staff based both reports on analyses of transaction data that market participants reported to 1 Swap Dealer De Minimis Exception Final Staff Report, a Report by Staff of the U.S. Commodity Futures Trading Commission Pursuant to Regulation 1.3(ggg), August 15, 2016, available here. 2 CFTC Regulation 1.3(ggg)(4)(i)(A). 3 CFTC Regulation 1.3(ggg)(4)(ii)(B) and (C). 4 If the CFTC does not either terminate the phase-in period or propose an alternative to the $3 billion de minimis threshold amount, then the phase-in period will terminate on December 31, 2017. See Final Report at 1; CFTC Regulation 1.3(ggg)(4)(ii)(D). 5 See Swap Dealer De Minimis Exception Preliminary Report, a Report by Staff of the U.S. Commodity Futures Trading Commission Pursuant to Regulation 1.3(ggg), November 18, 2015, available here. 6 See CFTC Regulation 1.3(ggg)(4)(ii)(B).

http://www.cftc.gov/idc/groups/public/@swaps/documents/file/dfreport_sddeminis081516.pdf

http://www.cftc.gov/idc/groups/public/@swaps/documents/file/dfreport_sddeminis_1115.pdf

2


swap data repositories. While the Final Report analyzes a calendar year of swap data in addition to the data analyzed in the Preliminary Report, and while the Final Report notes improvements in the CFTC’s analytical tools, the Final Report makes clear that its underlying data nonetheless remained problematic. That data lacked, among other things, detail regarding which swaps constitute dealing activity and, for certain swaps, reliable notional amount data or information regarding the identities of the counterparties.7 Such issues with data quality forced the Staff to make numerous assumptions to interpret the data, and limited the Staff’s ability to assess with precision the potential results of changes to the de minimis threshold.

Significantly, however, notwithstanding these difficulties with data quality, the Final Report reaffirms the Preliminary Report’s finding that only a very material increase or decrease in the de minimis threshold would have a significant impact on the amount of interest rate and credit default swap activity covered by swap dealer regulation, whether measured by number of transactions, number of counterparties, or notional amount. The Final Report interprets the data to indicate that, if the de minimis threshold were lowered to $3 billion, as currently contemplated, approximately 84 additional entities trading in interest rate swaps and credit default swaps might be required to register as swap dealers. However, as compared with the current $8 billion de minimis threshold, with a $3 billion threshold “less than 1% of additional notional activity and swap transactions and less than 4% of additional unique counterparties would potentially be covered by swap dealer regulation,” and thus “additional regulatory coverage” would be “insignificant.”8 Similarly, if the de minimis threshold were raised to $15 billion, while approximately 34 fewer entities trading in interest rates and credit might be subject to registration as swap dealers, overall coverage would decrease by less than 1%, whether measured by notional amounts, number of transactions or unique counterparties.9

While these numbers appear to provide a ready justification for keeping the de minimis threshold at its current $8 billion level, the Final Report gives little indication of how the CFTC will ultimately address the de minimis exception. Indeed, apart from its finding that only a large change in the de minimis threshold would have a material impact on the amount of interest rate and credit default swap activity covered by swap dealer regulation, the Final Report seems somewhat perfunctory and its findings less than revelatory. In its discussion of alternatives to the current de minimis exception and its inventory of key issues, the Final Report suggests the CFTC may wish to consider, among other things, whether to:

keep the de minimis notional threshold at its current $8 billion level, allow it to drop to $3 billion as scheduled, or delay its reduction while the CFTC continues its efforts to improve data quality;

exclude from the de minimis threshold, after further study, as the Staff did not have sufficient time to study the matter, swaps that are traded on a swap execution facility or designated contract market, or cleared;

maintain a single de minimis threshold based on notional amounts, rather than a threshold based on additional factors, such as counterparty or transaction counts;

maintain the current single gross notional de minimis exception rather than adopting an asset class-specific approach; and

request the Staff to obtain further information to continue to assess the insured depository institution (“IDI”) exclusion, which allows an IDI to exclude from its de minimis calculations certain swaps that it enters into with its borrowing customers, to determine whether the conditions of that exclusion are overly restrictive.

10

Even if the Final Report’s finding regarding the limited impact of changes in the de minimis threshold were the report’s only finding, however, that finding in itself would justify the Staff’s efforts in assembling the report. That said, it needs no surfeit of cynicism to consider that the Final Report may be a mere technical preliminary to the

7 See Final Report at 4-5, 18-19. 8 Final Report at 21. 9 Id. 10 Id. at 25-27.

3


political, or at least politics-tinged, debate over the de minimis threshold, and no abundance of imagination to think that, notwithstanding the Final Report’s central finding, the CFTC may become concerned about the optics of backing off of its view that, all things being equal, over time more entities should become subject to regulation as swap dealers. So let the real games begin. In any case, the swap market should know sooner rather than later whether the CFTC will seek to impose its swap dealer regulations on a broader range of market participants.

Author James Schwartz New York (212) 336-4327 [email protected]

Contacts Julian Hammar Washington, D.C. (202) 887-1679 [email protected]

Chrys Carey Washington, D.C. (202) 887-8770 [email protected]


We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, and Fortune 100, technology and life sciences companies. We’ve been included on The American Lawyer’s A-List for 13 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights reserved. For more updates follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.






1 IFLR/September 2016 www.iflr.com

M ore than six years after theenactment of the Dodd-FrankAct, and more than three years

after the US Commodity Futures TradingCommission (CTFC) required swapdealers to register in accordance with TitleVII of that Act, it remains unclear whenexactly the US Securities and ExchangeCommission (SEC) will require theregistration of security-based swap (SBS)dealers. But while the timing forregistration is unclear, SBS dealing entitiescan now begin to take steps to facilitatetheir SEC registration. Despite the SEC’s progress in recentmonths in finalising its rules for SBSdealers – it has, among other things,recently issued amendments to itsRegulation SBSR and finalised its businessconduct rules for SBS dealers – severalmore dominoes need to fall before SBSdealer registration will be required. Ofparticular note, the SEC’s SBS dealerregistration rules provide that registrationwill not be required until at least sixmonths after the publication in the FederalRegister of the SEC’s final margin rules forSBS dealers. The SEC proposed those rulesin 2012 but, after that proposal, the BaselCommittee on Banking Supervision andthe International Organization ofSecurities Commissions released theirwidely influential international frameworkfor margin for uncleared derivatives. As aresult, it seems likely, though perhaps notinevitable, that the SEC will re-propose itsmargin rules. In view of that likely re-proposal, the required six-month waitingperiod after the final margin rules’publication, and SEC Chair Mary JoWhite’s recent statement at an openmeeting that the SEC’s goal is to completeits regulations for SBS dealers by the endof 2016, an SBS dealer registrationcompliance date toward the middle or endof 2017 seems likely. Even if registration will not be requiredthis year, the SBS rules that the SEC hascreated to date give a helpful if stillsomewhat inexact roadmap for registrationby SBS dealers. What follows is a quickand non-exclusive list of action items forSBS dealing entities.SBS dealers should consider their

internal division of labour for SBSprocesses and compliance. The bifurcatedUS regulatory scheme for derivativesmeans that dealers will need to run manyprocesses in parallel. Those parallelprocesses, for CFTC-regulated swaps onthe one hand, and for SEC-regulated SBSon the other, will in many cases be quitesimilar, but they will generally not beidentical. Accordingly, a first-orderquestion for dealers is to what extent theycan and should use the same personnel andthe same systems to comply with theparallel CFTC and SEC regulatoryrequirements. Because SBS dealer registration is onlyrequired after an SBS dealing entity’strading activity exceeds an applicable deminimis threshold, many financialinstitutions that deal in SBS will wish toput in place processes to monitor the levelof their SBS trading activity. SBS dealinginstitutions that do not intend to registeras an SBS dealer should put in placeprocesses to monitor the amount of theirSBS dealing activity that counts toward theapplicable de minimis thresholds, andshould limit their trading activity so that itremains below those thresholds. Similarly,some institutions will likely wish tomonitor their SBS dealing activity todetermine when that activity exceeds arelevant threshold and requires SECregistration. Here, as in other areas, theCFTC and SEC rules are similar but notidentical. One difference: although theSEC’s phase-in de minimis threshold levelfor SBS that are credit default swaps is setat $8 billion in notional amount over a 12-month period, the same as the CFTC’sphase-in de minimis threshold level forswaps, the SEC’s rules, unlike the CFTC’srules, also contain a separate de minimisthreshold set at $400 million, for SBS thatare not credit default swaps.

RegistrationSBS dealing entities that intend to registerwith the SEC should begin preparations toprovide the certifications that the SECrequires for registration. In one of thosecertifications, a senior officer of theapplicant must certify that the applicanthas developed and implemented written

policies and procedures reasonablydesigned to prevent violation of the federalsecurities laws and rules thereunder, andhas documented the process by which theyreached such determination. Accordingly,an SBS dealing entity should consider notonly the range of the securities laws towhich it is subject – apparently includinglaws that do not apply directly to SBS orSBS dealing activity – but also how it willdocument the process supporting thesenior officer’s certification that theapplicant has implemented all requiredpolicies and procedures.SBS dealers will also need to develop thepolicies and procedures, reasonablydesigned to prevent violation of thesecurities laws, as to which the seniorofficer will certify. Because of the manysimilarities between the SEC and CFTCrules, SBS dealers should in many cases beable to use their CFTC swap dealerpolicies as models for their SEC SBS dealerpolicies. At the same time, because theSEC and CFTC rules differ in manydetails, the new SBS dealer policies mustbe drafted carefully to reflect faithfully theSEC’s requirements. Additional considerations apply for non-resident SBS dealers, those that areincorporated, or have their principal placeof business, outside of the United States.The SEC requires that such SBS dealerscertify that they will, and that they providean opinion of counsel stating that as amatter of law they can, provide the SECwith prompt access to books and recordsand submit to onsite SEC inspection andexamination. Certain non-resident SBSdealers may find these requirementsproblematic under the laws of their homejurisdictions. In its registration rulesrelease, the SEC goes so far as to suggestthat certain SBS dealers may wish toconsider restructuring their businesses topermit them to give this certification. As the SEC continues to finalise itsrequirements for SBS dealers, additionalconsiderations will undoubtedly arise. Inthe meantime, however, regardless of theexact timing for SBS dealer registration,there is no shortage of preparation thatSBS dealing entities may begin toundertake.

By Morrison & Foerster of counsel JamesSchwartz in New York

A step closer The SEC still has some work to do to finalise itsframework for SBS dealer registration but firms arealready expected to set compliance plans in motion

CAPITAL MARKETS US SWAP REGISTRATION


O n July 13 2016, the US Securitiesand Exchange Commission (SEC)adopted amendments and

guidance (Final Rules and Guidance)related to its rules on the regulatoryreporting and public dissemination ofsecurity-based swaps (SBSs), known asRegulation SBSR. Two key issues addressedby the Final Rules and Guidance that mayinterest market participants involved in thecross-border SBS market are the compliancedate for when SBS reporting begins and theapplicability of Regulation SBSR to certaincross-border situations.With regard to the compliance date, the

Final Rules and Guidance make asignificant modification to the complianceschedule as proposed that links the

reporting compliance date to thecompliance date for registration of SBSdealers and major SBS participants. Thisshould alleviate certain compliancechallenges in the cross-border context.Concerning the cross-border applicabilityof Regulation SBSR, the Final Rules andGuidance continue the SEC’s policy ofapplying Dodd-Frank Act requirements tocertain SBS transactions between non-USpersons, where such transactions are“arranged, negotiated, or executed” withinthe US.Regulation SBSR, which was adopted in

February 2015, sets forth the informationthat must be reported and publiclydisseminated for each SBS, assignsreporting duties for many SBSs, andrequires registered SBS data repositories(SDRs) to establish and maintain policiesand procedures for carrying out theirresponsibilities under Regulation SBSR. Italso addresses the application of RegulationSBSR to certain cross-border SBStransactions.

At the same time that Regulation SBSRwas adopted, the SEC proposed additionalprovisions of Regulation SBSR to addressissues not covered in the Regulation SBSRadopting release. The companion proposingrelease (Companion Proposal) included aproposed compliance schedule establishingwhen SBS must be reported underRegulation SBSR, as well as provisions forreporting platform-executed SBS that willbe submitted for clearing and for SBSresulting from the clearing process.Separately, in April 2015, the SECproposed rules addressing the application ofRegulation SBSR to SBS activity of non-USpersons within the US (US ActivityRelease). The Final Rules and Guidanceadopted by the SEC in its July release

address the open issues from theCompanion Proposal and the US ActivityRelease.

