About Steven Lofchie

Steven Lofchie is Senior Fellow of Legal Studies at the Center for Financial Stability and Co-chairman of the Financial Services Department at Cadwalader, Wickersham & Taft LLP.

CFTC, EU Make Comparability Determinations on Margin Requirements for Uncleared Swaps

The CFTC approved a comparability determination that European Union (“EU”) margin requirements for uncleared swaps are comparable in outcome to relevant CFTC Regulations. The European Commission announced a similar equivalence decision that the CFTC uncleared margin rules are comparable to the EU’s requirements.

The CFTC determination generally allows swap dealers that comply with the EU margin requirements, in circumstances enumerated in the CFTC Regulation 23.160, to be deemed to be in compliance with CFTC requirements. Such swap dealers would remain subject to CFTC examination and enforcement authority. CFTC Letter 17-22, which extended exemptive relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.

In addition, the CFTC announced that the CFTC and the EC have agreed to a “common approach” for certain authorized trading venues. Under the common approach, the CFTC plans to grant relief to certain EU trading venues from the swap execution facility (“SEF”) registration requirement, provided they satisfy the “comparable and comprehensive” standard for exemptive relief under CEA Section 5h(g). The EU would propose a corresponding equivalence decision recognizing CFTC-authorized SEFs and designated contract markets as eligible venues.

CFTC Chair J. Christopher Giancarlo characterized the cooperative efforts as an important step in cross-border harmonization:

“These cross-border measures will provide certainty to market participants. It will ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets.”

 

Lofchie Comment: This is a significant step by the CFTC both in improving relationships with the Europeans and in accomplishing Chair Giancarlo’s goals of facilitating the ability of firms to transact globally and undoing the geographic market fragmentation that had resulted from the post Dodd-Frank regulatory regime.  One can guess that the Chair will next turn attention to improving the rules for trading on U.S. swap execution facilities, which will benefit the competitiveness of the United States as a financial center.

SEC Names Chief of Office of International Corporate Finance

The SEC named Robert Evans III as Chief of the Office of International Corporate Finance. The office operates within the SEC Division of Corporation Finance and is responsible for “outreach to non-U.S. issuers that access the U.S. capital markets.”

Prior to the appointment, Mr. Evans was Deputy Director of the Division of Corporation Finance. Before that, worked as a partner in the capital markets practice at Shearman & Sterling LLP.

Treasury Releases Recommendations for Capital Markets Regulatory Reforms

The U.S. Treasury Department (“Treasury”) released a second report pursuant to President Donald J. Trump’s Executive Order establishing core principles for improving the financial system (see coverage of first report). The new report details plans to reduce burdens of capital markets regulation (see also Fact Sheet on report).

The report recommends supporting and promoting access to capital markets, reducing regulatory costs, making changes to market structure and modifying derivatives regulation to facilitate risk transfer.

In a “Table of Recommendations” (beginning on page 205), Treasury lists proposed recommendations. Some highlights include:

