CFTC Proposes Rules for Cross-Border Application of Margin Requirements for Uncleared Swaps

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1 AUGUST 4, 2015 DERIVATIVES UPDATE CFTC Proposes Rules f Cross-Bder Application of Margin Requirements f Uncleared Swaps On June 29, 2015, the Commodity Futures Trading Commission (CFTC) proposed rules that will determine the cross-bder application of its margin requirements f uncleared swaps (Margin Proposal). 1 With the Margin Proposal, the CFTC is revisiting, in a significant way, its 2013 cross-bder interpretive guidance (Cross-Bder Guidance), 2 which set out the CFTC s general approach to cross-bder application of its swap rules. It is unclear whether the approach taken in this limited, albeit imptant, context is a harbinger of things to come. Nonetheless, the Margin Proposal is notewthy f several reasons beyond its potential impact on swap margin requirements: In revisiting elements of the Cross-Bder Guidance, the CFTC has indicated a willingness to rein in the substance of its earlier approach. F example, it proposes to narrow the definitions of U.S. person and of guarantee (f purposes of applying its margin requirements f uncleared swaps). Meover, the CFTC has indicated a willingness to alter the means by which it takes cross-bder regulaty action related to swaps, as it is proceeding now with fmal rule-making rather than publishing further guidance and interpretive views. The CFTC has signaled a greater interest in collabating and, in imptant respects, trying to find common ground with regulats in other countries. F example, the Cross-Bder Guidance did not admit the possibility of substituted compliance f the margining of uncleared swaps where a non-u.s. swap dealer transacts with a U.S. person (other than the limited circumstance of its transacting with the feign branch of a U.S. swap dealer); the Margin Proposal contemplates a broader possibility in this regard. On the domestic front, some elements of the Margin Proposal may be viewed as reflecting the CFTC s taking a supervisy perspective not dissimilar from that of U.S. bank regulats. F example, the Margin Proposal would apply the margining requirements based on group accounting consolidation (whether not an interaffiliate guarantee is present). This approach echoes the approach traditionally taken by banking regulats toward consolidated supervision. 1 See CFTC, Margin Requirements f Uncleared Swaps f Swap Dealers and Maj Swap Participants Cross-Bder Application of the Margin Requirements; Proposed Rule, 80 Fed. Reg (July 14, 2015), available at: 2 CFTC, Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg (July 26, 2013), available at: The Cross-Bder Guidance was unsuccessfully challenged by industry groups in a recent lawsuit. See Sidley Update, CFTC Adopts Final Cross-Bder Guidance and Exemptive Order; Announces Path Fward with EU (July 19, 2013), available at: Sidley Austin provides this infmation as a service to clients and other friends f educational purposes only. It should not be construed relied on as legal advice to create a lawyer-client relationship. Attney Advertising - F purposes of compliance with New Yk State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New Yk, NY 10019, ; One South Dearbn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C ,

2 PAGE 2 The Margin Proposal was anticipated in an Advance Notice of Proposed Rule Making (ANPR) published by the CFTC in November 2014, when the CFTC also proposed rules that will generally implement the Dodd-Frank Act s statuty margining requirement f uncleared swaps (CFTC 2014 Proposal). 3 The Dodd-Frank Act requires U.S. federal regulats the CFTC, the Securities and Exchange Commission (SEC) and five U.S. prudential regulats (Prudential Regulats) to adopt implementing rules covering both initial and variation margin. The Prudential Regulats proposed their implementing rules in September 2014 (Prudential Regulat Proposal and, together with the CFTC 2014 Proposal, 2014 Proposals). 4 The 2014 Proposals mirr to a significant degree the final international standards on margin requirements f non-centrally cleared derivatives issued in September 2013 by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO). 