THE DELTA REPORT
On May 1, 2013, the Securities and Exchange Commission ("SEC") adopted and made public for comment proposed rules and interpretive guidance1 (the "2013 Cross-Border Proposing Release") to address the application of the provisions of the Securities Exchange Act of 1934 (the "Exchange Act") added by Subtitle B of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") to govern cross-border security-based swaps ("SBS") activities.
On June 25, 2014, the SEC adopted finalised rules (the "2014 SEC Cross-Border Rules") and interpretative guidance2 based on some, but not all, of the proposed rules set out in the 2013 Cross-Border Proposing Release. Importantly, the SEC did not include in the 2014 SEC Cross-Border Adopting Release the proposed rules dealing with the regulation of SBS transactions between two non-US persons where one or both are conducting dealing activity within the US. The SEC noted that these rules would be the subject of a separate rulemaking proposal.
On April 29, 2015, the SEC adopted and made public for comment proposed rules that reflected a modified approach to the application of certain requirements of the Dodd-Frank Act to SBS transactions between two non-US persons where one or both are conducting dealing activity within the US3 (the "2015 Cross-Border Proposing Release").
On February 10, 2016, the SEC issued a release4 (the "2016 SEC Cross-Border Adopting Release") adopting rule amendments (the "2016 SEC Cross-Border Rules") relating to one of the proposals in the 2015 Cross-Border Proposing Release, finalising the criteria for SBS transactions between two non-US persons that count toward the non-US person's requirement to register as a security-based swap dealer ("SBSD"). The 2016 SEC Cross-Border Rules require a non-US person to include in its de minimis threshold calculations any transactions related to its security-based swap dealing activity that are arranged, negotiated, or executed using its personnel located in a US branch or office, or using personnel of its agent located in a US branch or office.
This article outlines the important concepts and consequences of the 2016 SEC Cross-Border Rules and provides a summary of the final rules and interpretative guidance set out in the 2014 SEC Cross-Border Adopting Release in order to present a complete picture of the SEC's current rule-making with respect to cross-border SBS transactions.
The CFTC's approach
Before we discuss the 2016 SEC Cross-Border Rules, it is useful to briefly set out how the CFTC currently handles the consequences of trading activity from the US. In November 2013, the CFTC issued a Staff Advisory5 addressing the applicability of the CFTC's transaction level requirements to certain swap transactions of non-US registered swap dealers arranged, negotiated or executed by its personnel or agents in the US. In accordance with the Staff Advisory, non-US registered swap dealers regularly using personnel or agents located in the US to arrange, negotiate or execute a swap with a non-US person are generally required to comply with the certain "Transaction-Level Requirements." Transaction-Level Requirements, as defined by the CFTC, include clearing and swap processing, margining, mandatory trade execution, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, trade confirmation, daily trading records and external business conduct standards.6 The CFTC considers such activity results in US located personnel or agents performing core front-office activities of that swap dealers dealing business, which warranted regulation by the CFTC.
The CFTC sought comment on whether the Staff Advisory should be adopted as policy, either in whole or in part. Following receipt of various comments, the CFTC subsequently extended no-action relief until the earlier of September 30, 2016 and when the CFTC takes action in this respect.7
As we will see below, the SEC has taken a similar approach in the context of SBSD registration.
Definition of Security-Based Swap Dealer
The Exchange Act sets out certain activities that, if performed, would bring a person within the definition of SBSD. These activities are:
(a) holding oneself out as a dealer in SBS transactions;
(b) making a market in SBS transactions;
(c) regularly entering into SBS transactions with counterparties as an ordinary course of business for a person's own account; or
(d) engaging in any activity causing a person to be commonly known in the trade as a dealer in SBS transactions.
However, even if a person is engaged in any of the SBS activities listed above, it will not be designated as a SBSD if it engages in a de minimis level of SBS activity.
On May 23, 2012 the SEC and the CFTC published joint final rules in which they further defined various concepts relating to the regulation of swaps and SBS transactions and, relevantly, the SEC sets the thresholds that were applicable to the SBSD de minimis level as well as the types of SBS transactions that were to be counted in determining whether a person was above or below the applicable de minimis threshold. Currently, the thresholds are:
(a) US$8 billion in notional of credit default SBS transactions;
(b) US$400 million in notional of other types of SBS transactions; and
(c) US$25 million in notional of any type of SBS transaction with counterparties that are special entities (i.e., governments, government entities and certain benefit plans and endowments).
These thresholds represent the phase-in amounts and will be adjusted following further studies to be undertaken by the SEC.