Compliance date challengesPerhaps most important for marketparticipants is that the Final Rules andGuidance establish the much anticipatedcompliance schedule for reporting underRegulation SBSR. Market participants havebeen waiting for the commencement of SBSreporting, as reporting for swaps has been inplace for some time in the US under rules ofthe Commodity Futures TradingCommission (CFTC), which has hadjurisdiction over swaps based on interestrates, foreign exchange, commodities andbroad-based security indexes. Under theCompanion Proposal, the compliance datefor newly executed SBS reporting wouldhave been six months after the firstregistered SDR that could accept reports ofSBS in a particular asset class commencesoperations as a registered SDR. Commentators voiced a number of

concerns about requiring compliance beforeSBS dealer registration is required, notingthat, during any interim period after thecommencement of reporting of SBS butbefore SBS dealer or major SBS participantregistration is required, there would be noregistered SBS dealers or major SBSparticipants to occupy the highest rungs ofthe reporting hierarchy in RegulationSBSR.As under the CFTC’s reporting rules for

swaps, Regulation SBSR establishes areporting hierarchy under which only onecounterparty reports a SBS to an SDR basedon a counterparty’s regulatory status, withregistered SBS dealers and major SBSparticipants (except in SBSs with eachother) as the reporting counterparty withrespect to uncleared SBSs with all othercounterparties. Without any registered SBSdealers or major SBS participants, a numberof challenges in negotiating and carryingout reporting duties would result, includingparticular challenges with ascertainingreporting duties under the rules for cross-border transactions, especially for buy-sideUS. persons. Any interim solutions toassign reporting obligations negotiatedbetween counterparties would not be usefulfor the period after SBS entities registrationis required, when, by rule, SBS dealers ormajor SBS participants would be thereporting party.Recognising these challenges, the SEC

changed the compliance date for reportingnewly-executed SBSs in a particular assetclass under the Final Rules and Guidance.The compliance date, described asCompliance Date 1 in the Final Rules andGuidance release, is now the first Mondaythat is the later of: (1) six months after thedate on which the first SDR that can accepttransaction reports in that asset classregisters with the SEC or (2) one monthafter the SBS entities registrationcompliance date. The one-month periodafter the SBS entities registrationcompliance date according to the SEC isdesigned to allow market participants tobecome familiar with which firms haveregistered as SBS dealers, and for registeredSBS dealers to ensure that they havesystems, policies, and procedures in place tocommence their reporting duties underRegulation SBSR. Two additionalcompliance dates are provided for in theFinal Rules and Guidance, one for whenSDRs must commence publicdissemination of SBS data – or ComplianceDate 2 – which is the first Monday that isthree months after Compliance Date 1, andthe other for the reporting of historical SBS– or Compliance Date 3 – which is two

Setting the sceneFinal SEC guidance on cross-border SBSs is likely to ease concerns surrounding reporting duties andcompliance with the SEC’s Regulation SBSR

CAPITAL MARKETS US SBS COMPLIANCE

“There is no date certain for whensecurity-based entity registration will berequired, and thus no date certain whenSBS reporting will commence

www.iflr.com IFLR/September 2016 29

months after Compliance Date 2.With regard to Compliance Date 1, the

SBS entities registration compliance date, towhich SBS reporting is now linked underthe Final Rules and Guidance, is separatelyprovided for in the SEC’s final SBS dealerand major SBS participant registration rulesand, admittedly, is not definite (see JamesSchwartz’s swap registration article on pageXX). The registration rules provide that thecompliance date will occur only after theoccurrence of several events that, takentogether, have not yet occurred, cannotoccur for a minimum of six months, andseem relatively unlikely to occur until aftersignificantly more than six months havepassed. In any event, in light of thesecontingencies, there is no date certain underthe SBS entities registration rules for whensecurity-based entity registration will berequired, and thus no date certain for whenSBS reporting will commence. A number of commentators also

requested that the SEC defer compliancewith Regulation SBSR until the SEC hasmade substituted compliancedeterminations with respect to regulatoryreporting and public dissemination of SBStransactions for certain foreignjurisdictions, which would allow marketparticipants to comply with the foreignjurisdictions’ rules in place of SEC rules.This approach was taken by the CFTCthrough staff no-action letters, which havedelayed regulatory reporting of swaps for

certain registered non-US swap dealersbased in Australia, Canada, the EU, Japanor Switzerland with non-US counterpartiesthat are not guaranteed by a US person,until the earlier of 30 days after acomparability determination issued by theCFTC (which has not yet been issued forthese jurisdictions) or December 1 2016.However, the SEC declined to provide forsuch a delay, noting that it had not receivedany substituted compliance applicationsand that other jurisdictions were still in theprocess of promulgating reporting rules,which could lead to a significant delay inRegulation SBSR implementation. Nonetheless, despite the lack of a date

certain for when SBS reporting is tocommence and no provision for a delay forsubstituted compliance determinations tobe made, market participants will likelywelcome the new compliance date in theFinal Rules and Guidance for reportingunder Regulation SBSR and its linkage tothe compliance date for the SBS entitiesregistration rules because of the challengesand inefficiencies that it avoids.

Cross-border SBSR applicabilityAnother important issue for internationalmarket participants is the cross-borderapplicability of Regulation SBSR asprovided for in the Final Rules andGuidance. In particular, the Final Rules andGuidance address the applicability of SBSRto certain SBS transactions that are

“arranged, negotiated, or executed” by non-US persons within the US, and theassignment of reporting responsibilities incertain cross-border situations not providedfor in Regulation SBSR as adopted in 2015. When it was adopted in 2015, Regulation

SBSR provided for regulatory reporting andpublic dissemination of any SBS transactionthat (1) has a direct or indirect counterpartythat is a US person on either or both sidesof the transaction or (2) is accepted by aclearing agency having its principal place ofbusiness in the US. Regulation SBSR alsorequired regulatory reporting (but notpublic dissemination) of uncleared SBSs ofregistered non-US SBS dealers and majorSBS participants when there is no USperson on either side. It did not addressreporting and public dissemination oftransactions that are “arranged, negotiated,or executed” in the US. It also did notassign the reporting responsibility for SBSsbetween two unregistered non-US personsand between an unregistered US person andan unregistered non-US person. Theseissues were taken up in the US ActivityProposal, and in turn have been finalisedunder the Final Rules and Guidance.Under the Final Rules and Guidance,

SBSs in connection with a non-US person’sSBS dealing activity that are “arranged,negotiated, or executed” by personnel ofsuch non-US person located in a US branchor office, or by personnel of its agentlocated in a US branch or office, arerequired to be reported and publiclydisseminated. The Final Rules andGuidance do not subject additionaltransactions involving registered SBSdealers to Regulation SBSR’s regulatoryreporting requirements because registeredSBS dealers, whether US or non-US, arealready subject to regulatory reportingrequirements with respect to all of theircounterparties, whether US or non-US,under Regulation SBSR as previouslyadopted. However, this provision of theFinal Rules and Guidance would requirethat transactions of non-US SBS dealersthat are “arranged, negotiated, or executed”in the US be publicly disseminated. In addition, the Final Rules and Guidance

assign reporting responsibility for SBSs insituations involving non-registrants.Specifically, they provide that, for SBSsbetween two non-US persons engaged inSBS dealing activity that is “arranged,negotiated, or executed” in the US, orbetween one such non-US person and a USperson, the parties shall select the reportingside. For SBSs between a non-US personwho is not engaged in SBS dealing activity“arranged, negotiated, or executed” in the

US SBS COMPLIANCE

Reporting responsibilities under regulation SBSR asmodified by the Final Rules and Guidance

Party B

Party A

SBSD

Non-SBSD, US

Person

Non-SBSD,

non-US person,

SBS dealing,

ANE

Non-SBSD,

non-US person,

not ANE

SBSD

Parties select

Party B

Party B

Party B

Non-SBSD, U.S.

person

Party A

Parties select

Parties select

Party B

Non-SBSD,

non-US person,

SBS dealing

ANE

Party A

Parties select

Parties select

Party B

Non-SBSD,

non-US person,

not ANE

Party A

Party A

Party A

N/A, except if

effected by or

through a regis-

tered broker-

dealer, in which

case the broker-

dealer reports

Key: SBSD = SBS dealer

ANE = Arranged, negotiated, or executed by personnel of such non-US person

located in a US branch or office, or by personnel of its agent located in a US branch

or office


United States, and a non-US person who isengaged in such activity in the United Statesor a US person, the Final Rules andGuidance provide that the latter is thereporting side. If the SBS is between twonon-US persons who are not engaged in SBSdealing activity “arranged, negotiated, orexecuted” in the US, Regulation SBSR doesnot apply, unless the SBS is effected by orthrough a registered broker dealer, includinga registered SBS execution facility, in whichcase the registered broker-dealer reports. Asmodified by the Final Rules and Guidance,the reporting responsibility as between twocounterparties – Party A and Party B – to aSBS under Regulation SBSR is summarisedin the table on the preceding page.The Final Rules and Guidance thus

extend reporting requirements to dealingSBSs between non-US persons that are

“arranged, negotiated, or executed” in theUnited States. This follows rules the SECadopted in February 2016 that require aforeign dealing entity to count against its deminimis threshold (above which registrationas a SBS dealer is required) to transactionswith non-US persons where the foreigndealing entity is engaged in activity that is“arranged, negotiated, or executed” in theUS. The February 2016 release containsdetailed guidance about when a SBS isdeemed to be “arranged, negotiated, orexecuted” in the US that may facilitateguidance with the reporting rules. Theconcept originated with the CFTC in StaffAdvisory 13-69 issued in 2013, in whichCFTC staff stated that the CFTC’sTransaction-Level requirements wouldapply to a swap transaction between a non-US registered swap dealer and a non-US

person, if the transaction is “arranged,negotiated, or executed” in the US.The Advisory has not been implemented,

however, because after its issuance the CFTCrequested comment on whether the Advisoryshould be adopted as CFTC policy and issuedno-action relief from the effects of theAdvisory. That relief, which has beenextended several times and was set to expire onSeptember 30 2016, was extended again byCFTC staff on August 4 2016 untilSeptember 30 2017. In conjunction with thatrelief, CFTC Chairman Timothy Massad saidin a statement that he intends to ask theCFTC in the fall of 2016 to consider aproposed rule to address the “arranged,negotiated or executed” issue.While well behind the CFTC in terms of

its implementation of rules for SBSs, theSEC through the February 2016 release andthe Final Rules and Guidance has taken thelead with respect to when Dodd-Frank Actrequirements apply to a non-US person’sdealing activity involving SBSs “arranged,negotiated, or executed” in the US. Itremains to be seen whether the CFTC willadopt a similar approach to regulatoryrequirements under the Dodd-Frank Actwith respect to swaps – stay tuned.By Julian Hammar, of counsel with

Morrison & Foerster (Washington, DC)

US SBS COMPLIANCE

“Another important issue for internationalmarket participants is the cross-borderapplicability of Regulation SBSR asprovided for in the Final Rules andGuidance

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THE FEDERAL

RESERVE’S

PROPOSED RULES

FOR FINANCIAL

CONTRACTS OF

GLOBAL

SYSTEMICALLY

IMPORTANT BANKING

ORGANIZATIONS AND

ISDA’S RESOLUTION

STAY JURISDICTIONAL

MODULAR PROTOCOL

By James Schwartz, Julian Hammar,

and Chrys Carey

James Schwartz, Julian Hammar, and

Chrys Carey are attorneys with Mor-

rison & Foerster LLP, and may be

reached at

[email protected],

[email protected], and ccarey@mofo.

com, respectively. The views expressed in

this article are those of the authors only

and do not necessarily reflect the views of

Morrison & Foerster LLP, its attorneys, or

its clients. This article is for informational

purposes only and should not be taken as

legal advice.

On May 11, 2016, the Board of Gover-

nors of the Federal Reserve System (the

“Board”) published in the Federal Regis-

ter proposed new rules (the “Proposed

Rules”) intended to reduce the potential

risks posed to the U.S. financial system by

too-big-to-fail banks.1 The Proposed

Rules would, among other things, require

certain systemically important banks to

include in their contracts provisions that

would significantly limit their counterpar-

ties’ default rights in over-the-counter

swaps, repurchase and reverse repurchase

agreements, securities lending and bor-

rowing transactions, commodity con-

tracts, and forward agreements. The Pro-

posed Rules were open to public comment

until August 5, 2016.

Contemporaneously with the Board’s

release of the Proposed Rules, the Interna-

tional Swaps and Derivatives Association,

Inc. (“ISDA”) released its ISDA Resolu-

tion Stay Jurisdictional Modular Protocol

(the “JM Protocol”), intended to permit

market participants to comply with the

Proposed Rules (when adopted in their

final form) and similar rules of foreign

jurisdictions.

In this article, we examine the Proposed

Rules and related ISDA protocols.

Goals of the Proposed Rules

The Proposed Rules have two primary

goals, both aimed at facilitating the or-

derly liquidations of systemically impor-

tant financial institutions, including under

the orderly liquidation process created by

the Dodd-Frank Wall Street Reform and

Consumer Protection Act (the “Dodd-

Frank Act”).2

The first goal is to assure the cross-

border application of U.S. special resolu-

tion regimes to certain transactions be-

Reprinted with permission from Futures and Derivatives Law Report, Vol-ume 36, Issue 8, K2016 Thomson Reuters. Further reproduction withoutpermission of the publisher is prohibited. For additional information aboutthis publication, please visit www.legalsolutions.thomsonreuters.com.

RE

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Futu

res

&D

erivatives

Law

September 2016 ▪ Volume 36 ▪ Issue 8

tween a counterparty outside of the U.S. and a

U.S. global systemically important bank

(“GSIB”) or certain U.S. subsidiaries, branches

or agencies of U.S. or non-U.S. GSIBs. While it

is clear that existing U.S. special resolution

regimes provide the U.S. regulatory agencies

with the powers to prevent counterparties from

exercising contractual termination rights in cer-

tain circumstances, it is not entirely clear what

might happen if a court outside of the U.S. were

to disregard such powers. The Board intends that

the Proposed Rules, if adopted, will require par-

ties to add to their contracts provisions to make

clear that the U.S. special resolution regimes will

apply to cross-border transactions and will thus

bind authorities and parties outside of the U.S.

The Board’s second goal is to facilitate the res-

olution of a GSIB under a “single point of entry”

strategy, in which only the top-tier holding com-

pany would enter into a resolution proceeding

while its subsidiaries would continue to operate

and meet their financial obligations. The Board

takes the view that, to facilitate such a resolution,

it must ensure that operating subsidiaries of a

GSIB are not parties to contracts containing

cross-default rights that their counterparties

could exercise based on the entry into resolution

of an affiliate of such operating subsidiaries.