5 The 2014 Proposals establish initial and variation margin requirements that CFTC-registered swap dealers and maj swap participants must post to and collect from their counterparties. Under the 2014 Proposals, each registered swap dealer and maj swap participant that is supervised by one of the Prudential Regulats will be required to meet the minimum initial and variation margin requirements set by the Prudential Regulats; 6 other registered swap dealers and maj swap participants (collectively referred to as covered swap entities CSEs) will be subject to requirements set by the CFTC. 7 Imptant elements of the Margin Proposal are highlighted below, including differences between the Margin Proposal and cross-bder aspects of the Prudential Regulat Proposal. Annex A summarizes the application of the Margin Proposal in tabular fm. Note that the CFTC s uncleared swap margin requirements will ultimately apply to swaps only where one party to the transaction is a CSE. The Margin Proposal is open f public comment through September 14, See, CFTC, Margin Requirements f Uncleared Swaps f Swap Dealers and Maj Swap Participants; Proposed Rule, 79 Fed. Reg (October 3, 2014), available at: An earlier Sidley Update discussed the CFTC rule proposal. See Sidley Update, Margin Requirements f Uncleared Swaps Continue to Take Fm: Prudential Regulats and CFTC Re-Propose Similar Rules (November 12, 2014), available at: 4 See, Prudential Regulats, Margin and Capital Requirements f Covered Swap Entities; Proposed Rule, 79 Fed. Reg (September 24, 2014), available at: The five Prudential Regulats are the Comptroller of the Currency (OCC); the Board of Governs of the Federal Reserve System (Federal Reserve); the Federal Deposit Insurance Cpation (FDIC); the Farm Credit Administration (FCA); and the Federal Housing Finance Agency (FHFA). An earlier Sidley Update highlighted the re-proposed rules issued by the Prudential Regulats. See Sidley Update, Prudential Regulats Re-Propose Rules f Mandaty Margining of Uncleared Swaps; Similar CFTC Re-Proposal Anticipated Shtly (September 15, 2014), available at: 5 See BCBS and IOSCO, Margin requirements f non-centrally cleared derivatives (September 2013), available at: 6 A swap dealer s Prudential Regulat, if any, depends on the type of entity it is. F example, the Federal Reserve is the Prudential Regulat of bank holding companies and state-chartered banks that are members of the Federal Reserve System that are branches agencies of feign banks, and the OCC is the Prudential Regulat of national banks and federally-chartered branches and agencies of feign banks. Non-bank swap dealer subsidiaries of bank holding companies will be subject to the CFTC s minimum requirements rather than those of the Federal Reserve. 7 The Dodd-Frank mandate also covers security-based swaps. Although the SEC iginally proposed margin rules f uncleared security-based swaps, it has not yet followed the Prudential Regulats and the CFTC in re-proposing those rules in response to the BCBS/IOSCO Standards. Although it is expected that the SEC will also re-propose its own implementing rules, it is not clear when it will do so, though it has indicated that when it does propose implementing rules, it will (as with other rule proposals) simultaneously address their cross-bder application.

3 PAGE 3 U.S. Persons Perhaps the most striking aspect of the Margin Proposal is its definition of U.S. person (which is set out in its entirety in Annex B). With this definition, the CFTC expressly eschews the open-ended approach taken by the Cross-Bder Guidance, which gave the phrase an open-ended meaning that relied on detailed examples to demonstrate the CFTC s interpretation. It achieved this in the Cross-Bder Guidance by prefacing its definition of U.S. person (which is also set out in Annex B) with the phrase including but not limited to. However, the CFTC states in the Margin Proposal: The proposed U.S. person definition does not include the prefaty phrase includes, but is not limited to that was included in the Guidance. The Commission believes that this prefaty phrase should not be included in der to provide legal certainty regarding the application of U.S. margin requirements to cross-bder swaps. 8 Thus the CFTC s proposed definition perhaps signals a shift in regulaty approach generally from interpretation to rule-making. The definition also clearly indicates an interest in closer alignment with other regulats the SEC in this case. The CFTC states: [T]he Commission notes that the proposed definition of U.S. person is similar to the definition of U.S. person used by the SEC in the context of cross-bder security-based swaps. To demonstrate the point, the CFTC then sets out the entire text of the SEC cross-bder definition (which is also set out in Annex B). 