The 2014 SEC Cross-Border Rules built on the joint final rules discussed above by requiring non-US persons to include in their de minimis threshold calculation any SBS transactions arising out of dealing activity with counterparties that are US persons and non-US persons if the non-US persons are a conduit affiliate or if a counterparty has a right of recourse against a US person under the SBS transaction.
The 2016 SEC Cross-Border Rules amend the existing rules governing the de minimis threshold calculation by including certain dealing activity by a non-US person that has the specified connection with the US.
2014 SEC Cross-Border Rules
Definition of US Person
Under the 2014 SEC Cross-Border Rules, a "US person" is defined as:
(a) any natural person resident in the United States;
(b) any partnership, corporation, trust, investment vehicle, or other legal person organised, incorporated, or established under the laws of the United States or having its principal place of business in the United States;
(c) any account (whether discretionary or non-discretionary) of a US person; or
(d) any estate of a decedent who was a resident of the United States at the time of death.
Certain international organisations such as the World Bank, the International Monetary Fund and the United Nations as well as their agencies and pension plans are excluded from the definition of US person.8
The 2014 SEC Cross-Border Rules provide that a person may rely on a counterparty's representation regarding its status as a US person, unless such person knows, or has reason to know, that the representation is inaccurate.9 Importantly, a counterparty's representations regarding a person's status as a US person for purposes of CFTC regulations cannot be relied on for this purpose, although they may be useful in certain circumstances.
Registration and Regulations of SBSDs
As mentioned earlier, the Dodd-Frank Act introduced the concept of SBSDs, and requires entities that meet the definition of SBSD to register with the SEC.
Unlike the SBSD definition, the definition of major security-based swap participants ("MSBSP") does not focus on the quality of a person's swap market activities or on how the person "presents itself to the market." Rather, using objective numerical standards, the focus is on assessing the potential MSBSP's market impact and the risks associated with the person's SBS transaction positions. As with SBSDs, though, a person would not have to register as an MSBSP if the person's SBS transaction positions remain below certain thresholds. Due to the very limited application of this concept (the SEC estimates that there may only be five institutions that will be required to register as MSBSPs), this article does not provide any further information on MSBSPs.
Which Cross-Border SBS Dealing Transactions Count Towards the SBSD De Minimis Threshold?
Whether a SBS transaction is included in a person's de minimis threshold determination for SBSDs depends on the regulatory status of the applicable person and of its counterparties. Please refer to part 6 of this article for the rules regarding the counting of additional SBS transactions towards the de minimis thresholds under the 2016 SEC Cross-Border Rules.
We set out below details on the types of transactions that are to be counted towards the de minimis threshold.
(a) US person
A US person is required to count all of its SBS dealing transactions with US persons and non-US persons, including transactions conducted through a foreign branch.10
(b) Non-US person that is not a conduit affiliate
A non-US person that is not a conduit affiliate (as defined below) is required to count all its SBS dealing transactions with:
(i) US persons (other than foreign branches of US registered SBSDs, see below); and
(ii) non-US persons that have a right of recourse against a commonly controlled US affiliate of the counting entity. According to the SEC, a right of recourse exists "if the counterparty has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, a US person that is controlling, controlled by, or under common control with the counting entity in connection with the non-US Person's obligations under the SBS transaction."
(c) Non-US person that is a conduit affiliate
A conduit affiliate is required to count all their SBS dealing transactions against the de minimis threshold, regardless of the status of the counterparty.
Generally, a conduit affiliate is a non-US affiliate of a US person that enters into SBS transactions in the regular course of business with non-US persons, or with certain foreign branches of US banks that are registered SBSDs, on behalf of one or more of its US affiliates under common control, and enters into offsetting transactions with its US affiliates to transfer the risks and benefits of those SBS transactions. Affiliates registered as SBSDs or MSBSPs are not considered conduit affiliates.
In determining whether a person has met its de minimis threshold, a person is required to aggregate its positions with those of its affiliates (i.e., entities that it controls, that control it or with which it is under common control) to the extent such affiliates are also required to count SBS transactions towards their own de minimis thresholds. This requirement does not include an affiliate that is a registered SBSD (or a person that has exceeded the de minimis threshold and is in the process of registering as a SBSD).
