The SEC voted unanimously to propose rules and interpretive guidance for parties to cross-border security-based swap transactions. In addition to the rules that would be applicable to swap dealers, the proposal also would apply to the various participants in swap market infrastructure, including exchanges, swap data repositories and clearing corporations. The proposal sets out, among other things, which entities would be “U.S. persons,” which regulatory requirements apply when a transaction occurs partially within and without the U.S. The proposed rules also set forth a plan for reliance on “substituted compliance” in the case of regulated non-U.S. entities involved in U.S. transactions. (Note that these rules would apply to only those “security based swaps” and to “security-based swap dealers” regulated by the SEC.)
The major theme of the proposal is the SEC’s acceptance of “substituted compliance”; i.e., that non-U.S. entities are most appropriately subject to their home country regulators, provided those home country regulators impose swaps regulation which is comparable to that of the United States and that non-U.S. market participants comply with those rules. (See page 307 as to the procedures for making substituted compliance requests.) In determining whether substituted compliance exists, the SEC would look at four categories of requirements: (i) those applicable to swaps dealers; (ii) those related to regulatory reporting and public trade reporting; (iii) those relevant to clearing; and (iv) trade execution. [I would think that the first two would be by far the more important, as I expect that mandatory clearing and exchange trading of SBS is going to be fairly limited for a good while, given the size of those markets.] Comparability would be judged on a holistic basis; not on a rule by rule basis. A violation by a non-U.S. market participant of a non-U.S. rule where the non-U.S. market participant was subject to a regime of substituted compliance would be deemed a violation of a U.S. rule. [This is going to be one of the challenges of substituted compliance, however, it works: U.S. regulators and courts interpreting and enforcing non-U.S. rules on the basis that violations of those rules also create violations of U.S. law.]
The SEC takes a territorial approach to the definition of U.S. person, generally focusing on residency, jurisdiction and principal place of business. (See page 79 of the Release.) Under the SEC approach, a non-U.S. fund with a U.S. adviser would be a non-U.S. person (but note that transactions negotiated with the U.S. adviser may be SEC-regulated because the transaction is “conducted within the United States”; a non-U.S. branch of a U.S. bank would also be a U.S. person. Conversely, U.S. branches of non-U.S. banks and non-U.S. subsidiaries of U.S. holding companies would not be U.S. persons. Beginning on page 85, there is an extensive set of questions on this definition. This set of questions includes not only a discussion of the SEC’s proposals, but also a detailed comparison of the SEC proposals with the various CFTC proposals.
Transactions would be subject to SEC regulation (including by “substituted compliance”) if “conducted within the United States. A transaction would be conducted within the United States if “solicited, negotiated, executed, or booked with the United States, by or on behalf of either counterparty to the transaction…. ” [This is where transactions with non-U.S. funds having U.S. advisers are caught.] However, a transaction with a non-U.S. branch of a U.S. bank would not be a transaction conducted within the United States.
Beginning on page 624 of the Release and going to page 631, there is a series of charts that shows how the various Entity Level (e.g., capital and margin) and Transaction Level (e.g., sales practices, segregation, regulatory and public reporting, mandatory clearing and mandatory exchange execution) requirements would apply to particular facts situations such whether the trade involves (i) a U.S. office of a U.S. bank; (ii) a a non-U.S. branch of a U.S. bank; (iii) another U.S. based registered swap dealer; or (iv) a non-U.S. swap dealer, in each case trading with a U.S. or non-U.S. person of various types. These charts are a very useful and user-friendly summary of the application of the proposal to specific fact situations.
The SEC Release contains the most detailed attempt at an economic analysis of the effect of the rules that I have seem from any agency. [It clearly sets a higher bar for attempting this type of analysis and I hope will serve as a model for how the regulators look at their rules going forward. In terms of the SEC’s analysis of specific costs, my guess is that their estimates are still materially too low (nothing in a big organization gets done in “3 hours”). That said, what I found really bold about the SEC’s economic analysis is its effort at understanding and describing the market as it exists today and how that market might change as a result of the implementation of the SEC’s rules. In particular, the SEC was willing to take on a discussion of the possibility that business will move away from the United States as Dodd-Frank is implemented. Leaving aside the particulars of the discussion, the SEC’s efforts in this area wreak destroy the argument that it is simply impossible to perform a meaningful cost-benefit analysis of a new rule.]