9 As to the substance of the definition, of greatest interest is the absence of a majity-ownership prong f collective investment vehicles. The Cross-Bder Guidance s concept of U.S. person includes any commodity pool, pooled account, collective investment vehicle (whether not it is ganized incpated in the United States) of which a majity ownership is held, directly indirectly, by a U.S. person(s). The CFTC proposes to drop this prong from the U.S. person definition in the Margin Proposal solely as it relates to the CFTC s margin requirements f uncleared swaps, doing so in part because of implementation issues raised by commenters. 10 As a result, f purposes of the cross-bder application of the CFTC s margin requirements, an offshe investment fund would presumably be permitted to rely solely on the CFTC s principal place of business test to determine whether it was a U.S. person. A Prudential Point of View The ANPR contemplated three alternative general approaches to the cross-bder application of the CFTC s margin requirements f uncleared swaps. It defined them as the Guidance Approach (which would be consistent with the Cross-Bder Guidance), the Prudential Regulats Approach (which would follow the cross-bder approach reflected in the Prudential Regulat Proposal) and the Entity-Level Approach (which was newly set out in the ANPR). In fmulating the Margin Proposal, the CFTC is now taking (in its own wds) a hybrid approach. It explains: 8 Margin Proposal at Id. at footnote Id. at

4 PAGE 4 The Proposed Rule is a combination of the entity- and transaction-level approaches and is closely aligned with the Prudential Regulats Approach. In general, under the Proposed Rule, margin requirements are designed to address the risks to a CSE, as an entity, associated with its uncleared swaps (entity-level) Thus the CFTC s principal focus in the Margin Proposal is limiting the risk of CSE failure, not the risk faced by non-dealer market participants (such as end-users) when they trade with CSEs. Given this perspective, it is not surprising that the CFTC also cites the internal risk management function of swap margin and likens it to capital: Margin, by design, is complementary to capital. That is, margin and capital requirements serve different but equally imptant risk mitigation functions that are best implemented at the entity-level.... Standing alone, either capital margin may not be enough to prevent a CSE from failing, but together, they are designed to reduce the probability of default by the CSE and limit the amount of leverage that can be undertaken by CSEs (and other market participants), which ultimately mitigates the possibility of a systemic event. 12 Note the reference to systemic risk. Here, the CFTC sounds much me like a prudential bank regulat than a traditional market regulat. Presumably this reflects CFTC s close consultation with the Prudential Regulats 13 in the context of preparing the Margin Proposal. Feign Consolidated Subsidiaries Evidence of prudential regulation can also be seen in the CFTC s approach to Feign Consolidated Subsidiaries. In a way that the Cross-Bder Guidance does not, the Margin Proposal targets non-u.s. CSEs if they are consolidated f accounting purposes with an ultimate parent that is a U.S. person. Under the Cross-Bder Guidance, transaction-level requirements (such as swap margining) do not apply to a non-u.s. CSE (even if part of a U.S. banking group) unless its obligations are guaranteed by a U.S. person. In proposing to expand the application of its margin rules, the CFTC is following the lead of the Prudential Regulats, which histically supervise consolidated groups without reference to the presence absence of inter-affiliate guarantees. Meover, the Margin Proposal addresses the perception that certain U.S. banking ganizations took advantage of a loophole in the Cross-Bder Guidance when they de-guaranteed certain non-u.s. dealing subsidiaries. 14 In this regard, the CFTC notes (speaking again like a prudential bank regulat) that even in the absence of a parent guarantee, swaps of a consolidated subsidiary of a U.S. parent raise substantial supervisy concern in the United States. 15 Although the Margin Proposal would subject a Feign Consolidated Subsidiary to the CFTC s margin requirements, it would permit the Feign Consolidated Subsidiary to avail itself of substituted compliance (if otherwise available f the non-u.s. jurisdiction in question, as discussed below), but only if the Feign 11 Id. at (emphasis added). 12 Id. 13 Id. 14 See Id. at ( The Commission is aware that some non-u.s. CSEs removed guarantees in der to fall outside the scope of certain Dodd-Frank requirements. ) 15 Id. (emphasis added).