The common thread of these two goals is that,

if and when the Proposed Rules are adopted and

go into effect, they will likely require parties in

many transactions facing certain GSIBs (and

certain of their subsidiaries, branches and agen-

cies) expressly to relinquish certain of their

contractual rights.

Background: The U.S. SpecialResolution Regimes

There are two special resolution regimes

whose cross-border application the Proposed

Rules seek to assure. The first is Title II of the

Dodd-Frank Act (titled “Orderly Liquidation

Authority” and known in short as “OLA”), the

enactment of which enhanced the federal govern-

ment’s receivership authorities by expanding

them to large, interconnected financial

companies. OLA provides the Federal Deposit

Insurance Corporation (“FDIC”) with the author-

ity to serve as receiver for large financial compa-

nies whose failure would pose a significant risk

to the financial stability of the United States. In

addition, even prior to the Dodd-Frank Act, under

the Federal Deposit Insurance Act (“FDI Act”),3

the FDIC had receivership authority with respect

to federally insured banks and thrift institutions.

The Proposed Rules designate both the FDI Act

and the OLA provisions (and related regulations)

as “U.S. special resolution regimes.”4

Both of the U.S. special resolution regimes in

certain circumstances limit the contractual rights

of counterparties facing certain bank entities.

Under the OLA, after a determination is made

that a financial company should be placed in

receivership, the FDIC takes over as receiver, and

the bank’s counterparties are prohibited, or

“stayed,” from terminating certain contracts until

5 p.m. of the business day after the receivership

is commenced.5 Similarly, under the FDI Act, af-

ter a resolution is initiated and the FDIC becomes

a bank’s receiver, the bank’s counterparties are

prohibited from terminating certain contracts

until 5 p.m. of the business day following the day

on which the receiver was appointed.6 Under both

its OLA authority and the FDI Act, the FDIC has

the right, among other things, to transfer certain

contracts to a bridge financial company, which,

as contemplated by the special resolution re-

gimes, will be capable of performing under the

Futures and Derivatives Law ReportSeptember 2016 | Volume 36 | Issue 8

2 K 2016 Thomson Reuters

transferred contracts. After such a transfer, the

counterparty no longer has the right to terminate

based on events that occurred prior to the transfer.

These provisions of the U.S. special resolution

regimes are in accordance with recommendations

of the Financial Stability Board (“FSB”). After

the financial crisis of 2007-09, the FSB recom-

mended that countries put in place special resolu-

tion regimes to address failing financial institu-

tions, especially those whose collapse could have

systemic consequences.7 Thereafter, the Cross-

border Bank Resolution Group of the Basel Com-

mittee on Banking Supervision recommended

that such resolution regimes include powers to

continue needed contracts, terminate unneces-

sary contracts, and sell assets and transfer

liabilities.8 Many countries that are members of

the G20 group of nations have adopted or are in

the process of adopting similar resolution

regimes.

Provisions of the Proposed Rules

Entities and Contracts Subjectto the Proposed Rules

The Proposed Rules apply to “covered QFCs,”

that is, contracts that constitute “qualified finan-

cial contracts” to which a “covered entity” is a

party.

For these purposes, “covered entities” include:

E any U.S. bank holding company that is

identified as a global systemically important

bank holding company under the Board’s

rule establishing risk-based capital sur-

charges for GSIBs;

E any subsidiary of a U.S. GSIB described in

the preceding bullet point that is not a

national bank, federal savings association,

federal branch or federal agency; and

E a U.S. subsidiary, U.S. branch, or U.S.

agency of a non-U.S. GSIB (other than enti-

ties subject to regulation by the OCC,9 such

as national banks, federal savings associa-

tions, federal branches or federal

agencies).10

The Proposed Rules define the term “qualified

financial contracts” in accordance with section

210(c)(8)(D) of the Dodd-Frank Act.11 Accord-

ingly, QFCs include many swaps, repurchase

(and reverse repurchase) transactions, forward

contracts, commodity contracts and securities

sale, lending and borrowing transactions. The

“QFC” definition also includes any master agree-

ment that governs QFCs between parties.

The Proposed Rules expressly exclude cen-

trally cleared QFCs from their scope.12 Although

cleared QFCs may pose some of the risks that the

Proposed Rules were intended to address, the

Board appears to justify the exclusion of cleared

QFCs based on its view that the clearing of

transactions provides unique benefits to the

financial system.13 The Board has asked for com-

ments regarding the appropriate treatment of

cleared QFCs.

Also excluded from the Proposed Rules are

certain QFCs entered into under multi-branch

master agreements of foreign GSIBs. The defini-

tion of QFC generally includes a master agree-

ment that governs QFCs. Many such master

agreements permit the parties to trade from

multiple branches or offices. For non-U.S.

GSIBs, the definition of QFC contained in the

Proposed Rules, however, effectively excludes

transactions that are not booked at, and for which

Futures and Derivatives Law Report September 2016 | Volume 36 | Issue 8

3K 2016 Thomson Reuters

no payment or delivery may be made at, a U.S.

branch or U.S. agency of the non-U.S. GSIB.14

The Board invited comment on this point as

well.15

Provisions Required to beAdded to QFCs

The Proposed Rules would require covered

entities to add two distinct provisions to their

QFCs. One such provision would limit the exer-

cise of default rights under Covered QFCs, and

the other would permit transfers of QFCs to

bridge entities as contemplated by the special res-

olution regimes.

Limitations on Default Rightsunder Covered QFCs

To clarify the cross-border application of the

U.S. special resolution regimes, the Proposed

Rules would require each covered QFC to ex-

pressly provide that “default rights” under such

covered QFC “that may be exercised against the

covered entity are permitted to be exercised to no

greater extent than the default rights could be

exercised under the U.S. special resolution re-

gimes,” assuming U.S. law applied and the cov-

ered entity were under a U.S. special resolution

regime.16 Such a provision, if and when inserted

into covered QFCs, will make clear that the

covered entity’s counterparty, regardless of its

jurisdiction, will have no right to terminate a

covered QFC to the extent it would not have such

right under the applicable U.S. special resolution

regime.

The Proposed Rules define broadly the “default

rights” to which this mandatory provision

applies. “Default rights” include, among other

things, a right of a party, whether contractual or

otherwise, to liquidate, terminate, cancel, rescind,

or accelerate an agreement or transactions there-

under; set off or net amounts owing; exercise

remedies in respect of collateral or other credit

support or related property; demand payment or

delivery, suspend, delay, or defer payment or per-

formance; or modify the obligations of a party.

The “default right” definition does not generally

prevent, however, the exercise of rights to (i) net

same-day payments, (ii) demand delivery of col-

lateral based on a change in the value of relevant

transactions or (iii) terminate a contract based on

a provision that allows termination at a party’s

option without the need to show cause.17

Transfers of Covered QFCs

The Proposed Rules would also require each

covered QFC to support the U.S. special resolu-

tion regimes by permitting transfers of such

QFCs to bridge entities as contemplated by the

special resolution regimes. Specifically, the

Proposed Rules would require covered QFCs

expressly to provide that the transfer of the

covered QFC (and any interest in, or property

securing, the covered QFC) from the covered

entity will be effective to the same extent as the

transfer would be effective under the U.S. special

resolution regimes, assuming U.S. law applied

and the covered entity were under a U.S. special

resolution regime.18

Support for “Single Point ofEntry” Resolutions

The Proposed Rules also contain provisions

intended to support “single point of entry” resolu-

tions of banking organizations, in which only a

single legal entity, the GSIB’s top-tier bank hold-

ing company, is to enter into a resolution

proceeding. The Board contemplates that a GSIB

may enter into QFCs through operating subsid-



iaries, and, to the extent that such QFCs cause

losses, those losses will be passed up from the

operating subsidiaries that incurred them to the

holding company, where, by means of the resolu-

tion process, the losses will be imposed on the

holding company’s equity holders and unsecured

creditors. The “single point of entry” strategy is

intended to ensure that the operating subsidiaries

will remain adequately capitalized and able to

meet their financial obligations without default-

ing or entering resolution.19 To facilitate this res-

olution strategy, in which operating subsidiaries

are expected to remain continuously in operation

and out of resolution, the Board believes that it

must prevent counterparties facing operating sub-

sidiaries of GSIBs from exercising default rights

based on the entry into resolution or insolvency

proceedings of the operating subsidiaries’

affiliates.

Accordingly, the Proposed Rules, if finalized

in their proposed form, would provide that a

covered QFC may not permit the exercise of any

default right with respect to the covered QFC that

is related, directly or indirectly, to an affiliate of a

covered entity becoming subject to a receiver-

ship, insolvency, liquidation, resolution, or simi-

lar proceeding. However, a covered QFC could

permit the exercise of default rights based on (i)

a covered entity itself becoming subject to receiv-

ership, insolvency, liquidation, resolution, or

similar proceeding, other than under a special

resolution regime, or (ii) a party to a QFC, or an

affiliated credit support provider, failing to meet

a payment or delivery obligation under the cov-

ered QFC.20

The Proposed Rules would also generally

provide that no covered QFC may prohibit the

transfer of a credit enhancement supporting such

QFC provided by an affiliate of the covered entity

upon an affiliate of the covered entity becoming

subject to a receivership, insolvency, liquidation,

resolution or similar proceeding.21

Proposed Effective Date

Covered entities would be required to comply

with the Proposed Rules by the first day of the

first calendar quarter that begins at least one year

after the issuance of the final rule (such day, the

“Effective Date”). If a covered entity were to

enter into a new QFC after the Effective Date,

such QFC would be required to comply. With re-

spect to pre-existing QFCs, entered into prior to

the Effective Date, a covered entity would be

required to bring such QFCs into compliance no

later than the first date on or after the Effective

Date on which the covered entity or certain of its

affiliates were to enter into a new covered QFC

with the same counterparty to the preexisting

QFC or an affiliate of the counterparty.22

ISDA’s Resolution Stay Protocols

Contemporaneously with the Board’s release

of the Proposed Rules, ISDA released its JM Pro-

tocol,23 intended to permit market participants to

comply with the provisions of the Proposed Rules

(when adopted in their final form) and similar

rules of foreign jurisdictions. Like other ISDA

protocols, the JM Protocol is a mechanism to al-

low parties to amend numerous agreements in

one stroke. By adhering to the protocol, parties

agree that their contracts with other adhering par-

ties are amended in accordance with the terms of

the relevant protocol. The heart of the JM Proto-

col consists of the country-specific modules, a

large majority of which ISDA has not yet

published. Nonetheless, it is not too soon for mar-

ket participants to begin to consider the JM

Protocol.



The JM Protocol is the third ISDA protocol to

address compliance with the requirements of

special resolution regimes. Prior to publishing

the JM Protocol, ISDA published the ISDA 2015

Universal Stay Protocol (the “Universal Stay

Protocol”) and the ISDA 2014 Resolution Stay

Protocol (the “Resolution Stay Protocol”). The

Universal Stay Protocol covers a broader range

of transactions than does the Resolution Stay

Protocol but is otherwise quite similar to the Res-

olution Stay Protocol. Under the terms of both

the Universal Stay Protocol and the Resolution

Stay Protocol, adhering parties, among other

things, opt in to numerous special resolution

regimes of the U.S. and other countries. Within

certain limitations, those protocols provide that if

one adhering party is subject to a special resolu-

tion regime (regardless of the jurisdiction of that

special resolution regime), then the other adher-

ing party may exercise default rights under a

“covered agreement” or related credit support ar-

rangement only to the extent it would be able to

do so under such special resolution regime.

Primarily it has been the largest, systemically

important banks and their affiliates that, with the

encouragement of their regulators, have adhered

to the Universal Stay Protocol and the Resolution

Stay Protocol. Other market participants have

generally not adhered to those protocols. In par-

ticular, asset managers have been concerned

about the possibility of breaching their fiduciary

duties if they were to expressly relinquish default

rights under numerous jurisdictions in the ab-

sence of any legal requirement to do so.

The JM Protocol differs from the Universal

Stay Protocol and the Resolution Stay Protocol

in that, by means of the JM Protocol’s country-

specific modules, parties will be able to specify

exactly which special resolution regime modules

they will opt in to. Thus, although the Proposed

Rules specifically identify the Universal Stay

Protocol as a permitted means for covered parties

to amend their QFCs to comply with certain pro-

visions of the Proposed Rules,24 most market

participants will likely prefer to adhere to the JM

Protocol in order to comply.

The JM Protocol consists of a main agreement

and separate jurisdictional modules, each of

which relates to only one jurisdiction. So far, the

only jurisdictional modules that ISDA has pub-

lished are the modules for Germany and the UK.

Presumably the U.S. jurisdictional module will

not be published until after the Board finalizes

the Proposed Rules.

Conclusion

While it may be difficult to like regulations

that, if adopted, will require parties expressly to

give up their hard won contractual rights, the

Proposed Rules do seem well tailored to the

Board’s aims of first, assuring the cross-border

application of U.S. special resolution regimes

and second, facilitating the resolution of GSIBs

under a “single point of entry” strategy. If the

Proposed Rules are adopted in their proposed

form, the exercise of default rights in relation to

QFCs will be subject to limitations contained in

the U.S. special resolution regimes, and parties

facing GSIBs and certain of their subsidiaries in

covered QFCs will have fewer cross-default

rights and thus fewer opportunities to cause

multiple GSIB-related entities to enter insolvency

or resolution proceedings.