With respect to SBS transactions with a foreign branch of a US person, the 2014 SEC Cross-Border Rules allow non-US persons to not count their SBS transactions with foreign branches of US persons against the de minimis thresholds only when the foreign branch is part of a registered SBSD (or a person that has exceeded the de minimis threshold and is in the process of registering as a SBSD). A SBS transaction is conducted through a foreign branch if (i) the foreign branch is the counterparty to the transaction; and (ii) the SBS transaction is arranged, negotiated and executed on behalf of the foreign branch solely by persons located outside the US.
The 2014 SEC Cross-Border Rules define a "foreign branch" of a US bank to mean a branch that is (a) located outside the United States, (b) operates for valid business reasons and (c) is engaged in the business of banking and is subject to substantive banking regulation in the jurisdiction where it is located.
Exception for Cleared Anonymous Transactions
SBS transactions that a non-US person enters into anonymously on an execution facility or national securities exchange and that are cleared through a clearing agency are excepted from being counted against the de minimis thresholds (unless the non-US person is a conduit affiliate).11 The 2014 SEC Cross-Border Rules require that the transaction be actually "anonymous" (i.e., unknown to the non-US person prior to the transaction).12 The cleared anonymous transactions exception was adopted to avoid the exclusion of US market participants with non-US members because of the prospect of dealer regulation.13
2015 Cross-Border Proposing Release
The 2015 Cross-Border Proposing Release broadly set out proposed rules in the following areas:
(a) application of the de minimis exception to SBS transactions connected with a non-US person's dealing activity that are arranged, negotiated or executed by the personnel of such person located in the United States;
(b) application of the external business conduct standards to such SBS transactions; and
(c) application of the regulatory reporting and public dissemination requirements to such SBS transactions.
The de minimis threshold calculation application in 2015 Cross-Border Proposing Release was a response to the significant concerns raised by market participants to the SEC's proposed approach in the 2013 Cross-Border Proposing Release. In the 2013 Cross-Border Proposing Release, the SEC sought to require a non-US person to include in its SBSD de minimis threshold calculation those transactions that fell within the definition of "transaction[s] conducted within the United States." The SEC had defined this phrase as any "security-based swap that is solicited, negotiated, executed or booked within the United States, by or on behalf of either counterparty to the transaction, regardless of location, domicile or residence status of either counterparty to the transaction." It would not have, however, included a transaction conducted through a foreign branch of a US bank. This would have required a person undertaking dealing activity to include in its de minimis threshold calculation any transaction where such person, its counterparty or their respective agents performed relevant SBS transaction dealing activity from within the United States. The approach set out in the 2016 Cross-Border Proposing Release captured a narrower range of activities than those initially proposed and therefore represented a softening of the original formulation set out under the 2013 Cross-Border Proposing Release.
Of the proposals made in the 2015 Cross-Border Proposing Release, only the first item addressing the application of the de minimis exception to non-US persons was generally adopted and finalised in the 2016 SEC Cross-Border Adopting Release.
2016 SEC Cross-Border Rules
The 2016 SEC Cross-Border Rules are consistent with the US activity test proposed in the 2015 Cross-Border Proposing Release, which focuses on whether the sales or trading personnel (or such personnel of its agent) carrying out market-facing SBS dealing activities for non-US persons are located in the United States.
SBSD De Minimis Threshold Calculation
Pursuant to the 2016 SEC Cross-Border Rules set out in the 2016 SEC Cross-Border Adopting Release (and consistent with the 2015 Cross-Border Proposing Release), a non-US person would only be required to include in its SBSD de minimis threshold calculation any SBS transaction connected with its SBS dealing activities that it enters into with another non-US person when such SBS transaction is arranged, negotiated or executed by personnel of the non-US person located in a US branch or office, or by personnel of the non-US person's agent located in a US branch or office. This approach is consistent with that currently followed for the registration of brokers and dealers under the Exchange Act.
For the purposes of the 2016 SEC Cross-Border Rules, the SEC has provided the following guidance:
(a) "arrange" and "negotiate" indicate market-facing activity of sales or trading personnel (or personnel who engage in sales and trading even if they are not formally designated as sales persons or traders) in connection with a particular transaction, including interaction with counterparties or their agents, and does not include internal functions (such as design or processing of trades or other back-office activities). The final rules also do not include the preparation of underlying documentation for a transaction, including negotiation of a master agreement and related documentation.
(b) "execute" indicates the market-facing act that, in connection with a particular transaction, causes the person to become irrevocably bound under that transaction under applicable law.
(c) "arranging, negotiating or executing" includes directing other personnel to arrange, negotiate or execute a particular transaction, but does not include booking.
