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SEC Proposes Substituted Compliance for Cross-border Security-based Swaps under Dodd-Frank
Practical Law Legal Update 5-527-5888 (Approx. 7 pages)
SEC Proposes Substituted Compliance for Cross-border Security-based Swaps under Dodd-Frank
by PLC Finance
| Published on 07 May 2013 • USA (National/Federal) |
The SEC released its proposed rules for the treatment of cross-border security-based swaps (SBS) under Title VII of the Dodd-Frank Act. The proposed rules would permit SBS market participants to substitute compliance with comparable rules from non-US jurisdictions for compliance with US rules on a more broad basis than proposed CFTC cross-border rules for non-security-based swaps.
On May 1, 2013, the SEC released its proposed rules for the treatment under Title VII of the Dodd-Frank Act of cross-border security-based swaps (SBS). The proposed rules would permit SBS market participants to substitute compliance with comparable rules from non-US jurisdictions for compliance with US rules, provided certain conditions are met. The SEC's proposal has been met with favorable market reaction because it would allow much broader substituted compliance than the CFTC proposal on cross-border non-security-based swaps released last year (see Practice Note, The Dodd-Frank Act: Cross-border Application of Swaps Rules).
The proposed rules also contained proposed modifications to proposed SEC Regulation SBSR (Reg SBSR), the SEC's proposed SBS data reporting framework, necessitated by its cross-border proposal. Among other things, the SEC has proposed substituted compliance for Reg SBSR. For more details on the new proposed modifications to proposed Reg SBSR and how they dovetail with other proposed Reg SBSR rules, see Practice Note, The Dodd-Frank Act: Swap Data Reporting and Recordkeeping: Regulation SBSR: Proposed SEC Data Reporting Rules for Security-based Swaps.
Recognizing that many swaps are negotiated between entities subject to differing sovereign regulatory regimes, most of which are still being finalized, the SEC has proposed a regime that is intended to relieve much of the burden associated with multiple, overlapping and potentially conflicting regulations. The SEC has taken a territorial approach, meaning that, absent an exception, "US persons," as defined in proposed rule 3a71-3(a)(7) of the Commodity Exchange Act (CEA), and entities engaging in swaps with US persons would be required to adhere to US regulatory requirements. However, if the SEC deems a foreign regulatory regime comparable to that of the US, then it would allow market participants to comply with the foreign regime in place of US regulation.
The SEC proposal provides that, among other things:
- SBS transactions that take place in the US or that involve a US person are generally required to comply with Title VII of the Dodd-Frank Act. Transactions that take place in the US include any SBS that is negotiated, executed or booked in the US. A "US person" includes:
- a natural US resident;
- an entity organized under the laws of, or having its principle place of business in, the US;
- any account of a US person; and
- a foreign branch of a US bank, although foreign branches of US banks are eligible for non-US person treatment in some circumstances.
- If the SEC deems a foreign regulatory regime comparable to US regulatory requirements, a foreign market participant may substitute compliance with its home country regime for compliance with Title VII of Dodd-Frank.
- The SEC will separately assess the comparability of the foreign swaps regulatory regime to the Title VII SBS regulatory regime using four distinct categories. For instance, if a foreign regulatory regime is comparable to Title VII in only one category, only rules from the foreign regime that address that category may be substituted for compliance with the analogous Title VII rules. If the rules from the foreign regime are comparable to Title VII in two categories, rules from the foreign regime for those two categories may be substituted for compliance with Title VII, and so on. The four categories are:
- requirements applicable to registered non-US security-based swap dealers;
- requirements relating to regulatory reporting and public dissemination of SBS data;
- requirements relating to mandatory clearing for SBS; and
- requirements relating to mandatory trade execution for SBS.
- The SEC will examine the four categories of a foreign regulatory regime on a "holistic level," meaning that, so long as the regulatory outcome is comparable, differences in specific rules or regulations will not automatically render a foreign SBS regulatory regime incomparable to Title VII.
- The SEC will make substituted compliance determinations based on the regime, not on the market participant. In other words, if the SEC determines that a foreign regime is comparable to the US in one of the four categories, substituted compliance will be available to all foreign market participants organized in the jurisdiction to which that regime applies. This is different from the proposed CFTC cross-border rules, which require a separate determination of comparability for each entity that wishes to substitute US regulations with those of its home regime.
- The SEC reserves the right to withdraw or modify any determination that a foreign regime is comparable to Title VII.
For an overview of which SBS rules and regulations are eligible for substituted compliance for certain types of entities, see Rules Eligible for Foreign Substituted Compliance: Security-based Swaps.
Non-US Security-based Swap Dealer (SBSD) Registration Requirements
The proposed rules also offer guidance on when a non-US person is required to register with the CFTC as a security-based swap dealer (SBSD) under Section 15F(a)(1) of the CEA. Under rules adopted jointly by the CFTC and the SEC in 2012, non-US entities must register as an SBSD if their notional trading activity exceeds a certain de minimis threshold over a 12 month period (see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking). Under the SEC's proposed guidance, while US persons are required to count all SBS they enter into toward the de minimis threshold, non-US entities are only required to include in this calculation SBS that are either:
- Entered into with US persons.