In her opening statement, SEC Chairman White described substituted compliance as an “approach [that] would allow the elimination of overlapping regulation when it truly is duplicative, while recognizing that regulatory regimes will necessarily differ in some respects. Crucially and as required, acceptable substituted compliance would advance the important statutory goals of the Dodd-Frank Act, including stability, transparency, and protection against market abuse. Under the proposal, substituted compliance would not be based on a line-by-line comparison of the relevant rules in a foreign jurisdiction. Instead, in making a substituted compliance determination, the Commission would look at key categories of the Title VII regime, focusing on regulatory outcomes rather than the particular means of achieving those outcomes. As part of this process, the Commission would look not just at the way in which a country’s laws and regulations are written, but also at how that country supervises and enforces compliance with its rules.”
In her remarks, Commissioner Walter defines substituted compliance in this way: “allowing a foreign entity to satisfy the Commission’s requirements in a particular area – such as capital or risk management – by complying with comparable requirements in its home jurisdiction.” It is, according to the SEC, an approach which recognizes that market participants may be subject to conflicting or duplicative compliance obligations in the global derivatives market.
In his comments, Commissioner Gallagher went on to state that this approach to cross-border compliance “acknowledges the reality that as to any given financial product or activity, there are likely to be high quality regulatory regimes other than ours. It also recognizes the reality that we cannot, and should not, be the world’s securities regulator.”
Commissioner Paredes, while supportive of the proposal, expressed reservations as to whether it extends U.S. jurisdiction too far, stating: “I am concerned that international transactions that cut across different countries will be subject to Title VII to too great of an extent, particularly insofar as the proposal extends the reach of Title VII beyond the geographic territory of the United States to regulate activity occurring in other jurisdictions.” He further suggested that, for substituted compliance to yield results, the SEC “cannot be reluctant to find that a foreign regulatory regime achieves outcomes comparable to the U.S. ‘Comparable’ does not mean ‘identical.’ Rather, “comparable” contemplates that countries can be committed to a shared set of objectives but decide to achieve them differently.”
Commissioner Aquilar expressed some reservations as to the proposal’s limitations on U.S. jurisdiction. He asked for “commenters’ views as to whether a substituted compliance regime will inappropriately deny American investors the protection of American laws.” He also indicated that the definition of U.S. person might be expanded.
A ninety-day comment period for the proposed rules and interpretive guidance for cross-border security-based swap activities will occur after they are published in the Federal Register.
Separately, the SEC voted unanimously to reopen the public comment period for all rules not yet finalized, stemming from Title VII of the Dodd-Frank Act. The comment periods for these rules – and a policy statement describing the expected order for these new rules to take effect – will be reopened for 60 days after notice is published in the Federal Register.
On the very positive side, this is one of the most thoughtful and comprehensive attempts at rulemaking in any area given the scope of the challenge before the regulator: to superimpose a detailed scheme of regulation on an existing extremely complicated market. On the negative side, the SEC is working from a deeply flawed and carelessly written statute. While the SEC approach has the potential to go a long way to making the statute feasible (i.e., preventing it from being either a complete disaster or igniting a trade war), as the SEC’s own economic analysis discussion highlights, the question will be the extent to which market participants elect to move away from the United States to avoid Dodd-Frank. That will depend not only on the Rules adopted by the SEC, but also on the rules adopted by the CFTC, as well as in Europe and Asia.
The next big question is how other regulators, particularly the CFTC and European regulators respond. In his testimony before Congress, CFTC Chairman Gensler indicated that he is not in any way bound to follow the direction of the SEC, even if he consults with them. That is of course correct. However, given that the SEC, in its release, effectively engaged in a very direct dialogue with the CFTC by comparing its rule proposals to those of the CFTC, I would expect (or at least hope) that the CFTC will respond to the SEC in kind. That is, I think it is incumbent on the CFTC to compare its proposals with the SEC, to attempt a common approach to jurisdiction, and, if the two Commissions can not agree on a common approach, to explain why. It should certainly be obvious to both Commissions that the odds of Dodd-Frank being wholly unworkable increase exponentially if the two Commissions adopt very different rules to apply to almost identical sets of transactions. It is also incumbent on both Commissions to build on the SEC’s existing discussions with non-U.S. regulators.
For swap market participants, both buy-side and sell-side, consider (i) how you do your business now and (ii) how you are likely to do your business under the jurisdictional structure proposed by the SEC. I would expect that the SEC will be receptive to your comments, and will be attuned to the concern that its proposed rules will drive business out of the United States. That said, no matter how the jurisdictional rules come out, firms are going to need to think about how to situate their business activities. The structure of firms (buy-side and sell-side; corporates and advisers) is not going to be optimal in the post Dodd-Frank world. For firms that have not already done so, now is certainly the time to plan where various activities should be located as the SEC and the CFTC adopt their rules. This is likely to mean changing the location of booking entities, and likely of persons and operations.