5 Consolidated Subsidiary did not transact with the benefit of a guarantee from its U.S. parent ( any other U.S. person). The availability of substituted compliance in this context (and in others) is discussed further below. PAGE 5 Guarantees The Margin Proposal s treatment of guarantees is interesting f two principal reasons. First, the term guarantee is defined narrowly and with specificity. This approach contrasts with the approach to guarantees under the Cross-Bder Guidance, where the term was used inconsistently and, at least in one context, was given a very broad meaning. Under the Margin Proposal, guarantees are circumscribed to those arrangements where: a party to a swap transaction has rights of recourse against a U.S. person... [e.g.,] the party has a conditional unconditional legally enfceable right to receive otherwise collect, in whole in part, payments from the U.S. person in connection with the non-u.s. person counterparty s obligations under the swap. The Margin Proposal acknowledges a narrowing of the definition (by comparison to that found in the Cross- Bder Guidance); 16 however, it does not address the fact that the Cross-Bder Guidance treated guarantees inconsistently that the Margin Proposal s definition of guarantee is nearly the same as the narrower of the two principal approaches to guarantees taken in the Cross-Bder Guidance. 17 Second, guarantees (as defined) are referenced principally where a non-u.s. CSE s obligations are guaranteed not, by contrast, where any non-u.s. counterparty of the CSE is guaranteed by a U.S. person. This again signals a shift in approach from the CFTC Cross-Bder Guidance e.g., from the approach of a regulat focused on protecting non-dealer market participants (including U.S. persons who guarantee their obligations), to that of a regulat concerned with the prudential supervision of dealers themselves. Thus, when the question is which uncleared swap transactions of a non-u.s. person are subject to the CFTC s margining requirements, the presence of a guarantee from a U.S. person is relevant only if the guaranteed non- U.S. person is registered with the CFTC as a CSE (with one narrow exception). 18 Where a non-u.s. CSE is guaranteed by a U.S. person, then it is subject to margining requirements in the same manner as a U.S. CSE. But 16 See id. at In contrast to the narrow definition set out in the Margin Proposal, the concept of a guarantee under the Cross-Bder Guidance was quite broad: [T]he Commission would interpret the term guarantee generally to include not only traditional guarantees of payment perfmance of the related swaps, but also other fmal arrangements that, in view of all the facts and circumstances, suppt the non-u.s. person s ability to pay perfm its swap obligations with respect to its swaps. The Commission believes that it is necessary to interpret the term guarantee to include the different financial arrangements and structures that transfer risk directly back to the United States. In this regard, it is the substance, rather than the fm, of the arrangement that determines whether the arrangement should be considered a guarantee.... Cross-Bder Guidance at The Cross-Bder Guidance discussed guarantees in two principal contexts: (i) determining which swap dealing transactions a non-u.s. person is required to count against its swap dealer de minimis threshold (i.e., it must count swaps with non-u.s. persons if they are guaranteed by a U.S. person) and (ii) determining which Transaction-Level Requirements apply to a given cross-bder transaction. In the first context, the Cross-Bder Guidance used the defined term guaranteed affiliate, which incpated a very broad definition of guarantee, but limited the term s application to those guarantees provided by U.S. persons that are affiliated with the guaranteed non-u.s. person. In the second context, the Cross-Bder Guidance, not unlike the Margin Proposal, focused me narrowly on guarantees that result in the beneficiary having direct recourse against the guarant (i.e., certain keepwells would not be covered), but there was no requirement that the guarantee be provided by an affiliate. See Shirley, W., Guarantees, Conduits and Confusion Under the CFTC's Cross-Bder Guidance, Futures & Derivatives Law Rept (February 2014) at 7-11, available at: 18 The exception applies when a U.S. CSE a non-u.s. CSE guaranteed by a U.S. person trades with non-u.s. persons, but the exception is very narrow: If the non-u.s. person is not guaranteed by a U.S. person, substituted compliance applies to the CSE s obligation to post initial margin (but not to obligations to collect initial margin to post to collect variation margin). By contrast, if the non-u.s. person is guaranteed by a U.S. person, no substituted compliance is permitted at all. Meover, the narrow possibility of substituted compliance (with respect to the CSE s posting of initial margin) assumes that the non-u.s. person is under an obligation to collect initial margin, which is most likely where the non-u.s. person is itself a dealer. Put another way: If the non-u.s. person is not required under the feign regime to collect margin, it does not matter whether the CSE s non-u.s. person counterparty is guaranteed by a U.S. person not.

