The SEC’s Cross-Border Security Swap Rules

Securities Lawyer 101

The Securities and Exchange Commission (the “SEC”) adopted the first of a series of rules and guidance on cross-border security-based swap activities for market participants.

The SEC will use the new rules to finalizing the remaining proposals.

 

The SEC’s rules and guidance explain when a cross-border swap transaction must be counted toward the requirement to register as a security-based swap dealer or major security-based swap participant.  The rules also address the scope of the SEC’s cross-border anti-fraud authority.

The SEC also adopted a procedural rule regarding the submission of “substituted compliance” requests.

The new rules represent a first step in the SEC’s efforts to establish a framework to address the possibility that market participants may be subject to more than one set of comparable regulations across different jurisdictions as a result of their cross-border swaps activity.  If the SEC were to grant a request for substituted compliance, it would permit market participants to satisfy certain Title VII security-based swap regulatory requirements by complying with comparable non-U.S. rules.

“The rules we adopted today have been strengthened to the extent feasible under existing law while increasing their clarity and workability for market participants,” said SEC Chair Mary Jo White.  “The rules lay the foundation for an expansive, robust approach to the potential risk to U.S. market participants and the U.S. financial system from security-based swap activities.”

Steve Luparello, director of the SEC’s Division of Trading and Markets, said, “In developing the final rules and guidance adopted today, we worked carefully to balance the regulatory goals of Title VII, the practical needs of market participants and workability with the existing CFTC regime.  The rules and guidance are appropriately tailored to our markets and regulatory structure.” 

The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010.  Title VII established a comprehensive framework for regulating the over-the-counter derivatives market.

In future rulemakings on specific security-based swap requirements such as reporting of transactions to security-based swap data repositories, the SEC intends to address the cross-border application of these requirements, and when “substituted compliance” may be available for them.  Under the SEC’s contemplated approach to implementation of these security-based swap regulatory requirements, market participants would be made aware of both the domestic and cross-border aspects of these regulatory requirements before being required to comply with them. 

The rules will become final 60 days after publication in the federal register.  The SEC’s fact sheet is summarized below.

FACT SHEET

Cross-Border Security-Based Swap Rules and Guidance

The SEC’s rules and guidance, among other things, provide: 

• An explanation of when a cross-border transaction needs to be counted toward the requirement to register as a security-based swap dealer or major security-based swap participant, including transactions guaranteed by a U.S. person and transactions by a “conduit affiliate” (a foreign affiliate of a U.S. person that could be used to evade the requirements of Title VII of the Dodd-Frank Act).
• Procedures for foreign regulators or market participants to apply for substituted compliance, which would permit market participants to comply with U.S. requirements by complying with foreign requirements.
• An anti-fraud rule that addresses the scope of the Commission’s cross border anti-fraud enforcement authority, clarifying that the authority applies where the fraud occurs or is felt within the U.S.

Background

May 2013 Rule Proposals – The SEC proposed a series of rules to address the application of security-based swap regulatory requirements under Title VII to cross-border activities.  The final rules address one aspect of the proposal: determining when market participants are deemed to be security-based swap dealers or major security-based swap participants as a result of their cross-border activities and thus subject to dealer or major participant regulation.  In future rulemakings, the SEC expects to address other aspects of its May 2013 proposal, including trade reporting and dissemination of trade details to the public, mandatory clearing and trade execution, and rules applicable to registered security-based swap dealers and major security-based swap participants, and security-based swap market infrastructure.

Dodd-Frank Act – The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter derivatives market.  Title VII of the Dodd-Frank Act gave the SEC regulatory authority over security-based swaps and certain key players in that market, including security-based swap dealers and major security-based swap participants.

Security-Based Swaps Definition – In general, a derivative is a financial instrument or contract, such as a swap, whose value is “derived” from an underlying asset such as a commodity, bond, or equity security.  Derivatives provide a way for counterparties to transfer risk related to the underlying assets.  A security-based swap is a swap tied to a single security, loan, or issuer of securities, a narrow-based security index, or the occurrence of certain events relating to an issuer or issuers of securities in a narrow-based security index.