ENDNOTES:

1Restrictions on Qualified Financial Con-



tracts of Systemically Important U.S. BankingOrganizations and the U.S. Operations of Sys-temically Important Foreign Banking Organiza-tions; Revisions to the Definition of QualifyingMaster Netting Agreement and Related Defini-tions, 81 Fed. Reg. 29,169 (May 11, 2016). Inaddition, on August 19, 2016, the Office of theComptroller of the Currency (“OCC”) publishedin the Federal Register proposed rules, substan-tively identical to the Proposed Rules, for entitiesthat the OCC supervises. See Mandatory Contrac-tual Stay Requirements for Qualified FinancialContracts, 81 Fed. Reg. 55,381 (Aug. 19, 2016);note 9 infra and accompanying text. The com-ment period on the OCC’s proposed rules isscheduled to close on October 18, 2016.

2Dodd-Frank Wall Street Reform and Con-sumer Protection Act, Pub. L. No. 111-203,§§ 701-74, 124 Stat. 1376, 1641-802 (2010)(codified as amended in scattered sections oftitles 7, 12 and 15 U.S.C. (2012)).

312 U.S.C. 1811 et seq.

4Proposed Rules at § 252.81, 81 Fed. Reg. at29,190.

5Dodd-Frank Act at § 210(c)(10)(B).

6FDI Act at § 11(e)(10)(B).

7See generally, Financial Stability Board,Key Attributes of Effective Resolution Regimesfor Financial Institutions, October 15, 2014.

8Basel Committee on Banking Supervision,Report and Recommendations of the Cross-border Bank Resolution Group, March, 2010, at23.

9The OCC has proposed rules, substantivelyidentical to the Proposed Rules, for entities thatthe OCC supervises. See note 1 supra.

10Proposed Rules at § 252.82(a), 81 Fed. Reg.at 29,190.

11Id. at § 252.81, 81 Fed. Reg. at 29,190.

12Id. at § 252.88, 81 Fed. Reg. at 29,193.

1381 Fed. Reg. at 29,176.

14Proposed Rules at § 252.86, 81 Fed. Reg. at29,192-93.

15See generally 81 Fed. Reg. at 29,176-77.

16Proposed Rules at § 252.83(b)(2), 81 Fed.Reg. at 29,190.

17Id. at § 252.81, 81 Fed. Reg. at 29,190.18Id. at § 252.83(b)(1), 81 Fed. Reg. at

29,190.1981 Fed. Reg. at 29,172.20Proposed Rules at § 252.84(b)(1) and (e),

81 Fed. Reg. at 29,191. In addition, under theProposed Rules, a covered QFC would be re-quired to provide that, after an affiliate of thecovered party has become subject to a receiver-ship, insolvency, liquidation, resolution, or simi-lar proceeding, a party seeking to exercise adefault right must prove by clear and convincingevidence or a similar standard that the exercise ispermitted under the covered QFC. ProposedRules at § 252.84(j), 81 Fed. Reg. at 29,192.

21Proposed Rules at § 252.84(b)(2), 81 Fed.Reg. at 29,191. The Proposed Rules would alsoamend certain definitions contained in theBoard’s capital and liquidity rules to help ensurethat the regulatory capital and liquidity treatmentof QFCs to which a covered entity is a party isnot affected by the proposed restrictions on suchQFCs. Specifically, the Proposed Rules wouldamend the definition of the term “qualifyingmaster netting agreement” contained in theBoard’s regulatory capital and liquidity rules andwould similarly amend the definitions of theterms “collateral agreement,” “eligible marginloan,” and “repo-style transaction” contained inthe Board’s regulatory capital rules. See 81 Fed.Reg. at 29,185.

22See 81 Fed. Reg. at 29,184.23JM Protocol documents are available at: htt

p://www2.isda.org/functional-areas/protocol-management/protocol/24.

24See 81 Fed. Reg. at 29,181; Proposed Rulesat § 252.85(a), 81 Fed. Reg. at 29,192.



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Client Alert June 16, 2016

CFTC Approves Supplemental Proposal on Position Limits to Permit Exchanges to Recognize Non-Enumerated Bona Fide Hedges By Julian E. Hammar

On May 26, 2016, the Commodity Futures Trading Commission (“CFTC”) approved a proposed supplement (“Supplemental Proposal”) to its December 2013 proposal to establish position limits on 28 core physical commodity contracts and economically equivalent futures, options, and swaps (“2013 Position Limits Proposal”). The Supplemental Proposal would provide for a new process for exchanges to recognize certain positions in commodity derivatives contracts as “non-enumerated” bona fide hedges (not already enumerated in CFTC regulations) or enumerated anticipatory bona fide hedges, as well as to exempt from CFTC position limits certain spread positions, in each case subject to CFTC review. In addition, the Supplemental Proposal would amend the definition of the term “bona fide hedging position” for physical commodities and certain other definitions contained in the 2013 Position Limits Proposal and would also delay the requirement that designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) establish and monitor position limits on swaps where the DCM or SEF lacks access to sufficient swap position information. The Supplemental Proposal, which was published in the Federal Register on June 13, 2016,1 will be open for public comment until July 13, 2016. The Supplemental Proposal is available here.

BACKGROUND

Under the 2013 Position Limits Proposal,2 the CFTC limited the definition of the term bona fide hedging position to an enumerated list of hedging strategies. If a hedging strategy was not on the list, it did not qualify as a bona fide hedge, and, in order to exceed an applicable position limit, a market participant would either have to request an interpretive letter from CFTC staff pursuant to CFTC Regulation 140.993 that would recognize the proposed hedging strategy as a bona fide hedge or seek exemptive relief from the CFTC under Section 4a(a)(7) of the Commodity Exchange Act (“CEA”).4 A number of commenters expressed the view that the 2013 Position Limits Proposal’s narrow definition of enumerated hedges would exclude legitimate hedging transactions commonly used by commercial enterprises. Moreover, the processes for obtaining relief, which could only be obtained from the CFTC or its staff, did not provide for deadlines or standards, which raised concerns about whether a response could be obtained in a commercially reasonable time. At a meeting of the CFTC’s Energy and Environmental 1 See Position Limits for Derivatives: Certain Exemptions and Guidance, 81 Fed. Reg. 38,457 (June 13, 2016). 2 See Position Limits for Derivatives, 78 Fed. Reg. 75,679 (Dec. 12, 2013). For further background information on the 2013 Position Limits

Proposal, please see our client alert here. 3 17 CFR 140.99. 4 7 U.S.C. 6a(a)(7).

http://www.mofo.com/people/h/hammar-julian-e

http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016-12964a.pdf

http://media.mofo.com/files/Uploads/Images/131119-CFTC.pdf


Client Alert Markets Advisory Committee in July 2015, the CME Group and ICE Futures U.S. presented a proposal to allow the exchanges to issue hedge exemptions, as they currently do under CFTC rules, subject to CFTC oversight.

SUPPLEMENTAL PROPOSAL

In response to the concerns mentioned above, the CFTC issued the Supplemental Proposal, which provides for exchange recognition of bona fide hedges and exemption of spread positions, makes amendments to the definition of the term bona fide hedging position, and delays exchange-set position limits for swaps.

Exchange Recognition of Bona Fide Hedges and Exemption of Spread Positions

The Supplemental Proposal includes three proposed regulations that would permit exchanges to submit to the CFTC rules pursuant to which the exchange could, respectively: (i) recognize non-enumerated bona fide hedging positions (“NEBFHs”),5 (ii) grant exemptions to position limits for certain spread positions,6 and (iii) recognize enumerated anticipatory bona fide hedging positions.7 Market participants would be required to apply for recognition as bona fide hedges or spread exemptions prior to exceeding any applicable position limit, which would include both exchange-set and CFTC-set limits. Any recognition of a bona fide hedge or grant of a spread exemption by the exchange would apply for one year, after which a market participant would be required to reapply.

When determining whether to recognize positions as NEBFHs, an exchange would be required to apply the standards in the CFTC’s general definition of bona fide hedging, which incorporates the standards in Section 4a(c)(2) of the CEA.8 Spreads that the exchanges may approve under the process for granting spread exemptions include calendar spreads, quality differential spreads, processing spreads (such as energy “crack” or soybean “crush” spreads), and product or by-product differential spreads.9 The enumerated anticipatory bona fide hedging positions that would be eligible for recognition, which were included in the 2013 Position Limits Proposal, are unfilled anticipated requirements, unsold anticipated production, anticipated royalties, anticipated service contract payments or receipts, and anticipatory cross-commodity hedges.10

The CFTC would review an exchange’s actions under these processes under its rule enforcement review program. It also would retain the ability to review an exchange’s determination to recognize any non-enumerated hedge position as bona fide (or an enumerated anticipatory bona fide hedging position) or grant of a spread exemption, either before or after an exchange makes a determination or grants an exemption. If after such a review the CFTC determines to reverse a determination or revoke an exemption granted by the exchange, the

5 See Proposed Reg. 150.9. 6 See Proposed Reg. 150.10. 7 See Proposed Reg. 150.11. 8 7 U.S.C. 6a(c)(2). See Proposed Reg. 150.9(a)(1). 9 See Proposed Reg. 150.10(b)(2). 10 See Proposed Reg. 150.11(a)(1).


Client Alert recipient of the determination or exemption would be afforded a commercially reasonable amount of time to reduce its position below the applicable position limit.11

In order for an exchange to process applications for recognizing bona fide hedges or granting spread exemptions under the Supplemental Proposal, it would have to meet certain requirements that are generally similar for the three processes outlined above. For example, an exchange may process NEBFH applications only if (i) the commodity derivative is a “referenced contract,” (ii) the exchange lists the commodity derivative contract for trading, (iii) the commodity derivative contract is actively traded on the exchange, (iv) the exchange has established position limits for the commodity derivative contract, and (v) the exchange has at least one year of experience and expertise administering position limits for the commodity derivative contract.12 Exchanges would not be permitted to recognize an NEBFH or grant a spread exemption involving a commodity index contract and one or more futures contracts subject to position limits (i.e., risk management exemptions).13

If an exchange recognizes an NEBFH or grants a spread exemption, the Supplemental Proposal would require that the exchange post a summary of the general hedging strategy or spread position to its website (without revealing the identity of the hedger) that would be subject to CFTC review.14 With regard to NEBFHs only, an exchange would be permitted to establish separate application processes under its rules for persons to demonstrate why a position constitutes an NEBFH under novel facts and circumstances and under facts and circumstances substantially similar to a position for which a summary has been published.15 In the latter case, the process may be less expansive.16

Each of the processes includes detailed application requirements for market participants, including any additional information necessary for the exchange to process the application.17 In addition, an exchange would be required to have rules requiring that applicants file a report (that must be kept updated) with the exchange when such applicants own or control a position that has been recognized as a bona fide hedge (or granted a spread exemption) and for such applicants to report the offsetting cash position (in the case of a spread exemption, applicants must report each component of the spread).18

11 See Proposed Regs. 150.9(d), 150.10(d), and 150.11(d). 12 See Proposed Reg. 150.9(a)(1). Similarly, to process spread exemption applications, exchanges must list for trading at least one contract

that is either a component of the spread or a referenced contract that is a component of the spread, and such contract must be actively traded and have been subject to the Exchange’s position limits for at least one year. See Proposed Reg. 150.10(a)(1). The requirements for exchanges to recognize enumerated anticipatory bona fide hedges are similar to those for NEBFHs. See Proposed Reg. 150.11(a)(1).

13 The CFTC explains that the enumerated anticipatory bona fide hedges would not implicate commodity index contracts. See 81 Fed. Reg. at 38,480 n.195.

14 The web-posting requirement would not apply to enumerated anticipatory bona fide hedges. 15 See Proposed Reg. 150.9(a)(2). 16 See 81 Fed. Reg. at 38,471. 17 See Proposed Regs. 150.9(a)(3), 150.10(a)(3), and 150.11(a)(2). 18 See Proposed Regs. 150.9(a)(6), 150.10(a)(6), and 150.11(a)(5).


Client Alert Under each of the processes, exchanges would have to keep certain records, including all information and documents submitted by an applicant, records of oral and written communications between the exchange and the applicant in connection with an application, and all information in connection with the exchange’s analysis of an action on such application.19 The exchanges would also be required to submit reports to the CFTC that include information about NEBFHs (or enumerated anticipatory bona fide hedges) recognized and spread exemptions granted.20

Amendments to the Definition of Bona Fide Hedging Position

In addition to the processes in the proposed regulations outlined above, the Supplemental Proposal amends the definition of the term bona fide hedging position, which the exchanges must follow in recognizing non-enumerated bona fide hedges. The amended definition essentially tracks the definition of bona fide hedging in Section 4a(c)(2) of the CEA, which provides that a “bona fide hedging transaction or position” means a transaction or position that:

• represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel;

• is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and

• arises from the potential change in the value of—

o assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising;

o liabilities that a person owns or anticipates incurring; or

o services that a person provides, purchases, or anticipates providing or purchasing; or

• reduces risks attendant to a position resulting from a swap that was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction or that reduced the risk attendant to a position resulting from a transaction that qualifies as a bona fide hedging transaction.21

The 2013 Position Limits Proposal had defined the term bona fide hedging position to include two requirements in addition to those included in the statutory definition: the “orderly trading requirement” and the “incidental test,” which were contained in the CFTC’s regulatory definition of bona fide hedging. Under the orderly trading requirement, a bona fide hedging position would have to be established and liquidated in an orderly manner in accordance with sound commercial practices. The incidental test would have required that the risks offset by a commodity derivatives position must be incidental to the position holder’s commercial operations.

19 See Proposed Regs. 150.9(b) (NEBFHs), 150.10(b) (spread exemptions), and 150.11(d) (enumerated anticipatory bona fide hedges). 20 See Proposed Regs. 150.9(c) (NEBFHs), 150.10(c)(spread exemptions), and 150.11(c)(enumerated anticipatory bon fide hedges). 21 See 7 U.S.C. 6a(c)(2).