6 PAGE 6 in the absence of the non-u.s. CSE itself having a relevant U.S. connection (including being a Feign Consolidated Subsidiary of a U.S. group operating through a U.S. branch), the CSE would be permitted to comply with its home jurisdiction s margin requirements (assuming the CFTC has made a substituted compliance finding) even when it trades with a U.S. person. Substituted Compliance As noted above, the CFTC has indicated a greater willingness to permit substituted compliance on the part of non-u.s. CSEs. Under the Cross-Bder Guidance, substituted compliance would not have been permitted with respect to any transaction-level requirement (including swap margining) when a non-u.s. CSE traded with a U.S. person, with one limited exception. The exception was where the U.S. person is a U.S. bank operating through a feign branch. Thus, the CFTC demonstrated distrust of the ability of non-u.s. regulaty regimes to protect non-dealer U.S. market participants (even where the CFTC has made a comparability finding suppting the application of substituted compliance in other circumstances). Under the Margin Proposal, the CFTC s perspective has changed. If the CFTC finds that non-u.s. swap margin regulation is comparable to the [CFTC s] cresponding margin requirements, it will permit non-u.s. CSEs to comply with the non-u.s. regulation (in lieu of the CFTC s own) even when dealing with most U.S. persons. It draws the line, and requires its own rules to apply, if the U.S. person is itself a CSE, but even here it would permit substituted compliance with respect to those rules requiring the non-u.s. CSE to collect initial margin from the U.S. CSE (though not those rules requiring the non-u.s. CSE to post initial margin to the U.S. CSE, to post collect variation margin). The broader point is that the Margin Proposal effectively turns the Cross-Bder Guidance on its head with respect to the ability of non-u.s. CSEs to rely on substituted compliance when dealing with U.S. persons: Under the Cross-Bder Guidance, a U.S. person would have been ensured CFTC protection (i.e., no substituted compliance was possible) except where the U.S. person is itself a CSE (and operating through a feign branch). Under the Margin Proposal, a U.S. person is ensured CFTC protection only where the U.S. person is itself a CSE; and, thus, non-dealer U.S. market participants may find themselves relying on protections under a non-u.s. regulaty system when dealing with a non-u.s. CSE (provided, of course, the CFTC has found the non-u.s. system comparable to its own). All of this is consistent with the theme enunciated above (and acknowledged in the Margin Proposal): In developing the Margin Proposal, the CFTC has focused primarily on the prudential regulation of regulated swap dealers to mitigate the risk of failure, rather than on market regulation f the benefit of non-dealer market participants. Whether substituted compliance will open the do to significant variations in how market participants are treated in different jurisdictions remains to be seen. The CFTC stresses in the Margin Proposal its intention to consult closely with non-u.s. regulaty counterparts. Meover, the general thrust of regulaty developments in this area has been, since the publication of international standards noted above, one of cross-bder cooperation in pursuit of cross-bder consistency.

7 PAGE 7 Treatment of U.S. Branches of Non-U.S. CSEs In the Cross-Bder Guidance s well-discussed footnote 513, the CFTC took the position that a U.S. branch of a non-u.s. swap dealer MSP would be subject to Transaction-Level requirements, without substituted compliance available. The CFTC staff, in its November 2013 Advisy 13-69, extended this position beyond U.S. branches; the letter indicated that the requirements would apply to non-u.s. swap dealers regularly using personnel agents located in the U.S. to arrange, negotiate, execute a swap with a non-u.s. person. This position (under both footnote 513 and the advisy) cover the margin requirements f uncleared swaps because they were categized as transaction-level requirements under the Cross-Bder Guidance. The Margin Proposal does not mention either footnote 513 the staff s advisy. However, at least as to margin requirements f uncleared swaps, it revisits both. The Margin Proposal provides that uncleared swaps between non-u.s. CSEs and non-u.s. persons are excluded from application of the CFTC s margin requirements, subject to a number of qualifications and conditions. One of those conditions is that the non-u.s. CSE is not a U.S. branch of a non-u.s. CSE. However, the Margin Proposal does not propose particular