  • Public Companies and IPOs (e.g., decrease the cost of being a public company by eliminating the conflict minerals rule);
  • Challenges for Smaller Public Companies (e.g., increase the level at which a company may be considered “small”);
  • Expanding Access to Capital Through Innovation (e.g., allow accredited investors to invest freely in crowdfunded offerings);
  • Maintaining the Efficacy of Private Markets (e.g., expand the definition of accredited investor);
  • Market Structure and Liquidity, Equities (e.g., allow smaller companies to limit the exchanges on which they trade to facilitate the development of centralized liquidity);
  • Market Structure and Liquidity, Treasuries (e.g., provide greater support for the repo market);
  • Market Structure and Liquidity, Corporate Bonds (e.g., improve liquidity);
  • Securitization and Capital (e.g., simplify capital regulation of banks);
  • Securitization and Liquidity (e.g., treat certain securitizations as liquid assets);
  • Securitization and Risk Retention (e.g., provide exemptions from the risk retention requirements);
  • Securitization and Disclosures (e.g., reduce the number of required reporting fields for registered deals);
  • Derivatives and Harmonization Between the CFTC and SEC (e.g., the SEC should adopt its security-based swap rules);
  • Derivatives and Margin Requirements for Uncleared Swaps  (e.g., there should be exemptions from initial margin requirements between bank affiliates of a bank “consistent with the margin requirements of the CFTC and the corresponding non-US requirements”);
  • Derivatives and CFTC Use of No-Action Letters (e.g., rules should be fixed so it is not necessary to rely on no-action letters);
  • Derivatives and Cross-Border Issues (e.g., the U.S. regulators should work with global regulators on issues such as privacy);
  • Derivatives and Capital Treatment in Support of Central Clearing (e.g., required capital should be reduced on centrally cleared transactions);
  • Derivatives and Swap Dealer De Minimis Threshold (e.g., there should be no reduction in the de minimis threshhold for dealer registration);
  • Derivatives and Definition of Financial Entity (e.g., modify the definition, presumably with the goal of reducing the central clearing requirement);
  • Derivatives and Position Limits (e.g., adopt rules but provide hedging exemptions);
  • Derivatives and SEF Execution Methods and MAT Process (e.g., permit a broader range of trading mechanisms);
  • Derivatives and Swap Data Reporting (e.g., improve standardization of reporting requirements);
  • Financial Market Utilities (e.g., consider providing “Fed access” to certain clearing corporations);
  • Regulatory Structure and Processes, Restoration of Exemptive Authority (e.g., restore the SEC’s and CFTC’s plenary exemptive authority under the statutes that they monitor);
  • Regulatory Structure and Processes, Improving Regulatory Policy Decision Making (e.g., adopt clear rules);
  • Regulatory Structure and Processes, Self-Regulatory Organizations (e.g., better define the roles of the SROs in rulemaking); and
  • Internal Aspects of Capital Market Regulation (e.g., U.S. regulators should seek to reach “outcomes based non discriminatory substituted compliance arrangements” with foreign regulators to mitigate “the effects of regulatory redundancy and conflict”).

Lofchie Comment: The prior Administration viewed financial markets as creators of risk that had to be controlled; this Administration appears to view financial markets as creators of growth that would benefit from decreased controls. This is simply a tremendous difference in perspective and tone.

There will and should be a fair amount of discussion over these many and specific recommendations. One broad recommendation, however, stands out: restoring to both the SEC and the CFTC complete exemptive authority as to the requirements of the statutes that they enforce. Depriving the regulators of this authority in the wake of the Congressional enthusiasm for Dodd-Frank had limited the regulators ability to fix Congressional mistakes and over-reaches in drafting. The prior Administration had simply become so locked into defending Dodd-Frank against any criticism that it had become impossible for the regulators to consider, or even discuss, what aspects of it might be working or not. The new Administration does not bear the burden of justification.

SEC Chair Jay Clayton Updates House Finance Committee on EDGAR System Breach

SEC Chair Jay Clayton testified before the U.S. House Financial Services Committee providing an update on the EDGAR system cybersecurity breach (see previous coverage). He also outlined the SEC’s regulatory agenda reiterating previous testimony provided to the Senate Banking Committee (see previous coverage). His principal priorities include the facilitation of capital formation and encouraging initial public offerings.

SEC Clarifies Intent of Amendments to “Fully Paid Securities” Definition

In a letter to FINRA, the SEC clarified that an amendment to the definition of “fully paid securities” in Exchange Act Rule 15c3-3 (“Customer Protection – Reserves and Custody of Securities”) was not intended to expand the scope of securities that cannot be rehypothecated by the broker-dealer. Rather, the SEC said that the technical amendment was merely meant to “amend out-of-date” citations and “remove text that the Commission believed to be superfluous or redundant.”

Lofchie Comment: In a somewhat cryptically worded letter, the SEC staff clarified that securities that have no lending value for purposes of the broker-dealer margin regulations, but that serve to collateralize a margin loan, may be rehypothecated by a broker-dealer. Any such rehypothecation would of course remain subject to the limits set out in Rule 15c3-3, which are intended to ensure that even an insolvent broker-dealer be able to make its custodial customers whole.