Client Alert The Supplemental Proposal would eliminate the orderly trading requirement and the incidental test from the definition of the term bona fide hedging position. With regard to the orderly trading requirement, the CFTC states that it is not aware of a denial of a bona fide hedge due to a lack of orderly trading on an exchange and notes that disruptive trading activity by a commercial entity engaged in establishing or liquidating a hedging position would generally appear to be contrary to its economic interests. Moreover, the CFTC notes that market participants would remain subject to other provisions within the CEA in any event, such as restrictions on disruptive trading and manipulation, and thus the orderly trading requirement is unnecessary.22 With respect to the incidental test, the CFTC states that it interprets the incidental test similarly to the requirements of the statutory requirement that bona fide hedges be “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise,” rendering the incidental test unnecessary. The CFTC confirmed that it continues to read the statutory “economically appropriate” test to refer to price risk only (consistent with its interpretation of the “incidental test’) and does not include other risks, such as execution, logistics, or credit risk.23

Delay for Exchange-Set Position Limits for Swaps

The Supplemental Proposal also proposes to temporarily delay the requirement for an exchange to establish position limits on swaps where the exchange lacks access to sufficient swap position information. The CFTC states in the preamble that it believes that most exchanges do not have access to sufficient swap position information at this time to effectively monitor swap position limits. The Supplemental Proposal includes proposed guidance that would provide that DCMs or SEFs need not demonstrate compliance with the position limit core principles applicable to swaps until they have access to sufficient swap position information, after which the guidance would no longer be applicable.24 While providing for this delay in exchange-set limits, the Supplemental Proposal notes that federal position limits would apply to swaps that are economically equivalent to referenced futures contracts subject to federal limits.25

CONCLUSION

The Supplemental Proposal likely will be welcomed by many market participants. It should provide greater flexibility than the 2013 Position Limits Proposal by allowing the exchanges to recognize bona fide hedges and grant spread exemptions, rather than the CFTC processing the applications itself, which, given the CFTC’s chronic lack or resources could create delays and inefficiencies. It also would draw upon the exchanges’ extensive expertise in administering position limits, which they have done under the current position limits framework for many years, and their understanding of hedging activity. For those in favor of a robust position

22 See generally 81 Fed. Reg. at 38,463-64. 23 See generally 81 Fed. Reg. at 38,463. In addition to amending the term bona fide hedging position, the Supplemental Proposal would also

amend the definition of the terms futures equivalent, intermarket spread position and intramarket spread position contained in the 2013 Position Limits Proposal. The amendments make certain clarifications regarding the term futures equivalent and expand the definitions of the terms intermarket spread position and intramarket spread position. See generally 81 Fed. Reg. at 38,482-83.

24 See Proposed Guidance in Appendix B to Part 37, Core Principle 6 (applicable to SEFs) and Appendix B to Part 38, Core Principle 5 (applicable to DCMs). The guidance provides that an exchange would have access to sufficient swap position information if, for example: (i) it has access to daily information about its market participants’ open swap positions or (ii) it knows that its market participants regularly engage in large volumes of speculative trading activity on the exchange that would cause reasonable surveillance personnel to inquire further. Id.

25 See 81 Fed. Reg. at 38,462.


Client Alert limits regime, the Supplemental Proposal provides for strong CFTC oversight of the exchanges in recognizing bona fide hedges and granting hedge exemptions, both through rule enforcement reviews of the exchanges and review of individual applications in appropriate circumstances. However, market participants may not favor the Supplemental Proposal’s prohibition on risk management exemptions, which exchanges would not be permitted to grant.

Contact:

Julian E. Hammar (202) 887-1679 [email protected]

About Morrison & Foerster:

We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.





Client Alert June 7, 2016

CFTC Issues Final Rules Regarding the Cross-Border Application of its Uncleared Swaps Margin Requirements

By Julian Hammar

On May 24, 2016, the Commodity Futures Trading Commission (“CFTC”) in a much anticipated action approved

the issuance of final rules (“Final Rules”) regarding the cross-border application of its uncleared swaps margin

requirements that it adopted on December 16, 2015. The Final Rules are closely aligned with the cross-border

rules for uncleared swaps margin that the Prudential Regulators1 adopted in October of 2015 for swap dealers

and major swap participants subject to their supervision.2 The CFTC’s Final Rules, which were published in the

Federal Register on May 31, 2016, are scheduled to become effective on August 1, 2016.3

I. BACKGROUND

In December of 2015, the CFTC adopted final rules (“December 2015 Final Margin Rules”) regarding margin

requirements for uncleared swaps for swap dealers and major swap participants that do not have a Prudential

Regulator (“Covered Swap Entities” or “CSEs”). The rules that became the December 2015 Final Margin Rules

had been re-proposed in October of 2014 (along with those of the Prudential Regulators) to take into account

recommendations of the Basel Committee on Bank Supervision (“BCBS”) and the Board of the International

Organization of Securities Commissions (“IOSCO”) (referred to herein as the “BCBS/IOSCO Standards”).4 The

CFTC’s October 2014 re-proposal did not include proposed rules regarding the cross-border application of these

rules; instead, the October 2014 re-proposal included an advance notice of proposed rulemaking requesting

comment on three alternative approaches.

Subsequently, in June of 2015, the CFTC separately proposed rules regarding the cross-border application of its

uncleared swaps margin rules (“Proposed Rules”). The Proposed Rules by their terms would apply the uncleared

swap margin rules at the entity level, meaning that they would apply to CFTC-registered swap dealers or major

swap participants—as entities—that do not have a Prudential Regulator. However, certain uncleared swaps

would be eligible for substituted compliance or excluded from the CFTC’s margin rules entirely under the

Proposed Rules based on the counterparties’ relationship to the United States relative to other jurisdictions.5

1 The Prudential Regulators are the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the

Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency.

2 See Margin and Capital Requirements for Covered Swap Entities; Final Rule, 80 Fed. Reg. 74,839 (Nov. 30, 2015).

3 See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements, 81 Fed. Reg. 34,817 (May 31, 2016), available here.

4 See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants; Final Rule, 81 Fed. Reg. 635 (Jan. 6. 2016). For more information regarding the CFTC’s December 2015 Final Margin Rules, please see our client alert here.

5 For more information regarding the Proposed Rules, please see our client alert here.


http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016-12612a.pdf

http://www.mofo.com/~/media/Files/ClientAlert/2015/12/151223CFTCUnclearedSwaps.pdf

http://www.mofo.com/~/media/Files/ClientAlert/2015/07/150713CFTCIssuesProposedRules.pdf


Client Alert II. FINAL RULES

The Final Rules generally are the same as the Proposed Rules with a few modifications that are described in this

client alert. In general, as under the Proposed Rules, the Final Rules provide for the applicability of the CFTC

Margin Rules depending upon the location of the counterparties to an uncleared swap and the nexus of the

counterparties to the United States. As discussed in greater detail below, where the covered swap entity is a U.S.

CSE or a CSE guaranteed by a U.S. person, the uncleared swaps margin rules apply to a greater extent than to a

non-U.S. CSE that is not guaranteed by a U.S. person, whose swaps may in certain circumstances be excluded

from the rules.

A. Application of the Margin Rules to U.S. CSEs and U.S.-Guaranteed CSEs

Under the Final Rules, the uncleared swaps margin requirements will generally apply to all uncleared swaps of a

U.S. CSE and a non-U.S. CSE that is guaranteed by a U.S. person (“U.S. Guaranteed CSE”), without exclusion.

Substituted compliance (i.e., compliance with a non-U.S. regulator’s rules that the CFTC has determined to be

sufficiently comparable to meet the CFTC’s uncleared swaps margin requirements, discussed in section C. below)

would be available in one circumstance only: with respect to initial margin posted to (but not collected from) any

non-U.S. person counterparty (including any non-U.S. CSE) whose obligations are not guaranteed by a U.S.

person. The CFTC believes that, with regard to a non-U.S. counterparty whose swap obligations are not

guaranteed by a U.S. person, in the interest of comity substituted compliance in these circumstances would be

reasonable. The CFTC’s rules afford U.S. CSEs and U.S. Guaranteed CSEs the same treatment as under the

Prudential Regulators’ final uncleared swaps margin rules, which provide for the possibility of substituted

compliance for U.S. CSEs and U.S. Guaranteed CSEs with regard to the posting of initial margin to

non-U.S. counterparties.6

B. Application of Margin Rules to Non-U.S. CSEs that are Not Guaranteed by a U.S. Person

1. Availability of Substituted Compliance

The Final Rules would allow non-U.S. CSEs that are not guaranteed by a U.S. person to avail themselves of

substituted compliance with non-U.S. uncleared swaps margin rules for swaps with any counterparty, except for a

U.S. CSE or U.S. Guaranteed CSE. Notably, the availability of substituted compliance under the Final Rules is

broader than under the CFTC’s Cross-Border Guidance issued by the agency in 2013,7 which would have applied

the CFTC’s margin requirements to swaps between non-U.S. swap dealers and all U.S. persons, with substituted

compliance available only for swaps between a non-U.S. swap dealer and a foreign branch of a U.S. swap dealer.

The availability of substituted compliance under the Final Rules also applies to a non-U.S. CSE not guaranteed by

a U.S. person that is consolidated for accounting purposes with an ultimate parent entity that is a U.S. person,

described in the rules as a “Foreign Consolidated Subsidiary” (“FCS”). For this purpose, the term “ultimate parent

entity” means an entity in a consolidated group in which none of the other entities in the group has a controlling

6 See 80 Fed. Reg. at 74,885.

7 See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,291 (July 26, 2013) (“Cross Border Guidance”).


Client Alert interest in accordance with U.S. Generally Accepted Accounting Principles. While eligible for substituted

compliance, FCSs, as well as U.S. branches of non-U.S. CSEs, are not eligible for the exclusion from the

uncleared swaps margin rules for non-U.S. CSEs described in section B.2. below.

If the swap obligations of a non-U.S. CSE (including an FCS or U.S. branch of a non-U.S. CSE) are not

guaranteed by a U.S. person, and its counterparty is a U.S. CSE or a U.S. Guaranteed CSE (including an FCS or

U.S. branch of a non-U.S. CSE the swap obligations of which are guaranteed by a U.S. person), substituted

compliance would be available only with respect to initial margin collected from the U.S. CSE or U.S. Guaranteed

CSE, and in no other circumstances.

2. Exclusion from Margin Rules

The Final Rules provide for an exclusion from the CFTC’s uncleared swaps margin rules with respect to swaps

entered into by a non-U.S. CSE with a non-U.S. person, provided that neither the non-U.S. CSE’s nor the non-

U.S. person’s swap obligations are guaranteed by a U.S. person, and neither counterparty is an FCS or a U.S.

branch of a non-U.S. CSE.8 In a new provision not contained in the Proposed Rules, the Final Rules provide, in

connection with inter-affiliate swaps that under the December 2015 Final Margin Rules are exempt from the

uncleared swaps margin requirements under certain conditions, that this exclusion is not available if (i) the

market-facing transaction of the non-U.S. CSE (that is otherwise eligible for the exclusion) is not subject to

comparable initial margin collection requirements in the home jurisdiction and (ii) any of the risk associated with

the uncleared swap is transferred, directly or indirectly, through inter-affiliate transactions, to a U.S. CSE.9

C. Procedures for Substituted Compliance Determinations

The Final Rules will permit a U.S. CSE or a non-U.S. CSE in the circumstances described above that is eligible

for substituted compliance to comply with the margin requirements of the relevant foreign jurisdiction in lieu of

compliance with the CFTC’s margin requirements, only if the CFTC makes a comparability determination to the

effect that such jurisdiction’s margin requirements are comparable to the CFTC’s margin requirements. Persons

eligible to request a comparability determination include any CSE that is eligible for substituted compliance and

any foreign regulatory authority that has direct supervisory authority over one or more CSEs and that is

responsible for administering the relevant foreign jurisdiction’s margin requirements. Such persons may request a

comparability determination individually or collectively and with respect to some or all of the CFTC’s margin

requirements; the CFTC advises that eligible CSEs may wish to coordinate with their home regulators and other

CSEs to streamline the process.

A comparability determination applicant must submit (i) copies of the relevant foreign jurisdiction’s margin

requirements, (ii) a description of their objectives, (iii) a description of how they differ from the BCBS/IOSCO

standards, and (iv) a description of how they address the elements of the CFTC’s margin requirements, as well as

any other documentation the CFTC deems relevant.10

The CFTC will issue a comparability determination to the

8 See 17 CFR 23.160(b)(2)(ii).

9 See 17 CFR 23.160(b)(2)(ii)(B).

10 See 17 CFR 23.160(c)(2).


Client Alert extent that it determines that some or all of the relevant foreign jurisdiction’s margin requirements are comparable

to the CFTC’s corresponding margin requirements. In making a comparability determination, the Final Rules

provide that the CFTC will consider all relevant factors, including: (i) the scope and objectives of the relevant

foreign jurisdiction’s margin requirements, (ii) whether the relevant foreign jurisdiction’s margin requirements

achieve comparable outcomes to the Commission’s corresponding margin requirements, (iii) the ability of the

relevant regulatory authority or authorities to supervise and enforce compliance with the relevant foreign

jurisdiction’s margin requirements, and (iv) any other facts and circumstances the CFTC deems relevant.11

The

CFTC will also consider the consistency of the margin requirements of the foreign jurisdiction with the

BCBS/IOSCO Standards, although the CFTC states that, while a finding of consistency with the BCBS/IOSCO

Standards is necessary, it may not be sufficient for a finding of comparability.12

The CFTC describes its comparability standard as “outcome-based” with a focus on whether margin requirements

in the foreign jurisdiction achieve the same regulatory objectives as margin requirements under the Commodity

Exchange Act without regard to whether the foreign jurisdiction has implemented specific rules that are identical

to the CFTC’s rules. The standard takes the form of an “element-by-element” determination involving 12

elements, where the CFTC may find some elements comparable with its rules, but not others.13

In a dissenting

statement to the Final Rules, CFTC Commissioner J. Christopher Giancarlo expressed the view that this

approach is impractical, unnecessary, and contrary to the spirit of the 2009 G-20 Pittsburgh Accords and the

BCBS/IOSCO standards, and that a better approach would be to determine whether, in the aggregate, a foreign

regulator has adopted the BCBS-IOSCO standards.14

It remains to be seen how the CFTC will apply its standard

in an actual comparability determination.