(d) "located in a US branch or office" only includes those personnel, whether of the non-US person or its agent, physically located in a US branch or office. This would generally include personnel assigned to, on an ongoing or temporary basis, or regularly working in a US branch or office, but would not include those only incidentally present in the US (e.g., due to attendance at an educational or industry conference). This would capture personnel located in a US branch or office that respond to inquiries from a non-US person counterparty because it was outside of business hours in the counterparty's jurisdiction.
(e) "personnel" should be interpreted, with respect to both the non-US person and its agent, in a manner consistent with the definition of "associated person of a security-based swap dealer" as contained in section 3(a)(70) of the Exchange Act,14 regardless whether such non-US person or its agent is itself a SBSD.
The SEC stated in the accompanying interpretative guidance that the following activities undertaken by personnel located in the US would not, on their own, require a SBS transaction to be included in a non-US person's SBSD de minimis threshold calculation:
(a) submission of the SBS transaction for clearing in the US;
(b) reporting of the SBS transaction to a security-based swap data repository in the US;
(c) collateral management of an SBS transaction, such as the exchange of margin, that occurs in the US;
(d) preparation of underlying documentation for the SBS transaction, including negotiation of a master agreement and related documentation, or performing ministerial or clerical tasks in connection with the SBS transaction; and
(e) booking the SBS transaction in the non-US person.
In interpreting and applying the 2016 SEC Cross-Border Rules, it is helpful to understand the SEC's view on the appropriate territorial application of the Dodd-Frank Act. The SEC explained in the 2015 Cross-Border Proposing Release and reiterated in the 2016 SEC Cross-Border Adopting Release that the regulatory requirements applicable to SBS transactions under the Dodd-Frank Act are not solely focused on the risks to the US financial system. The SEC rejected the commenters' suggestion of assessing a SBS dealing activity's counterparty credit risk to judge if there is a nexus sufficient to warrant SBSD registration. With respect to the regulation of SBSDs, in the SEC's view, the appropriate analysis is whether a non-US person under a SBS transaction is engaged, in the US, in any of the activities set out in the definition of SBSD (see above) and, if so, it is appropriate under a territorial approach to require that non-US person to include such SBS transaction in its de minimis threshold calculation. The SEC is more broadly concerned with market stability and transparency and, as such, considers that any dealer activity being conducted in the US should be subject to appropriate regulatory oversight. The SEC anticipates that the significant proportion of dealing activity captured by the 2016 SEC Cross-Border Rules will likely be transactions carried out by foreign affiliates of US financial groups. The SEC noted that it expects the 2016 SEC Cross-Border Rules to reduce the likelihood of competitive disparities and market fragmentation between non-US-person dealers and US-person dealers.
The SEC stated that it does not intend for market participants to look beyond those personnel who are involved in, or directing, market-facing activities in connection with a particular SBS transaction. That is, the involvement of non-market-facing personnel located in a US branch or office in a transaction would not fall within the scope of the rules. The SEC's reasoning for taking this approach is consistent with its territorial approach discussed above–that is, activities in the US that do not involve the arrangement or negotiation of the economic terms of a SBS transaction are unlikely to raise the types of concerns addressed by the Dodd-Frank Act.
For example, it is for this reason that, unlike the original proposed rules set out in the 2013 Cross-Border Proposing Release that required a non-US person engaged in dealing activity to include in its de minimis threshold calculation any "transaction conducted within the United States", the finalised rule set out in the 2016 SEC Cross-Border Adopting Release does not include booking a trade as an activity that would result in a SBS transaction being counted in the de minimis threshold calculation, as the SEC considers booking activity to not be a market-facing activity.
Exception for Cleared Anonymous Transactions
A non-US person, other than a conduit affiliate (see paragraph 4.4), is not required to include in its de minimis threshold calculation a SBS transaction that is entered into anonymously and is cleared.
However, in the 2016 SEC Cross-Border Adopting Release, the SEC confirmed that this exception will not apply to non-US person transactions that are arranged, negotiated or executed by US personnel, primarily because a non-US person is only required to look to the location of its own SBS dealing activity and not that of the other party in determining whether to count SBS transactions in its de minimis threshold calculation. As such, the SEC has determined that applying this exception is inconsistent with the purposes underlying the exception, namely of only exempting non-US persons from having to determine the treatment of SBS transactions under the de minimis exception in circumstances where the information necessary to make that determination is unavailable.