President Trump Signs FSOC Bill Assuring Insurance Regulator Continuity

President Donald J. Trump signed into law the Financial Stability Oversight Council Insurance Member Continuity Act (H.R. 3110) on September 27, 2017.

The bill, introduced by Representatives Randy Hultgren (R-IL) and Maxine Waters (D-CA), permits an FSOC independent member with insurance expertise to remain past his or her term for the earlier of (i) 18 months or (ii) when a successor is confirmed.

Representative Hultgren explained the importance of the bipartisan bill:

“[I]t is now extremely important that we have someone with a deep understanding of our insurance markets, and how they interact with our entire financial system, to continue serving as a voting member of FSOC. The Financial Stability Oversight Council Insurance Member Continuity Act ensures that this key regulatory body is able to benefit from the perspective of a voting member with insurance expertise without any unnecessary lapses.”

 

Lofchie Comment: The realization of the “importance” of industry participation in the FSOC designation process is welcome. When FSOC designated MetLife as being systemically important, it generally ignored the views of the FSOC member with insurance industry experience. See FSOC Proposes Preliminary Designation of MetLife as a Non-Bank Systematically Important Financial Institution (with Lofchie Comment).  See also D.C. District Court Calls FSOC’s Review of MetLife’s Status “Fatally Flawed”.

MSRB Advises Dealers on Compliance Risks

The MSRB issued a Compliance Advisory to aid municipal securities dealers, brokers and dealers (collectively, “dealers”) in addressing compliance risks and in supplementing evaluations of existing compliance programs and controls.

In the Advisory, the MSRB highlighted several factors (as summarized below) for dealers to consider when evaluating compliance:

  • Standards of Professional Qualification (Rules G-2, G-3, A-12): Firms should consider how they ensure that employees perform functions only as permitted by their qualifications and whether appropriate training procedures have been implemented to train employees on the scope of their qualifications.
  • Best Execution and Fair Pricing Standards (Rules G-18, G-30): Firms should evaluate whether they have policies and procedures that take into account the entire “market” when making best execution determinations, and cover how and when retail customer orders are exposed to multiple bids, in addition to considering whether they are periodically evaluating processes for determining whether aggregate prices charged to customers are fair and reasonable.
  • Standards of Conduct in the Performance of Financial Advisory Activities (Rule G-23): Firms should assess whether they have procedures to notify issuers of their role in a particular transaction and to consider factors that necessitate classification (and possible registration) as a “municipal advisor.”
  • Fair Dealing with All Persons in the Conduct of Municipal Securities Activity (Rule G-17): Firms should consider employee training on standards of fair dealing, procedures for determining the best account structure for particular customers, and processes for evaluating disclosures and representations made by underwriters.
  • Pay-to-Play Restrictions (Rule G-37): Firms should evaluate current training available to make employees aware of reporting requirements for certain political contributions, assess processes for monitoring for such contributions for two-year look-back periods, and ensure that firms are meeting all reporting and disclosure requirements.
  • Time of Trade Disclosures to Customers (Rule G-47): Firms should examine their procedures to determine whether they have a process for ensuring they are using established industry sources of information relating to municipal securities transactions (particularly as new sources become available and are more generally used by dealers). Firms should also examine whether they have procedures to ensure that all material information about municipal securities transactions is properly disseminated to registered representatives engaged in sales to and purchases from a customer.
  • Supervisory Controls (Rule G-27) and Books and Records (Rules G-8G-9): Firms should assess all of their supervisory controls to ensure that they are properly monitoring regulatory developments, maintaining written procedures and accurately documenting the nature and function of particular securities accounts.

Lofchie Comment: The MSRB’s statement provides a useful outline for firms to undertake a general review of their compliance procedures in this space. There is nothing like a priority risk list from the regulators to focus one’s attention.

CFTC Enforcement Director Offers Incentives for Cooperation and Self-Reporting

On September 25, 2017, CFTC Director of Enforcement James McDonald described an enforcement approach that emphasizes self-reporting and cooperation by regulated financial institutions.