D. Definition of U.S. Person

As under the Proposed Rules, the Final Rules’ definition of U.S. person differs from the U.S. person definition in

the CFTC’s 2013 Cross-Border Guidance, which is generally applicable to Dodd-Frank Title VII CFTC

requirements. While broadly similar in most respects, key differences adopted by the Final Rules include:

Elimination of the “including, but not limited” language contained in the U.S. person definition in the

Cross-Border Guidance. This change provides greater legal certainty for market participants as to who is

(and who is not) a U.S. person.

11 See 17 CFR 23.160(c)(3).

12 81 Fed. Reg. at 34,837.

13 The twelve elements generally are similar to the elements as proposed, except one element, the treatment of inter-affiliate derivative transactions, has been added. The twelve elements are as follows: (A) The products subject to the foreign jurisdiction’s margin requirements; (B) The entities subject to the foreign jurisdiction’s margin requirements; (C) The treatment of inter-affiliate derivative transactions; (D) The methodologies for calculating the amounts of initial and variation margin; (E) The process and standards for approving models for calculating initial and variation margin models; (F) The timing and manner in which initial and variation margin must be collected and/or paid; (G) Any threshold levels or amounts; (H) Risk management controls for the calculation of initial and variation margin; (I) Eligible collateral for initial and variation margin; (J) The requirements of custodial arrangements, including segregation of margin and rehypothecation; (K) Margin documentation requirements; and (L) The cross-border application of the foreign jurisdiction’s margin regime. See 17 CFR 23.160(c)(2)(ii).

14 See generally 81 Fed. Reg. at 34,853-54.


Client Alert Elimination of the U.S. majority ownership prong that was included in the Cross-Border Guidance

definition for funds or other collective investment vehicles. Market participants commented that this

requirement is burdensome and difficult to comply with.

Elimination of the requirement that a legal entity owned by one or more U.S. person(s), for which such

person(s) bear unlimited responsibility for its obligations and liabilities, be majority owned by one or more

U.S. persons.15

It is likely that the final definition of U.S. person will be welcomed by market participants, as it eliminates aspects

of the Cross-Border Guidance definition that created legal uncertainty and were burdensome to implement.

However, it should be noted that, while similar to the Prudential Regulators’ rules, the CFTC’s definition of U.S.

person includes two types of entities that are not mentioned in the Prudential Regulators’ rules: (i) an entity with

its principal place of business in the United States and (ii) an entity for which a U.S. person bears unlimited

responsibility for the entity. This may mean, in practice, that the CFTC’s uncleared swaps margin rules will apply

in more situations than the Prudential Regulators’ rules.

E. Definition of Guarantee

For purposes of the Final Rules, a guarantee is not as broadly defined as it is in the CFTC’s Cross-Border

Guidance. The Final Rules would define the term “guarantee” as an arrangement, pursuant to which one party to

an uncleared swap transaction with a non-U.S. counterparty has rights of recourse against a U.S. person

guarantor (whether such guarantor is affiliated with the non-U.S. counterparty or is an unaffiliated third party) with

respect to the non-U.S. counterparty’s obligations under the swap. A party has rights of recourse against a U.S.

guarantor if the party has a conditional or unconditional legally enforceable right, in whole or in part, to receive

payments from, or otherwise collect from, the U.S. person in connection with the non-U.S. person’s obligations

under the swap. The terms of the guarantee need not be included with the swap documentation or reduced to

writing so long as legally enforceable rights are created under the laws of the relevant jurisdiction.16

15

The final definition of the term U.S. person in the Final Rules is as follows: (i) A natural person who is a resident of the United States; (ii) An estate of a decedent who was a resident of the United States at the time of death; (iii) A corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of entity similar to any of the foregoing (other than an entity described in paragraph (a)(10)(iv) or (v) of this section) (a ‘‘legal entity’’), in each case that is organized or incorporated under the laws of the United States or having its principal place of business in the United States, including any branch of such legal entity; (iv) A pension plan for the employees, officers or principals of a legal entity described in paragraph (a)(10)(iii) of this section, unless the pension plan is primarily for foreign employees of such entity; (v) A trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) A legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is owned by one or more persons described in paragraphs (a)(10)(i) through (v) of this section and for which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity, including any branch of the legal entity; or (vii) An individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in paragraphs (a)(10)(i) through (vi) of this section.

17 CFR 23.610(a)(10).

16 See 17 CFR 23.160(a)(2).


Client Alert The Final Rules add a provision to the definition of the term guarantee not contained in the Proposed Rules,

which provides that, in the case of any arrangement pursuant to which the guarantor has a conditional or

unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from any other

guarantor with respect to the counterparty’s obligations under the uncleared swap, such arrangement will be

deemed a guarantee of the counterparty’s obligations under the uncleared swap by the other guarantor. This

provision conforms the CFTC’s definition of the term guarantee to that of the Prudential Regulators in their final

margin rules. Notwithstanding this modification, the Final Rules’ definition of the term guarantee is generally

narrower than that in the Cross-Border Guidance because it does not include other types of financial

arrangements, such as keepwells and liquidity puts, certain types of indemnity agreements, master trust

agreements, liability, or loss transfer or sharing agreements.

F. Reliance on Counterparty Representations

The Final Rules expands the circumstances under which market participants may reasonably rely on written

representations with respect to the status of their counterparties compared with the Proposed Rules. Under the

Final Rules, a market participant may reasonably rely on a counterparty’s written representation of its status as a

U.S. person, FCS, or a non-U.S. person whose obligations are guaranteed by a U.S. person, unless the market

participant has information that would cause a reasonable person to question the accuracy of the

representation.17

By contrast, the Proposed Rules would have permitted reliance on a counterparty’s

representation only in the case of representing its status as a U.S. person (and not as an FCS or whether the

obligations of the counterparty are guaranteed by a U.S. person).

G. Special Provisions for Non-Segregation and Non-Netting Jurisdictions

In order to conform the CFTC’s uncleared swaps margin rules to those of the Prudential Regulators, the Final

Rules add two provisions similar to the Prudential Regulators’ Rules to address non-segregation and non-netting

foreign jurisdictions. Specifically, the first provision addresses swaps with counterparties in foreign jurisdictions

where limitations in the legal or operational infrastructure of the jurisdiction make it impracticable to comply with

the custodial arrangement requirements contained in the December 2015 Final Margin Rules. Subject to

conditions, an FCS or a foreign branch of a U.S. CSE transacting with counterparties in such jurisdictions need

not comply with either the requirement to post initial margin or the custodial arrangement requirements that

pertain to initial margin collected by a CSE under the December 2015 Final Margin Rules.18

The second provision

addresses the situation where a CSE cannot conclude, with a well-founded basis, that a netting agreement with a

counterparty in a foreign jurisdiction meets the definition of an “eligible master netting agreement” set forth in the

December 2015 Final Margin Rules. The provision provides that a CSE may net uncleared swaps in such

17 See 81 Fed. Reg. at 34,827.

18 See 17 CFR 23.160(e). The conditions include that (i) the CSE’s counterparty must be a non-U.S. person that is not a CSE, and the counterparty’s obligations must not be guaranteed by a U.S. person; (ii) the CSE must collect initial margin in cash on a gross basis and post and collect variation margin in cash in accordance with the December 2015 Final Margin Rules; and (iii) for each broad risk category set out in the December 2015 Final Margin Rules (credit, equity, foreign exchange and interest rates, and commodities), the total outstanding notional value of all uncleared swaps in the broad risk category as to which the CSE is relying upon this relief may not exceed 5% of the CSE’s total outstanding notional value for all uncleared swaps in that same broad risk category. In addition, the CSE must have policies and procedures to ensure compliance with the requirements of the exception and maintain books and records documenting that the requirements are satisfied. See 81 Fed. Reg. at 34,833.


Client Alert circumstances in determining the amount of initial and variation margin that it posts, provided that certain

conditions are met.19

III. CONCLUSION

Certain aspects of the CFTC’s Final Rules may be viewed favorably by market participants, including the greater

legal certainty provided for in the U.S. person definition, the expansion (as compared with the CFTC’s Cross-

Border Guidance) of the scope for potential substituted compliance determinations and the broadened number of

situations where counterparty representations may be relied upon. However, much of the Final Rules’ impact on

market participants may depend upon how the substituted compliance determination process is implemented,

which, although labeled an “outcomes-based” approach, may not achieve that objective with its element-by-

element determinations in practice. The element-by-element determinations may also result in findings that some

foreign margin requirements are comparable, but not others, leading to the potential for a complex patchwork of

U.S. and non-U.S. requirements to apply to cross-border swap transactions, which may greatly increase the

compliance burden and cost for market participants.

Contact:

Julian Hammar

(202) 887-1679

[email protected]

James Schwartz

(212) 336-4327

[email protected]

Chrys Carey

(202) 887-8770

[email protected]

David Kaufman

(212) 468-8237

[email protected]


We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest

financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been

included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best

Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our

clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations

and should not be acted upon without specific legal advice based on particular situations. Prior results do not

guarantee a similar outcome.

19 See 17 CFR 23.160(d). These conditions are that the CSE must treat uncleared swaps covered by the agreement on a gross basis in

determining the amount of initial and variation margin that it must collect and that the CSE have policies and procedures to ensure, and maintain books and records to document, compliance with the requirements of 17 CFR 23.160(d).



http://www.mofo.com/people/s/schwartz-james


http://www.mofo.com/people/c/carey-chrys-a


http://www.mofo.com/people/k/kaufman-david-h




Cross-Border Application of Uncleared Swaps Margin Requirements under CFTC Final Rules

Covered Swap Entity (“CSE”) Counterparty Cross-Border Application of

Margin Requirements

U.S. CSE or

Non-U.S. CSE (including U.S. branch of a non- U.S. CSE or a Foreign Consolidated Subsidiary (‘‘FCS’’)) whose obligations under the relevant swap are guaranteed by a U.S. person.

Any (except for a non-U.S. person whose swap obligations are not guaranteed by a U.S. person as noted immediately below).

CFTC Margin Rules apply.

U.S. CSE or

Non-U.S. CSE (including a U.S. branch of a non-U.S. CSE or an FCS) whose obligations under the relevant swap are guaranteed by a U.S. person.

Non-U.S. person (including a non-U.S. CSE, FCS, or U.S. branch of a non-U.S. CSE) whose swap obligations are not guaranteed by a U.S. person.

CFTC Margin Rules generally apply

Substituted compliance may be available for the posting of initial margin by the CSE.

Non-U.S. CSE that is not:

an FCS of a U.S. person or

a U.S. branch of a non-U.S. CSE, and

whose obligations under the swap are not guaranteed by a U.S. person.

Non-U.S. person counterparty (including a non-U.S. CSE but not:

an FCS or

a U.S. branch of a non-U.S. CSE), and

whose obligations under the swap are not guaranteed by a U.S. person

CFTC Margin Rules do not apply (except in connection with certain inter-affiliate swaps).

Non-U.S. CSE that is not an FCS and whose swaps are not guaranteed by a U.S. person or

Non-U.S. CSE whose obligations under a swap are not guaranteed by a U.S. person, but which is an FCS or a U.S. branch of the non-U.S. CSE.

U.S. CSE or

Non-U.S. CSE (including U.S. branch of a non-U.S CSE or an FCS) whose swap obligations are guaranteed by a U.S. person).

CFTC Margin Rules apply.

Substituted compliance may be available for collection of initial margin by the non-U.S. CSE.

Non-U.S. CSE that is not an FCS and whose swaps are not guaranteed by a U.S. person or

Non-U.S. CSE whose obligations under a swap are not guaranteed by a U.S. person, but which is an FCS or a U.S. branch of the non-U.S. CSE.

U.S. person (except as noted above for a U.S. CSE).

Non-U.S. person whose swap obligations are guaranteed by a U.S. person (except a non-U.S. CSE, U.S. branch of a non-U.S. CSE, or FCS whose obligations are guaranteed as noted above).

Non-U.S. CSE, U.S. branch of a non-U.S. CSE or foreign consolidated subsidiary whose obligations are not guaranteed by a U.S. person.

Substituted compliance may be available for all requirements.

1 Attorney Advertisement

Client Alert May 10, 2016

SEC Issues Business Conduct Rules

for Security-Based Swap Entities

In an important step in the ongoing regulation of the market for security-based swaps (both individually and in

the plural, “SBS”), last month the Securities and Exchange Commission (“SEC”) issued its final business conduct

rules (the “SEC Conduct Rules”) for security-based swap dealers (each, an “SBSD”) and major security-based swap

participants (each, an “MSBSP”).1 This Client Alert highlights the most significant features of those rules.