In large part, the SEC expects to address the issue regarding the availability of substituted compliance as part of future rulemakings.15 However, the 2014 SEC Cross-Border Rules include a final procedural rule regarding substituted compliance stating that a request for a substituted compliance order may be submitted either by a party that potentially would comply with requirements under the Exchange Act pursuant to a substitute compliance order, or by a relevant foreign financial regulatory authority or authorities.16
The 2014 SEC Cross-Border Rules further provide that a substituted compliance proposal should include supporting documentation regarding the methods that foreign financial regulators use to enforce compliance with the applicable rules.17 The SEC requires such information because substitute compliance assessments will not be limited to comparison of underlying goals, but will include the capability of foreign regulators to monitor compliance and enforce actions in response to violations.18
Finally, since foreign regulators may submit substituted compliance proposals, the SEC has expanded the scope of the confidentiality requests to such proposals pursuant to any applicable provisions governing confidentiality under the Exchange Act.19
The provisions of the rules and guidance mentioned above do no limit the cross-border reach of the anti-fraud provisions or other provisions of the federal securities law that are not addressed in the 2014 SEC Cross-Border Rules and the 2016 SEC Cross-Border Rules.20 The SEC interprets cross-border antifraud enforcement to include cross-border frauds that implicate US territory, US markets, US investments, other US market participants, and other US interests.21 The SEC's anti-fraud enforcement authority includes the authority under the Exchange Act, the Securities Act and the Investment Advisers Act.22
The 2016 SEC Cross-Border Rules became effective on April 19, 2016. The compliance date for the 2016 SEC Cross-Border Rules is the later of February 1, 2017, or the date that is two months prior to the compliance date for SBSD registration (as provided in the SEC's release23 addressing SBSD and MSBSP registration requirements).
Other than the US activity test for de minimis threshold calculation discussed above, the 2016 SEC Cross-Border Adopting Release does not address the other proposals from the 2015 Cross-Border Proposing Release. The SEC anticipates addressing the application of external business conduct standards or clearing and trade execution requirements to certain SBS transactions in subsequent releases.
1 Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Form Relating to the Registration of Security-Based Swap Participants, Release No. 69490 (May 1, 2013), 78 FR 30967 (May 23, 2013), available at federalregister.gov/a/2013-1083.
2 Application of "Security-Based Swap Dealer" and "Major Security-Based Swap Participant" Definitions to Cross-Border Security-Based Swap Activities, Release No. 72472 (June 25, 2014), 79 FR 47277 (August 12, 2014 (republication)), available at federalregister.gov/a/R1-2014-1533.
3 Application of Certain Title VII Requirements to Security-Based Swap Transactions Connected with a Non-US Person's Dealing Activities That are Arranged, Negotiated, or Executed by Personnel Located in a US Branch or Office or in a US Branch or Office of an Agent, Release No. 34-74834 (April 29, 2015), 80 FR 27443 (May 13, 2015), available at federalregister.gov/a/2015-10382.
4 Security-Based Swap Transactions Connected With a Non-US Person's Dealing Activity that are Arranged, Negotiated, or Executed by Personnel Located in a US Branch or Office or in a US Branch or Office of an Agent; Security-Based Swap Dealer De Minimis Exception, Release No. 77104 (February 10, 2016), 81 FR 8597 (February 19, 2016), available at federalregister.gov/d/2016-03178.
5 CFTC Staff Advisory 13-69. For further information on CFTC Staff Advisory 13-69 please refer to our client alert CFTC Extends No-Action Relief for Dodd-Frank Act Requirements.
6 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations; Rule, 78 FR 45292 (July 26, 2013), available at federalregister.gov/a/2013-17958. For further information on the CFTC's cross-border guidance please see our client alert CFTC Issues Final Cross-Border Guidance.
7 CFTC No-Action Letter No. 15-48. For further information on CFTC Staff Advisory 13-69 please refer to our client alert CFTC Extends No-Action Relief for Dodd-Frank Act Requirements. For information on the CFTC's cross-border guidance please refer to our client alert CFTC Issues Final Cross-Border Guidance.
8 Supra note 2 at 93-4.
9 Supra note 2 at 94.
10 Supra note 2 at 79.
11 Supra note 2 at 159.
12 Supra note 2 at 160.
13 Supra note 2 at 158.
14 This section is substantially similar to section 3(a)(18) of the Exchange Act.
15 Supra note 2 at 278.
16 Supra note 2 at 279.
17 Supra note 2 at 280.
18 Supra note 2 at 280.
19 Supra note 2 at 281.
20 Supra note 2 at 285.
21 Supra note 2 at 288.
22 Supra note 2 at 286.
23 Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, 80 FR 48963 (August 4, 2015), available at federalregister.gov/a/2015-19661.
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