In remarks before the New York University Institute for Corporate Governance & Finance, Mr. McDonald described a continuing dedication to vigorous prosecution combined with a new emphasis on cooperation and self-reporting in order to best achieve the mission of the CFTC to “foster open, transparent, competitive and financially sound markets.” In addition to pursuing enforcement actions, Mr. McDonald stressed the importance of receiving buy-in from the companies regulated by the CFTC in order to safeguard these markets and achieve meaningful deterrence. The CFTC self-reporting and cooperation program, Mr. McDonald explained, is intended to incentivize companies to report violations and cooperate in CFTC investigations by making clear the “substantial” benefits of cooperation, such as “significantly” reduced monetary penalties. Mr. McDonald also emphasized the commitment of the CFTC to working with industry members to facilitate voluntary compliance and contribute to a cooperative business environment.

Mr. McDonald outlined the kind of cooperation that might lead to CFTC special consideration and reduced penalties:

  • Voluntarily self-reporting of wrongdoing to the CFTC Division of Enforcement. This includes disclosure of all relevant facts within a reasonably prompt time.
  • Full cooperation throughout the CFTC investigation. This involves proactive disclosure of all relevant facts and participating individuals as a company becomes aware of them. The CFTC focus on individuals reaches not only traders, but also the supervisors who directed or made decisions underlying a violation.
  • Remedial measures to prevent future misconduct. This includes fixing problems with compliance and internal programs that led to the misconduct in question.

In return, Mr. McDonald stated that the Division of Enforcement will clearly communicate all expectations, facilitate and help the self-reporting company with remediation efforts, and offer concrete benefits. Mr. McDonald explained that if a company complies with all three criteria, the Division of Enforcement will recommend a substantial reduction in penalties, and, in extraordinary circumstances, may decline to prosecute a case. Cooperation in the absence of a self-report may also warrant a lower penalty, albeit one that involves a significantly smaller reduction.

Mr. McDonald said that his remarks reflected his “own views and not necessarily those of the Commission or its staff” and should not be interpreted as a softening in the CFTC stance on the enforcement or prosecution of corporate misconduct. He indicated that the CFTC will continue to aggressively pursue bad actors. The Director expressed hope that the CFTC’s commitment to encouraging self-reporting will add another layer of deterrence to misconduct by market participants and help to prevent future misconduct.

Lofchie Comment: There are few policy decisions that are as significant for a regulatory agency as determining how to handle firms and individuals that come forward with admissions of their own legal violations. It often seems to outside observers that the desire of regulators to chalk up an easy win, or to be acclaimed for collecting a fine, overwhelms any inklings of common sense (or compassion). This is unfortunate because when a firm comes forward, particularly with information as to unintended violations, it often provides notice to other market participants of areas where they may need to shore up their own compliance procedures or, very significantly, their technology. In any case, the proof of the CFTC’s word will be in the pudding (or in the Cabinet news) and, as enforcement actions are reported, individual firms will continue to make their own assessment of whether to come forward.

SEC Provides Guidance on Compliance with Pay Ratio Disclosure Requirements

The SEC released interpretive guidance on compliance with the pay ratio disclosure rule, which mandates that companies begin filing reports in early 2018 (for fiscal year 2017). Under the pay ratio disclosure rule, a public company is obligated to disclose (i) the median of the annual total compensation of all its employees, except that of the CEO, (ii) the annual total compensation of its CEO, and (iii) the ratio of those two amounts.

As explained in the guidance, a company has “significant flexibility” in determining the appropriate methodology to identify its median employee. The SEC acknowledged that industry members expressed concerns about compliance and liability due to the imprecision that could arise from estimation. The guidance states that “if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.”

The guidance also details how a company is permitted to use payroll or tax records to (i) identify a median employee and (ii) make a determination about the inclusion of non-U.S. employees. Under the rule, non-U.S. employees representing up to 5% of the company’s total personnel generally are exempted from calculations.

In separate staff guidance, SEC Division of Corporation Finance Staff outlined important information regarding reasonable methodologies for calculations as required by the pay ratio disclosure rule.