standards f determining when a non-u.s. CSE has executed a swap in a manner that would meet this condition. Instead, it asks specific questions in this regard (including whether a Volcker Rule standard should apply here as well): How should the Commission determine whether a swap is executed through by a U.S. branch of a non-u.s. CSE f purposes of applying the Commission s margin rules on a cross-bder basis? Should the Commission base the determination of whether the swap activity is conducted at a U.S. branch of a non-u.s. CSE f purposes of applying the Commission s margin rules on a cross-bder basis on the same analysis as is used in the Volcker rule? 19 Comparison With the Prudential Regulat Proposal The Margin Proposal is substantially similar, but not identical, to the Prudential Regulat Proposal f crossbder application of margin requirements f uncleared swaps. The similarities (and min differences) relate to aspects of the two proposals that exclude some uncleared swaps entirely from CFTC regulation and that permit substituted compliance with respect to others. Excluded Swap Transactions Under both the Margin Proposal and the Prudential Regulat Proposal, certain uncleared swaps of certain non- U.S. CSEs 20 would be excluded entirely from the application of U.S. margin requirements. One difference between the Margin Proposal and the Prudential Regulat Proposal is how U.S. nexus is defined. In the case of both proposals, the criteria f U.S. nexus are two-fold: (i) the nexus of the non-u.s. CSE to the United States, and (ii) the nexus of its swap counterparty to the United States. With respect to the first criterion, the exclusion under the Margin Proposal is available (as noted above) only to non-u.s. CSEs that are neither guaranteed by a U.S. person n have an ultimate parent entity that is a U.S. person and consolidates the CSE f accounting purposes (as the result of a controlling financial interest under 19 Margin Proposal at F simplicity s sake, we speak here of CSEs in the case of the Prudential Regulat Proposal as well as the Margin Proposal, even though the fmer proposal applies to banks other entities that are subject to oversight by the Prudential Regulats (and not to CSEs per se).

8 PAGE 8 U.S. GAAP); meover, even if these two conditions are met, the exclusion is not available if the non-u.s. CSE is a U.S. branch. Exclusion under the Prudential Regulat Proposal is restricted to feign covered swap entities, a categy which excludes not only U.S. entities, but also non-u.s. entities that are controlled, directly indirectly, by a U.S. entity that are U.S. branches of non-u.s. banks. Control f these purposes is defined as: ownership, control power to vote 25 percent me of a class of voting securities of the company, directly indirectly, acting through one me other persons; ownership control of 25 percent me of the total equity of the company, directly indirectly, acting through one me other persons; control in any manner of the election of a majity of the directs trustees of the company. 21 Thus, a question arises whether the GAAP-based test under the Margin Proposal would produce a different result from the control test under the Prudential Regulat Proposal. With respect to the second criterion f exclusion, there is also broad similarity with some variation. In the case of both proposals, an eligible non-u.s. CSE is not able to claim exclusion in respect of a swap with (i) a U.S. person, (ii) a non-u.s. person that is guaranteed by a U.S. person, (iii) a non-u.s. CSE that (A) is a Feign Consolidated Subsidiary (in the case of the Margin Proposal) (B) is not a feign covered swap entity (in the case of the Prudential Regulat Proposal). Substituted Compliance Both the Margin Proposal and the Prudential Regulat Proposal permit substituted compliance in certain circumstances (where exclusion is not permitted). Under both proposals, full (as opposed to partial) substituted compliance is available only to non-u.s. CSEs and only if their obligations are not guaranteed by U.S. persons. However, the Margin Proposal imposes a further restriction not found in the Prudential Regulat Proposal: if the (non-guaranteed) non-u.s. CSE s counterparty is either a U.S. CSE a non-u.s. CSE that is guaranteed by a U.S. person, then substituted compliance is available only in respect of the obligation to collect initial margin from the counterparty. A similar limitation does not apply under the Prudential Regulat Proposal (which permits full substituted compliance in analogous circumstances). Both proposals permit U.S. CSEs and non-u.s. CSEs that are guaranteed by U.S. persons to take advantage of only limited substituted compliance. Such CSEs may avail themselves of substituted compliance but only in respect of their obligation to post initial margin. However, the Margin Proposal contains an additional condition in this context that is not found in the Prudential Regulat Proposal: the limited relief is permitted only if the counterparty of the U.S. CSE (guaranteed) non-u.s. CSE is a non-u.s. person and is not guaranteed by a U.S. person. The Prudential Regulat Proposal permits the limited relief without regard to the identity of the counterparty (provided the counterparty is required to collect initial margin under the relevant non-u.s. regulaty framewk). 