The SEC Conduct Rules are generally (though not entirely) consistent with certain of the business conduct rules

that the Commodity Futures Trading Commission (“CFTC”) finalized for the swaps market in 2012.2 For that

reason, the substance of the SEC Conduct Rules should be generally familiar to many dealers and other market

participants. Moreover, it should be possible for the industry to facilitate compliance with the SEC Conduct Rules,

to the extent that those rules address dealings with counterparties, by means similar3 to the protocol by which the

industry facilitated compliance with corresponding CFTC external business conduct rules.4

While the SEC Conduct Rules largely overlap with the CFTC external business conduct rules, they also include

provisions similar to certain CFTC internal business conduct rules (with respect to, for example, supervisory

requirements and the requirement that SBSDs designate a chief compliance officer). Further, unlike the CFTC’s

business conduct rules, which are subject to the CFTC cross-border guidance that applies generally to the CFTC’s

1 Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-77617, File No. S7-25-11 (April 14, 2016) (the “Business Conduct Release”), available here. 2 See Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Fed. Reg. 9733 (Feb. 17, 2012); Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 Fed. Reg. 20127 (April 3, 2012). Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) gives the CFTC jurisdiction over “swaps,” “swap dealers” and “major swap participants” and the SEC jurisdiction over “security-based swaps,” “security-based swap dealers” and “major security-based swap participants.” 3 The SEC Conduct Rules provide that an SBSD or MSBSP may rely on written representations of its counterparties to satisfy its due diligence requirements “unless it has information that would cause a reasonable person to question the accuracy of the representation.” SEC Conduct Rules at Rule 15Fh-1(b). However, the SEC expressly rejected a “commenter’s suggestion that we provide that in every instance an SBS Entity that is also registered with the CFTC as a Swap Entity will be permitted to rely on a counterparty’s pre-existing written representations with respect to the CFTC’s business conduct rules to satisfy its due diligence requirements under the [SEC Conduct Rules], provided that the SBS Entity provides notice of such reliance to the counterparty and the counterparty does not object… The question of whether reliance on the representations that had been obtained with respect to the CFTC business conduct rules, including the process by which the SBS Entity makes that determination, would satisfy an SBS Entity’s obligations under our business conduct rules will depend on the facts and circumstances of the particular matter.” Business Conduct Release at 69-70. See generally Business Conduct Release at 62-70. 4 See ISDA August 2012 DF Protocol, available at https://www2.isda.org/functional-areas/protocol-management/protocol/8.

https://www.sec.gov/rules/final/2016/34-77617.pdf

https://www2.isda.org/functional-areas/protocol-management/protocol/8


swaps rules,5 the SEC Conduct Rules expressly state the circumstances in which they may or may not apply to

cross-border transactions.

The compliance date of the SEC Conduct Rules remains some time away, in no case earlier than the compliance

date of the SEC’s rules requiring SBSDs and MSBSPs to register with the SEC.6

Background

The Dodd-Frank Act reflects the concern that dealers might not in all cases obtain sufficient information

regarding their counterparties, disclose material information to their counterparties or communicate with their

counterparties in a balanced manner in relation to derivatives. It requires the SEC to adopt business conduct

requirements for SBSDs and MSBSPs (“SEC Swap Entities”) and the CFTC to adopt business conduct

requirements for swap dealers and major swap participants (“CFTC Swap Entities” and collectively with SEC Swap

Entities, “Swap Entities”). Such business conduct standards must, among other things, require Swap Entities to

(i) verify that any counterparty constitutes an eligible contract participant (“ECP”), (ii) disclose to any

counterparty (other than another Swap Entity) material information regarding a particular transaction and (iii)

communicate in a fair and balanced manner based on principles of fair dealing and good faith.7

Primary Provisions of SEC Conduct Rules

The primary provisions contained in the SEC Conduct Rules can be summarized as follows.

Verification of ECP and Special Entity Status

An SEC Swap Entity must, unless the relevant SBS is executed on a registered national securities exchange, verify

that its counterparty constitutes an ECP8 before entering into such SBS with such counterparty.9

In addition, an SEC Swap Entity must, if it knows the identity of the counterparty at a reasonably sufficient time

prior to execution of the transaction, verify whether such counterparty constitutes a “Special Entity” (a category

that includes certain types of public entities, endowments and employee benefit plans)10 before entering into an

SBS with that counterparty.11

5 See Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45291, 45369 App. E (July 26, 2013). 6 See Business Conduct Release at 502-503. The compliance date for the SEC registration rules (and thus the SEC Conduct Rules) will occur only after the occurrence of several events that, taken together, have not yet occurred, cannot occur for a minimum of six months, and seem relatively unlikely to occur until after significantly more than six months have passed. For further detail regarding the compliance date of the SEC’s rules requiring SBSDs and MSBSPs to register with the SEC, see our client alert on the SEC registration rules, available here. 7 See Dodd-Frank Act at Sections 731, 764(a). 8 See SEC Conduct Rules at Rule 15Fh-2(b) for the ECP definition. 9 Id. at Rule 15Fh-3(a)(1). 10 See id. at Rule 15Fh-2(d) for the full definition of “Special Entity.” 11 Id. at Rule 15Fh-3(a)(2).

http://www.mofo.com/~/media/Files/ClientAlert/2015/08/150828SECsRegistrationRules.pdf


Disclosures to Counterparties

If an SEC Swap Entity knows the identity of its counterparty prior to the execution of an SBS, and if such

counterparty is not a Swap Entity, then the SEC Swap Entity must, at a reasonably sufficient time prior to entering

into such SBS, make disclosures to such counterparty.12

The SEC Swap Entity must disclose to such counterparty information in a manner reasonably designed to allow

the counterparty to assess the material risks and characteristics of the relevant SBS. Such “material risks and

characteristics” may include, with respect to a particular SBS, (i) market, credit, liquidity, foreign currency, legal,

operational, and any other applicable risks, and (ii) the material economic terms of the SBS, the terms relating to

the operation of the SBS, and the rights and obligations of the parties during the term of the SBS.13

The SEC Swap Entity must similarly disclose to its counterparty information in a manner reasonably designed to

allow the counterparty to assess any material incentives or conflicts of interest that the SEC Swap Entity may have

in connection with the relevant SBS. Such “material incentives or conflicts of interest” may include any material

incentives or conflicts of interest that the SEC Swap Entity may have in connection with the relevant SBS,

including any compensation or other incentives from any source other than the counterparty in connection with

the relevant SBS.14

Daily Marks

An SEC Swap Entity must disclose an SBS’ daily mark to a counterparty that is not a Swap Entity. For an

uncleared SBS, on each business day during the term of an SBS, the SEC Swap Entity must provide a daily mark

equal to the midpoint between the bid and offer, or the calculated equivalent thereof, as of the close of business,

unless the parties agree in writing otherwise to a different time. For a cleared SBS, upon the request of the

counterparty, the SEC Swap Entity must provide the daily mark that the SEC Swap Entity receives from the

relevant clearing agency.15

Disclosure of Clearing Rights

A SEC Swap Entity must disclose information relating to the potential clearing of an SBS to a counterparty that is

not a Swap Entity, so long as the SEC Swap Entity knows the identity of the counterparty at a reasonably sufficient

time prior to execution of the SBS.16

Before entering into an SBS that is subject to mandatory clearing, an SEC Swap Entity must (i) disclose to the

counterparty the names of the clearing agencies that accept the SBS for clearing, and through which of those

clearing agencies the SEC Swap Entity is authorized or permitted to clear the SBS, and (ii) notify the counterparty

that it shall have the sole right to select which applicable clearing agencies shall be used to clear the relevant SBS.17

Before entering into an SBS that is not subject to mandatory clearing, an SEC Swap Entity must (i) determine

whether the SBS is accepted for clearing by one or more clearing agencies, (ii) disclose to the counterparty the

12 Id. at Rule 15Fh-3(b). 13 Id. at Rule 15Fh-3(b)(1). 14 Id. at Rule 15Fh-3(b)(2). 15 Id. at Rule 15Fh-3(c). 16 Id. at Rule 15Fh-3(d). 17 Id. at Rule 15Fh-3(d)(1).


names of the clearing agencies that accept the SBS for clearing, and whether the SEC Swap Entity is authorized or

permitted to clear the SBS through such clearing agencies and (iii) notify the counterparty that the counterparty

may elect to require clearing of the SBS and will have the sole right to select the clearing agency at which the SBS

will be cleared, provided it is a clearing agency at which the SEC Swap Entity is authorized or permitted to clear

the SBS.18

Know Your Counterparty Requirements

Each SBSD must establish, maintain and enforce written policies and procedures reasonably designed to obtain

and retain a record of the essential facts concerning each counterparty whose identity is known to the SBSD that

are necessary for conducting business with such counterparty. Such essential facts concerning a counterparty

include (i) facts required to comply with applicable laws, regulations and rules, (ii) facts required to implement

the SBSD’s credit and operational risk management policies in connection with transactions entered into with

such counterparty and (iii) information regarding the authority of any person acting for such counterparty.19

Recommendations of Security-Based Swaps or Trading Strategies

An SBSD that recommends an SBS or a trading strategy involving an SBS to a counterparty that is not a Swap

Entity must (i) undertake reasonable diligence to understand the potential risks and rewards associated with the

recommended SBS or trading strategy and (ii) have a reasonable basis to believe that a recommended SBS or

trading strategy is suitable for the counterparty. To establish a reasonable basis for a recommendation, an SBSD

must have or obtain relevant information regarding the counterparty, including the counterparty’s investment

profile, trading objectives, and its ability to absorb potential losses associated with the recommended SBS or

trading strategy.20

In many but not all cases, an SBSD will also be able to establish a reasonable basis for a recommendation based in

part on representations provided by the counterparty or an agent to which the counterparty has delegated

decision-making authority.21

Fair and Balanced Communications

An SEC Swap Entity must communicate with counterparties in a fair and balanced manner based on principles of

fair dealing and good faith. In particular, communications must provide a sound basis for evaluating the facts

with regard to any particular SBS or trading strategy involving an SBS.22

18 Id. at Rule 15Fh-3(d)(2). 19 Id. at Rule 15Fh-3(e). 20 Id. at Rule 15Fh-3(f)(1). 21 Id. at Rule 15Fh-3(f)(2), (4). Such rules permit SBSDs to satisfy the “reasonable basis” requirement in part by means of representations given by or on behalf of “institutional counterparties,” which must, among other things, have total assets of at least $50 million. For counterparties with less than $50 million in assets, SBSDs will likely be required to conduct substantial due diligence to establish a reasonable basis for a recommendation. The parallel CFTC external business conduct rule regarding recommendations contains no such asset threshold determining when dealers may rely upon counterparty representations as to suitability. See 17 CFR 23.434. 22 Id. at Rule 15Fh-3(g).


Antifraud Provisions

The SEC Conduct Rules make it unlawful for an SEC Swap Entity to (i) engage in any act, practice, or course of

business that is fraudulent, deceptive, or manipulative, (ii) employ any device or scheme to defraud any Special

Entity or prospective customer that is a Special Entity or (iii) engage in any transaction, practice, or course of

business that operates as a fraud or deceit on any Special Entity or prospective customer that is a Special Entity.23

Requirements for SBSDs Acting as Advisors to Special Entities

An SBSD acting as an advisor to a Special Entity has a duty to make a reasonable determination that any SBS or

trading strategy involving an SBS recommended by the SBSD is in the best interests of the Special Entity.24 Such

an SBSD must make reasonable efforts to obtain such information that the SBSD considers necessary to make a

reasonable determination that an SBS or such a trading strategy is in the best interests of the Special Entity,

including, among other things, information as to (i) the authority of the Special Entity to enter into the SBS,

(ii) the financial status of the Special Entity, as well as future funding needs, (iii) the tax status of the Special

Entity, (iv) the hedging, investment, financing or other objectives of the Special Entity and (v) the experience

of the Special Entity with respect to entering into SBS generally and SBS of the type and complexity

being recommended.25

Such requirements do not apply if the relevant transaction is executed on an SBS execution facility or registered

national securities exchange and the SBSD does not know the identity of the counterparty at a reasonably

sufficient time prior to execution of the transaction.26

Duties for SEC Swap Entities Acting as Counterparties to Special Entities

An SEC Swap Entity that enters into an SBS with a Special Entity must have a reasonable basis to believe that the

Special Entity has either a qualified independent representative or a fiduciary under the Employee Retirement

Income Security Act of 1974, 29 U.S.C. 1002 (“ERISA”)).27

In order to constitute a qualified independent representative, a representative must, among other things, (i) have

a duty to act in the best interests of the Special Entity, (ii) have sufficient knowledge to evaluate the transaction

and related risks, (iii) evaluate the fair pricing and the appropriateness of the SBS and (iv) be independent of the

relevant SEC Swap Entity.28

The SEC Conduct Rules provide a safe harbor under which the SEC Swap Entity, based on representations or

information provided to it, is deemed to have a reasonable basis to believe that a Special Entity has a qualified

independent representative or ERISA fiduciary.29

23 Id. at Rule 15Fh-4(a). 24 Id. at Rule 15Fh-4(b)(1). 25 Id. at Rule 15Fh-4(b)(2). 26 Id. at Rule 15Fh-4(b)(3). 27 Id. at Rule 15Fh-5(a). 28 Id. at Rule 15Fh-5(a)(1). 29 Id. at Rule 15Fh-5(b). The requirements of Rule 15Fh-5 do not apply if the relevant transaction is executed on an SBS execution facility or registered national securities exchange and the SEC Swap Entity does not know the identity of the counterparty at a reasonably sufficient time prior to execution of the transaction.