Cross-Border Security-Based Swap Market – The security-based swap market often involves counterparties located in different countries.  According to data analyzed by SEC staff, a majority of transactions involving single-name credit default swaps on U.S. reference entities involve one or more counterparties located abroad.  Based on staff estimates, only 13 percent of global notional volume between 2008 and 2012 was between two U.S.-domiciled counterparties.  This compares to 48 percent entered into between one U.S-domiciled counterparty and one foreign-domiciled counterparty, and 39 percent entered into between two foreign-domiciled counterparties.  In addition, some security-based swaps may be negotiated and executed in two different countries and then booked in other countries.  Finally, the security-based swap market is largely an inter-dealer market.  Commission staff estimates that more than 80 percent of notional volume has ISDA-recognized dealers as counterparties on both sides of the transaction.

Regulating a Global Market – Regulating the swap market is challenging because of its global and interconnected nature.  (See: www.sec.gov/swaps-chart/swaps-chart.shtml – which depicts the regulatory regime for security-based swaps trading.)  The U.S. and other countries now are implementing reforms that, when in effect, could potentially subject swap market participants to multiple and overlapping regulatory regimes.  Any resulting regulatory overlaps or conflicts could impact liquidity and efficiency in the security-based swap market.

CFTC’s July 2013 Cross-Border Guidance – The July 2013 cross-border guidance issued by the Commodity Futures Trading Commission set forth its approach to the application of Title VII to swap (as opposed to security-based swap) activity.  Many market participants engage in both swap and security-based swap activity and will be subject to regulation under Title VII by both the SEC and the CFTC.  For this reason, many commenters urged the SEC to minimize differences between its final cross-border rules and the CFTC guidance.

In developing the final rules, the SEC took into account the related elements of the CFTC guidance. As a practical matter, the final rules generally would produce similar outcomes in terms of whether an entity is a “U.S. person” and whether a particular transaction or position is counted toward the relevant dealer or major participant thresholds.  Many of the steps that market participants have taken to comply with the CFTC’s cross-border guidance may be transferable to compliance with the SEC’s final cross-border rules, thus mitigating the costs that market participants otherwise would incur.

Rule Highlights

Non-U.S. Person’s Requirement to Register with the SEC as a Security-Based Swap Dealer

Transactions Included in the Dealer Calculation

In 2012, the SEC adopted rules jointly with the CFTC, providing that a market participant would be considered a security-based swap dealer required to register with the SEC if its dealing transactions conducted in the past 12 months exceeded certain thresholds.  The final rules specify which cross-border dealing transactions count toward these dealer thresholds. 

Under the final rules, U.S. persons are required to count their security-based swap dealing transactions toward the thresholds, including dealing transactions conducted through their foreign branches.

Non-U.S. persons are required to count the following against the thresholds:

• Dealing transactions with counterparties that are U.S. persons, including foreign branches of U.S. banks (unless the foreign branch is a branch of a registered security-based swap dealer).
• Dealing transactions with any counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person in connection with the non-U.S. person’s obligation under the security-based swap.
• All dealing activity if a non-U.S. person acts as a “conduit affiliate.”

Definition of a U.S. Person

For purposes of these rules, a “U.S. person” is defined in a territorial manner that encompasses:

• Any natural person who resides in the U.S.
• Any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the U.S. or having its principal place of business in the U.S.
• Any discretionary or non-discretionary account of a U.S. person.
• Any estate of a decedent who was a resident of the United States at the time of death.

Definition of a Principal Place of Business
The final rules define a principal place of business to mean the location from which the officers, partners, or managers of the legal person primarily direct, control and coordinate the activities of the legal person.  The definition provides that with respect to an externally managed investment vehicle, this location is the office from which the manager of the investment vehicle primarily directs, controls, and coordinates the investment activities of the investment vehicle.

The final “U.S. person” definition excludes certain international organizations, regardless of where they are organized or where their primary place of business is located.

For these purposes – and consistent with rules adopted by the SEC jointly with the CFTC regarding the Title VII definitions of dealer and major participant – foreign branches of U.S. banks and U.S. branches of foreign banks are not separate legal persons for purposes of Title VII and have the same U.S.-person status as the bank’s home office.