Lofchie Comment: Given the absence of any specific requirements as to how the compensation calculation should be made and the complete absence of any reasonable policy rationale for this rule (after all, the CEO’s salary is disclosed), issuers have significant flexibility as to how to comply with this rule. Don’t waste resources overthinking the reporting methodology. The important compliance rules are (i) choose a methodology (doesn’t really matter what it is), (ii) fully document it, and (iii) stick to it rigidly.

SEC Committee on Small and Emerging Companies Makes Final Recommendations

The SEC Advisory Committee on Small and Emerging Companies (the “Committee”) met to review the Final Report of the Committee. The report included recommendations for future areas of focus including (i) capital raising by “emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization,” (ii) trading securities of these companies, and (iii) public reporting and corporate governance requirements for them. The Committee also reviewed the auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act and the registration exemption under Securities Act Rule 701.

The Committee recommended that the SEC focus on facilitating exempt offerings for privately held small companies, asserting that legal costs and associated risks have made such offerings less attractive to broker-dealers, which in turn makes it difficult for small companies to find investors.

Specifically, the Committee noted that (i) non-registered entities are hesitant to take part in exempt offerings because there is significant uncertainty in the market about what activities require broker-dealer registration under the current definition of “broker” and (ii) companies seeking to comply with the rules find it difficult to determine when they can engage a “finder” or online platform that is not registered as a broker-dealer. As a remedy, the Committee encouraged the SEC to provide regulatory clarity in this area and to create a less burdensome avenue for small businesses to engage potential investors.

The Committee also proposed that the SEC should revisit the definition of “accredited investor” under Rule 506 of Regulation D, and to avoid raising the threshold to qualify as an accredited investor. The Committee supported potential revisions that would take into account the “sophistication” of investors, but cautioned against revisions on the basis of net worth or income.

With respect to reporting and corporate governance requirements, the Committee urged the SEC to finalize a rule that would expand the number of small businesses that qualify for “scaled disclosure requirements.” The Committee explained that, since the implementation of the JOBS Act, 87% of initial public offerings (“IPOs”) have qualified as emerging growth companies (“EGCs”) (companies with less than $1,070,000,0000 in gross revenue during its most recently completed fiscal year), and that IPOs have declined significantly in recent years. This decline was described as being a result of the high costs of compliance and disclosure requirements that impose undue burdens on small companies. The Committee expressed support for the rule that would allow smaller reporting companies to qualify for the same disclosure and reporting requirements as EGCs. Furthermore, the Committee suggested amendments to the “accelerated filer” definition to exempt certain smaller companies from Section 404(b) auditor attestation requirements.

The meeting also included a presentation by executives from Orrick and Warby Parker regarding amendments to Securities Act Rule 701. The executives recommended (i) removal of the “hard cap limit” that restricts the value of securities sold in reliance on Rule 701, (ii) increase of the “soft cap limit” from $5 million to at least $10 million, and (iii) exclusion of material amendments from calculation of either limit. The executives asserted that equity compensation is a crucial aspect of facilitating success for small businesses, and said that it can be “critical to recruit talent” for companies that are not able to offer competitive cash compensation.

Finally, the Committee made recommendations for facilitating secondary market liquidity through preemption of certain state registration requirements, continued monitoring of the tick-size pilot program and less strict listing requirements for smaller companies.

This was the final meeting of the current Committee, as the two-year term expires on September 24, 2017.

Lofchie Comment: New SEC Chair Clayton has pledged to focus on improving the ability of companies to raise money in the public markets at a reasonable cost. This is an important change to the persistent governmental mindset of “ever more regulation.” After almost a decade of regulatory explosion that has shaped the norms and expectations of government behavior, any real reduction in regulation seems extraordinary.

One aspect of the recommendations was odd: the notion that it is not clear who must register as a “broker.” Under the law, it’s actually pretty clear: just about anyone who touches a securities transaction must register as a broker. Legal clarity isn’t really the issue; the issue is whether there should be a real exemption from registration for private placement brokers or else a form of much lighter registration/regulation that looks more like the regulatory scheme that applies to investment advisers (which may not be light, but it is much lighter than the broker-dealer scheme).