Political Contributions

The SEC Conduct Rules limit the circumstances in which an SBSD may enter into, or offer to enter into, an SBS, or

a trading strategy involving an SBS, with a municipal entity. Subject to certain exceptions, the SEC Conduct Rules

generally make such transactions unlawful within two years after an SBSD, or any “covered associate” of an SBSD,

makes any contribution to an official of such municipal entity.30 For these purposes, the term “covered associate”

includes, among other things, (i) any general partner, managing member or executive officer and (ii) any

employee who solicits a municipal entity to enter into an SBS with the SBSD and any person who directly or

indirectly supervises such employee.31

Supervision

An SEC Swap Entity must establish and maintain a system to supervise (and must diligently supervise) its

business and the activities of its associated persons. Its system must be reasonably designed to prevent violations

of the provisions of applicable federal securities laws and related rules and regulations relating to its business as

an SEC Swap Entity.32

Such a system must, at a minimum, include (i) the designation of at least one person with authority to carry out

the supervisory responsibilities of the SEC Swap Entity for each type of business in which it engages for which

registration with the SEC is required, (ii) the use of reasonable efforts to determine that all supervisors are

qualified to carry out their assigned responsibilities and (iii) the establishment, maintenance and enforcement of

written policies and procedures for the supervision of the types of SBS business in which the SEC Swap Entity is

engaged and the activities of its associated persons that are reasonably designed to prevent violations of applicable

federal securities laws and related rules and regulations.33

Chief Compliance Officer and Annual Compliance Reports

Similar to the CFTC’s rules, an SEC Swap Entity must designate an individual to serve as its chief compliance

officer (“CCO”). The CCO must report directly to the board of directors or to the senior officer of the SEC Swap

Entity and take reasonable steps to ensure that the SEC Swap Entity establishes, maintains and reviews written

policies and procedures reasonably designed to achieve compliance with the portions of the Securities Exchange

Act of 1934 (15 U.S.C. 78a et seq.) and related rules and regulations relating to the entity’s business as an SEC

Swap Entity.34

The CCO must, among other things, administer each required policy and procedure, and annually prepare and

sign a detailed compliance report that contains a description of the relevant written policies and procedures of the

SEC Swap Entity. The compliance report must also describe the SEC Swap Entity’s assessment of the

effectiveness of its policies and procedures relating to its business as an SEC Swap Entity and any material

non-compliance matters identified. The annual report must be submitted to the board of directors and audit

30 Id. at Rule 15Fh-6(b). 31 Id. at Rule 15Fh-6(a)(2). 32 Id. at Rule 15Fh-3(h)(1). 33 Id. at Rule 15Fh-3(h)(2). The SEC rule regarding the supervisory system is substantially more prescriptive than is the CFTC’s parallel rule. Compare SEC Conduct Rules at 15Fh-3(h)(2) and 17 CFR 23.602. The SEC supervision rule is generally based on current FINRA standards and would likely not be especially burdensome for SBSDs that are registered broker-dealers. See generally Business Conduct Release at 182-97. However, for non-broker-dealer SBSDs, the SEC rule could present implementation challenges. 34 SEC Conduct Rules at Rule 15Fk-1(a), (b).


committee (or equivalent bodies), to the senior officer of the SEC Swap Entity and to the SEC itself. The

compliance report must include a certification by the chief compliance officer or senior officer that, to the best of

his or her knowledge and reasonable belief and under penalty of law, the information contained in the compliance

report is accurate and complete in all material respects.35

Cross-border Application of SEC Conduct Rules

For registered SBSDs, the SEC Conduct Rules will generally not apply to “foreign business.”36 For SBSDs that are

U.S. persons,37 “foreign business” is effectively defined as an SBS that is conducted through such SBSD’s foreign

branch with either (i) a non-U.S. person or (ii) a U.S.-person counterparty acting through a foreign branch. For

SBSDs that are not U.S. persons, “foreign business” is effectively defined as an SBS transaction that is not (i) with

a U.S. person (other than a transaction conducted through a foreign branch of that person) or (ii) arranged,

negotiated, or executed by personnel of the foreign SBSD swap dealer (or its agent) located in a U.S. branch

or office.38

The SEC Conduct Rules also state the circumstances in which the SEC may make substituted compliance

determinations, to the effect that compliance with particular requirements under a foreign financial regulatory

system may satisfy the corresponding requirements under the SEC Conduct Rules. In order to make such a

determination, the SEC must, among other things, determine that the relevant foreign requirements are

comparable to its own otherwise applicable requirements and enter into a memorandum of understanding or

other arrangement with the relevant foreign financial regulatory authority.39

Conclusion

With the finalization of the SEC Conduct Rules, the number of rulemakings that the SEC must complete before

implementing its SBS regulatory regime continues to diminish. There are still significant hurdles – for example, it

seems likely that the SEC will re-propose its margin rules for SEC Swap Entities before finalizing them.40 But

while the timing for compliance remains uncertain, it is clear that the SEC’s progress on its rulemakings is

bringing the compliance date for the regulation of SBS steadily nearer. A registration and compliance date for

SEC Swap Entities occurring in 2017 seems ever more likely.

Author

James Schwartz New York (212) 336-4327 [email protected]

35 Id. at Rule 15Fk-1(b), (c). 36 Id. at Rule 3a71-3(c). 37 The SEC has defined “U.S. person” in previous final rules. See Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, 79 Fed. Reg. 47277, 47371 (August 12, 2014). 38 SEC Conduct Rules at Rule 3a71-3(a)(8), (9). 39 Id. at Rule 3a71-6(a). 40 The SEC originally proposed those rules in 2012, before the Basel Committee on Banking Supervision and the International Organization of Securities Commissions jointly published a final framework establishing consistent global standards for margin requirements. See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, 77 Fed. Reg. 70213 (Nov. 23, 2012).



Contact

Julian Hammar Washington, D.C. (202) 887-1679 [email protected]


We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial

institutions, investment banks, Fortune 100, technology and life sciences companies. We’ve been included on The American

Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are

committed to achieving innovative and business-minded results for our clients while preserving the differences that make us

stronger. This is MoFo. Visit us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights reserved. For more updates, follow

Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.





Client Alert February 16, 2016

SEC Adopts Rule Amendments Addressing Dealing Transactions Between Non-U.S. Persons that are “Arranged, Negotiated, or Executed” in the United States

By Julian Hammar

On February 10, 2016, the U.S. Securities and Exchange Commission (“SEC”) approved final rule amendments to its cross border rules that address how the security-based swap dealer definition applies to security-based swap dealing transactions between non-U.S. persons that are “arranged, negotiated, or executed” in the United States. The final rules will become effective 60 days after publication in the Federal Register, which is forthcoming. Compliance with the final rules will be required after the later of 12 months following such publication or 2 months prior to the compliance date for registration as a security-based swap dealer under the registration rules. The final rules are available here.

SECURITY-BASED SWAPS BETWEEN NON-U.S. PERSONS THAT COUNT TOWARD THE DE MINIMIS THRESHOLD

Under the final rules, a security-based swap dealing transaction that is entered into by a non-U.S. person will count toward the non-U.S. person’s de minimis exception threshold from registration as a security-based swap dealer, regardless of whether the counterparty is a “U.S. person,” if the transaction is “arranged, negotiated, or executed” through personnel of:

• the non-U.S. person located in a U.S. branch or office; or

• an agent (whether affiliated or unaffiliated) of such non-U.S. person located in the United States.

Accordingly, a non-U.S. person that conducts security-based swap dealing activity through personnel located in the United States will have to register with the SEC if its dealing activity in the United States – including security-based swaps with non-U.S. persons that are “arranged, negotiated, or executed” using U.S. personnel under the final rules – exceeds the relevant de minimis threshold.1 The non-U.S. person is not required to consider under the final rules the location of its counterparty’s operations or personnel (or that of the counterparty’s agent) in determining whether the transaction should be considered in its own de minimis calculation.

1 Under SEC rules, the current de minimis threshold for security-based swap dealer registration is $8 billion in aggregate gross notional

amount of dealing activity over the preceding 12 months for credit default swaps and $400 million for all other security-based swaps. These phase-in thresholds are temporary and, in the absence of action by the SEC, are set to drop to $3 billion and $150 million, respectively. The threshold for security-based swaps with special entity counterparties (e.g., governments, certain pension plans, and endowments) is $25 million.


http://www.sec.gov/rules/final/2016/34-77104.pdf


Client Alert “ARRANGED, NEGOTIATED, OR EXECUTED”

Under interpretive guidance contained in the rule release, a security-based swap transaction is considered to be “arranged, negotiated, or executed” in the United States if it is “market-facing activity.” In this context, “arrange” and “negotiate” means market-facing activity of sales or trading personnel in connection with a particular transaction, including interactions with counterparties or their agents.2 “Execute” 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. “Arranging,” “negotiating,” and “executing” also includes directing other personnel (including non-U.S.-based personnel) to arrange, negotiate, or execute a particular security-based swap. Personnel directing the arrangement, negotiation, or execution of security-based swaps include personnel located in a U.S. branch or office that specify the trading strategy or techniques carried out through algorithmic trading or automated electronic execution of security-based swaps (although not personnel solely engaged in coding the algorithm), even if the related server is located outside the United States.

The release also clarifies the types of activities that are not market-facing with respect to a specific transaction (and thus are not arranging, negotiating, or executing the transaction). These activities include:

• Designing security-based swaps (but not communicating regarding the contract in connection with a specific transaction or executing trades in the contract);

• Preparation of underlying documentation for the transaction, including the negotiation of a master agreement and related documents;

• Performing ministerial or clerical tasks in connection with the transaction (as opposed to negotiating with the counterparty the specific economic terms);

• Collateral management activities (e.g., the exchange of margin payments) that may occur in the United States;

• Submission of security-based swap transactions for clearing in the United States; and

• Reporting security-based swap transactions to U.S. security-based swap data repositories.

Involvement of U.S.-based attorneys in the negotiation of the terms for a transaction also would not, by itself, bring a transaction within “market-facing activity.” The final rule also does not require persons engaged in dealing activity to consider the location of personnel booking the transaction because the ministerial task of entering transactions on a non-U.S. person’s books once the transaction has been executed does not constitute market-facing activity.

2 The SEC explains that it uses the term “arrange” rather than “solicit” in recognition of the fact that a security-based swap 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.


Client Alert “LOCATED IN A U.S. BRANCH OR OFFICE”

In addition, the market-facing activity of arranging, negotiating, or executing a transaction must be conducted by personnel “located in a U.S. branch or office” of the non-U.S. person or its agent in order to be counted toward the de minimis threshold. The SEC expects that a non-U.S. person will include in its de minimis calculation any transactions arranged, negotiated, or executed in the United States by personnel assigned to, on an ongoing or temporary basis, or regularly working in a U.S. branch or office. However, the non-U.S. person would not have to include transactions arranged, negotiated, or executed by personnel assigned to a foreign office if such personnel are only “incidentally” in the United States, such as to attend an education or industry conference.

“PERSONNEL”

In a footnote, the SEC states that “personnel” in this context is to be interpreted in a manner consistent with the definition of the term “associated person of a security-based swap dealer” in the Securities Exchange Act of 1934, irrespective of whether the non-U.S. person or its agent is itself a security-based swap dealer. This definition is not dependent upon whether a natural person is technically an “employee” of the non-U.S. person, and the SEC expects to consider whether the non-U.S. entity is able to control or supervise the actions of an individual when determining whether the individual is “personnel” of a U.S. branch or office or an agent of that entity.

TRANSACTIONS THAT ARE EXEMPT OR NOT EXEMPT FROM THE RULES

The final rule exempts from its requirements security-based swaps arranged, negotiated, or executed in the United States by certain international organizations (e.g., multilateral development banks) as defined in SEC rules. The final rule does not exempt security-based swaps that are entered into anonymously on an execution facility or national securities exchange and are cleared through a clearing agency if the transaction is arranged, negotiated, or executed in the United States. Such security-based swaps must be counted toward the de minimis total.

ISSUES NOT ADDRESSED BY THE FINAL RULES

The final rule is limited to addressing the calculation of the de minimis threshold by non-U.S. persons of security-based swap dealing activity arranged, negotiated, or executed in the United States. It does not address other issues that were contained in the April 2015 release proposing the rules, including whether external business conduct standards or security-based swap reporting requirements apply to such transactions. The SEC states that these matters will be addressed in subsequent releases.

CFTC APPROACH

The approach taken in the final rules differs from that of the Commodity Futures Trading Commission (“CFTC”) in a 2013 staff advisory, in which CFTC staff took the position that, where a swap is between a non-U.S. swap dealer and another non-U.S. person, the CFTC’s transaction-level requirements (e.g., mandatory clearing, trade execution, margin for uncleared swaps) would apply to the swap if it is arranged, negotiated, or executed by personnel or agents of the non-U.S. swap dealer located in the United States. However, under the CFTC’s rules for determining which swaps count toward a non-U.S. person’s de minimis threshold for purposes of swap dealer registration, such swaps do not count toward that threshold. The CFTC requested comment on whether it


Client Alert should adopt the staff advisory, and through a series of no-action letters the CFTC staff has granted relief until September 30, 2016 (or any prior date of CFTC action) to non-U.S. swap dealers from complying with the advisory. CFTC action with respect to the staff advisory is pending at this time.

Contact:

Julian E. Hammar (202) 887-1679 [email protected]

David H. Kaufman (212) 468-8237 [email protected]

James Schwartz (212) 336-4327 [email protected]


We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.



http://www.mofo.com/people/k/kaufman-david-h


http://www.mofo.com/people/s/schwartz-james



Derivatives Regulation Update: Latest U.S. Developments · Julian Hammar, Of Counsel, Morrison &...

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