Non-U.S. Dealers Whose Counterparties Have Rights of Recourse Against a U.S. Person Affiliate

Under the final rules in response to comments on the proposal, a non-U.S. person is required to count against the dealer thresholds its dealing transactions with a non-U.S. counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person.  For these purposes, recourse is present if the counterparty has a legally enforceable right against the U.S. affiliate in connection with the non-U.S. person’s obligation under the security-based swap.

Conduit Affiliates

As an anti-evasion measure, the final rules expand the proposal’s treatment of non-U.S. affiliates of U.S. persons by requiring non-U.S. persons that act as “conduit affiliates” to count all of their dealing transactions towards the dealer thresholds.  A “conduit affiliate” is a non-U.S. affiliate of a U.S. person that enters into security-based swaps with non-U.S. persons or with certain foreign branches of a U.S. bank on behalf of its U.S. affiliates (other than U.S. affiliates that are registered as security-based swap dealers or major security-based swap participants) and enters into offsetting transactions with its U.S. affiliates to transfer the risks and benefits of those security-based swaps.

Aggregating Transactions Involving Dealing Activity of Affiliates

In 2012, the SEC adopted jointly with the CFTC a rule providing that persons engaged in dealing activity would be required to aggregate certain security-based swap dealing transactions of their commonly controlled affiliates.  The final rules clarify that a person may exclude from its dealer threshold calculations the dealing transactions of any affiliate registered with the SEC as a security-based swap dealer.  In response to comments on the proposal, the final rule does not condition the exclusion on the person and its affiliate being operationally independent.

Cleared Anonymous Transactions

Based on comments on the proposal, the final rules provide an exclusion from non-U.S. persons having to count a transaction against the thresholds if the transaction is entered into anonymously and is cleared.

Further Consideration of Activity in the United States Involving Only Non-U.S. Persons

The final rules do not include an element of the proposal that would have required dealing activity between two non-U.S. persons to be counted for purposes of the dealer definition if the security-based swap transaction was conducted within the United States.  Given the complex and important issues raised by that proposed requirement, the SEC expects to solicit additional comment regarding when a transaction between two non-U.S. persons should be included in the relevant dealer thresholds because one or both counterparties are engaged in security-based swap activity within the U.S.

Non-U.S. Person’s Requirement to Register with the SEC as a Major Security-Based Swap Participant

Transactions Included in the Major Participant Calculations

In 2012, the SEC adopted rules jointly with the CFTC that provide that a market participant would be deemed to be a “major security-based swap participant” if its security-based swap positions exceeded certain thresholds.

Under the final rules approved today, U.S. persons are required to count all of their security-based swap positions when determining whether they are major participants. 

Non-U.S. persons are required to count the following positions against the major participant thresholds:

• Positions with U.S. persons, including foreign branches of U.S. banks (unless the foreign branch is a branch of a registered security-based swap dealer).
• Positions with a counterparty that has rights of recourse against a U.S. affiliate of the non-U.S. person in connection with the non-U.S. person’s obligation under the security-based swap.
• All positions if a non-U.S. person acts as a “conduit affiliate.”

Attribution of Guaranteed Positions

The 2012 joint rulemaking by the SEC and CFTC provided that persons generally should include within their major participant calculations any positions they guarantee.

Under the final rules, guaranteed positions are attributed as follows in the cross-border context:

• A non-U.S. person that provides a recourse guarantee of the security-based swap obligations of a U.S. person counts all of the U.S. person’s security-based swap positions that it guarantees.
• A non-U.S. person that provides a recourse guarantee of the security-based swap obligations of another non-U.S. person counts only the guaranteed security-based swap positions arising from transactions with U.S.-person counterparties.
• A U.S. person that provides a recourse guarantee of the security-based swap obligations of a non-U.S. person counts all of that non-U.S. person’s security-based swap positions that it guarantees.

Under the final rules, a guarantor is not required to count any guaranteed positions entered into by a non-U.S. person if the non-U.S. person is subject to Basel capital standards, to capital regulation by the SEC or the CFTC, or is regulated as a bank in the United States.

The Anti-Fraud Rule

The final rules include an antifraud rule that addresses the scope of the SEC’s cross-border antifraud civil enforcement authority, clarifying that the antifraud authority applies where sufficient conduct in furtherance of the fraud occurs or sufficient effects of the fraud are felt, within the U.S.