- Conducted within the US, defined as dealing activity undertaken by non-US persons that are physically located within the United States, such as through a US branch of a non-US bank, or through an agent, such as a non-US person’s US subsidiary or an unaffiliated third party acting on the non-US person’s behalf.
Non-US entities would also not be required to include in their de minimis SBSD calculations SBS entered into with:
- Foreign branches of US banks.
- Non-US persons, even if the swap is guaranteed by a US person.
Moreover, both US and non-US persons need not aggregate the SBS of a commonly controlled affiliate for the purpose of determining whether they meet the de minimis SBSD threshold if the affiliate is registered with the SEC as an SBSD and the SBS activity is operationally independent from the registered affiliate.
Under the proposed rules, non-US persons that have registered as SBSDs with the SEC are required to comply with Dodd-Frank:
- External business conduct standards (EBCS) for SDs (see Practice Note, Swap Dealers and MSPs: Final Dodd-Frank External Business Conduct (EBC) Rules).
- Swap margin collateral segregation requirements, but generally only if the counterparty is a US person (see Practice Note, The Dodd-Frank Act: Derivatives Margin Collateral Rules: Optional Segregation of Uncleared Swaps Initial Margin).
US persons that are registered SBSDs would be required to adhere to all Title VII requirements applicable to SBSDs. While on-US branches of US banks that enter into SBS out of the non-US branch must still comply with Dodd-Frank entity-level and swap margin collateral segregation requirements, they would not have to adhere to EBCS for their non-US business. For a non-US branch of a US bank, "non-US business" includes any transaction that is entered into by the non-US branch with a counterparty that is a non-US person or another non-US branch of a US bank, regardless the location of the transaction.
For an overview of which SBS rules and regulations are eligible for substituted compliance for certain types of entities, see Rules Eligible for Foreign Substituted Compliance: Security-based Swaps.
Non-US Major Security-based Swap Participant (MSBSP) Registration Requirements
The proposed rules also offer guidance on when a non-US person is required to register with the SEC as a major security-based swap participant (MSBSP). Under rules adopted jointly by the CFTC and the SEC in 2012 (see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking), a non-US entity must register as an MSBSP if its swaps trading:
- Exceeds a defined substantial position.
- Exceeds a substantial counterparty exposure threshold.
Under the SEC cross-border SBS proposal, US persons must include all SBS into which they have entered in this calculation. Non-US persons must include only swaps entered into with US persons, including swaps with foreign branches of US banks.
Additionally, entities that guarantee swaps will have their guaranteed swaps attributed to them as follows:
- If a non-US person guarantees a US person's swaps, all guaranteed swaps are attributed to the guarantor.
- If a non-US person guarantees a non-US person's swaps, only swaps in which the counterparty is a US person will be attributed to the guarantor.
- A US person that guarantees a non-US person's swaps must attribute to itself all guaranteed swaps, regardless of counterparty.
However, if the guaranteed party is a non-US person subject to the Basel capital standards, no swaps must be attributed. For more information on Basel III, see Practice Note, Basel III: An Overview and Article, Basel III and the New US Capital Framework Proposals.
Under this proposal, US persons that are registered MSBSPs would be required to comply with all rules under Title VII. Non-US persons that are registered MSBSPs would be required to:
- Comply with all entity-level requirements.
- Comply with all transactions level requirements for transactions with US persons.
For an overview of which rules and regulations are eligible for substituted compliance with which entities, see Rules Eligible for Foreign Substituted Compliance: Security-based Swaps.
Registration for Security-based Swap "Infrastructures"
The proposed rules require US registration of swap infrastructures that perform the relevant infrastructure function within the US. These SBS infrastructures would be required to self-determine their registration requirement, and would include:
- Clearing agencies. An SBS clearing agency performs its function in the US if it has one or more US persons as members.
- Swap execution facilities (SEFs). A SEF performs its function in the US if it allows a US person or any person located in the US to directly participate in the non-US SBS market.
- Swap Data Repositories. A swap data repository performs its functions in the US if it receives data from a US person or operates in the US.
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Practical Implications
It appears that the SEC cross-border proposal could permit certain US swaps entities to sidestep certain Dodd-Frank requirements, most notably the EBCS, when entering into SBS with non-US persons by having a non-US-based affiliate enter into the swap, rather than its US entity. Such a swap would, of course, be required to comply with any swaps rules in the non-US branch's home jurisdiction.
Market participants have generally praised the SEC's approach, which is viewed as more flexible than the CFTC's cross-border proposal (see Practice Note, The Dodd-Frank Act: Cross-border Application of Swaps Rules). because it permits swaps market participants to avoid duplicative compliance with similar rules in various jurisdictions. non-US regulators have also applauded the comity of the SEC's cross-border approach as compared to that of the CFTC.