The CFTC approved on Friday its “final guidance” on cross-border issues, as well as a related exemptive order. The summary below provides some brief descriptions of the guidance and order, and we expect to release a more substantial memorandum later in the day. The final guidance contains (i) an interpretation of the CFTC’s jurisdiction under Dodd-Frank (which the CFTC asserts is very, very expansive); (ii) a revised definition of “U.S. person,” including an explanation of how the definition applies to offshore funds managed by a U.S. adviser (generally the fund is regarded as “U.S.” if either the fund is majority-owned or if the principal decision-makers are based in the United States) – in addition, entities located outside the United States may be deemed to be U.S. persons if either they are guaranteed by a U.S. person or they are deemed to be conduits for swaps activities back into the United States; (iii) effectively, some further changes in what constitutes “transaction-level” vs. “entity-level” requirements (for example, “large trader reporting” is called a transaction-level requirement, but substituted compliance is not available for it); and (iv) a concession that substituted compliance should be available to swap dealers based in various key jurisdictions, but no actual details as to how substituted compliance will work.
The revised definition of U.S. person will have a material effect on the manner in which potential swap dealers and major swap participants calculate the aggregate notional of their swaps for purposes of determining whether they are required to register. In addition, the guidance changes the manner in which affiliated non-registered entities are required to aggregate their swaps positions for purposes of determining whether they are required to register.
The revised definition of U.S. person is to come into effect 75 days after its publication in the Federal Register, but during that time market participants would have some ability to comment on the guidance.
As of today (July 15), non-U.S. swap dealers may be required to comply with Large Trader Reporting for swaps with non-U.S. counterparties even though this result is not consistent with the transition relief afforded by the CFTC for other requirements, including swap data repository reporting. Obviously, this requirement is not likely to be satisfied, given the complete absence of notice.
In conjunction with the final guidance, the CFTC also approved an exemptive order that is available to swap dealers located in six regions or jurisdictions (the European Union, Canada, Japan, Australia, Hong Kong and Switzerland). Swap dealers in these six jurisdictions may delay compliance with Entity-Level Requirements, and may comply with the requirements of the local jurisdiction in which it is established (and only to the extent required by such jurisdiction) in lieu of complying with any Transaction or Entity-Level Requirement for which substituted compliance is possible, until the earlier of December 21, 2013 or 30 days following the issuance of a substituted compliance determination for the relevant requirements of the jurisdiction in which the non-U.S.swap dealer is established. As we understand that the only non-U.S. swap dealers that have registered with the CFTC are located in the six jurisdictions, the exemptive order is of much more immediate significance than is the guidance on substituted compliance.
Linked below are the documents that the CFTC had circulated in advance of the meeting. The final guidance and exemptive order are not yet available, although drafts of these have been circulated (these are not attached). In addition, in advance of the approval, the CFTC staff has issued four no-action letters dealing with cross-border issues. See news story with the summary of these letters.
The CFTC simply seems indifferent to regulatory process. According to the CFTC, its actions with respect to cross-border issues are not required to be published as rulemakings for comment in the Federal Register because they are mere “guidance” and not “rules.” The basis for this distinction is entirely unclear, as the guidance has a material effect on the way in which firms determine whether they are required to register as swap dealers or major swap participants with the CFTC; the guidance will also have a determinative effect on whether non-U.S. CFTC registrants will be required to comply with the CFTC rules or will be subject to substituted compliance. While calling its statements “guidance,” the CFTC does not seem to be leaving the door open for market participants to reach different interpretations of the law. The question that follows is whether there is a challenge to the legality of the CFTC’s “guidance” based on a violation of the Administrative Procedures Act – any such challenge seems to have a material basis. (The Administrative Procedures Act defines as “rule” as “the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy” – a definition that would seem to include the CFTC’s guidance.”)
Publishing rules for comment in the Federal Register, and addressing public comments on them, is not a matter of mere formality. Publication and public comment allows the regulator proposing a rule to obtain the benefit of the experience and insight of a far broader group than it can obtain through merely internal conversations. In this regard, I note that the CFTC’s final guidance as to the application of the definition of “U.S. person” as applied to non-U.S. funds is quite different from any proposal that it has previously made – and there seems to be no reasonable policy basis for it. That is, the CFTC would treat as a U.S. person any fund with (i) either a U.S. adviser, but wholly foreign ownership or (ii) a foreign adviser but majority U.S. ownership. Yet the implications of these two situations are entirely different. In the first case, there is a U.S. sales practice issue, but no direct economic effect on U.S. investors; in the second situation, matters are reversed.
Publication in the Federal Register would also allow commentary on the incentives that the guidance will create to move jobs outside of the United States. Certainly, any swap dealer doing business with non-U.S. persons will be very strongly motivated to move its operations to a non-U.S. swap dealer so as to avoid being subject to the CFTC’s transaction-level compliance requirements. Likewise, advisers to non-U.S. funds are going to be motivated to move their headquarters outside the United States to avoid being deemed a U.S. person. Conversely, swap dealers and advisers who remain in the United States will be subject to competitive disadvantage in their dealings with non-U.S. counterparties. Had the CFTC’s proposal been published in the Federal Register, these competitive issues might be at least vetted for public comment.
We will discuss many of the cross-border issues further and in more detail as official documents become available.