21 Prudential Regulat Proposal at

9 PAGE 9 ANNEX A Summary Tables Application of the CFTC Margin Rules to CFTC-Registered Covered Swap Entities (CSEs) 1 Table 1 is based on the table found at the end of the Margin Proposal, 2 which we have simplified in certain respects to improve readability. Table 2 reganizes the same summary infmation in a different manner. Table 1 Applicable CSE 3 Swap Counterparty CFTC Proposed Approach U.S. CSE U.S. person 4 CFTC Margin Rules: Applicable Non-U.S. CSE whose swap obligations are guaranteed by a U.S. person Non-U.S. person whose swap obligations are guaranteed by a U.S. person (including, in either case, any CSE) Non-U.S. person whose swap obligations are not guaranteed by a U.S. person Substituted Compliance: No CFTC Margin Rules: Applicable (including any CSE) Substituted Compliance: Yes, but only with respect to initial margin posted by Applicable CSE to Swap Counterparty 1 Covered Swap Entities are defined as CFTC-registered swap dealers and maj swap participants that do not have a Prudential Regulat. 2 Margin Proposal at U.S. CSEs refer to CSEs that are U.S. persons, and Non-U.S. CSEs refer to CSEs that are not U.S. persons (and include feign consolidated subsidiaries as separately defined (see below) and U.S. branches of non-u.s. CSEs). 4 The term U.S. person is defined in proposed CFTC Rule (a)(10) of the Margin Proposal solely f the purposes of the application of the CFTC s margin rules. See Margin Proposal at

10 Applicable CSE 3 Swap Counterparty CFTC Proposed Approach Non-U.S. CSE whose U.S. CSE obligations under the relevant swap are not guaranteed by a U.S. person, if it is either: CFTC Margin Rules: Applicable Substituted Compliance: Yes, but only with respect to initial margin collected by Applicable CSE o Non-U.S. CSE whose swap obligations are guaranteed from Swap Counterparty a Feign Consolidated by a U.S. person Subsidiary ( FCS ) 5 Non-U.S. CSE whose swap obligations are not CFTC Margin Rules: Applicable guaranteed by a U.S. person PAGE 10 o a U.S. branch of the non- U.S. CSE Non-CSE (whether not a U.S. person guaranteed by a U.S. person) Substituted Compliance: Yes 5 Feign Consolidated Subsidiary is defined as a non-u.s. CSE in which an ultimate parent entity that is a U.S. person has a controlling financial interest, in accdance with U.S. GAAP, such that the U.S. ultimate parent entity includes the non-u.s. CSE s operating results, financial position and statement of cash flows in the U.S. ultimate parent entity s consolidated financial statements, in accdance with U.S. GAAP.

11 Applicable CSE 3 Swap Counterparty CFTC Proposed Approach Non-U.S. CSE (other than FCS U.S. branch of a non- U.S. CSE CFTC Margin Rules: Applicable U.S. CSE, which are addressed above) whose swap obligations are not guaranteed by a U.S. person Non-U.S. CSE whose swap obligations are guaranteed by a U.S. person Substituted Compliance: Yes, but only with respect to initial margin collected by Applicable CSE from Swap Counterparty PAGE 11 Non-U.S. CSE whose swap obligations are not guaranteed by a U.S. person, if it is either: o an FCS CFTC Margin Rules: Applicable Substituted Compliance: Yes o a U.S. branch of the non-u.s. CSE Non-CSEs if it is either: o a U.S. person o a non-u.s. person whose swap obligations are guaranteed by a U.S. person Non-U.S. person (other than an FCS a U.S. branch of a non-u.s. CSE, which are addressed above) whose swap obligations are not guaranteed by a U.S. person CFTC Margin Rules: Not applicable Substituted Compliance: N/A

12 PAGE 12 Table 2 SWAP COUNTERPARTY U.S. Person Non-U.S. Person Guaranteed by U.S. Person Not Guaranteed by U.S. Person APPLICABLE CSE CSE Non-CSE CSE Non-CSE CSE Non-CSE FCS U.S. Branch Non-FCS/U.S. Branch U.S. CSE Non-U.S. CSE Guaranteed by U.S. Person Not Guaranteed by U.S. Person FCS U.S. Branch Non-FCS/U.S. Branch CFTC Rules: Applicable Substituted Compliance: No 2. CFTC Rules: Applicable Substituted Compliance: Yes, but only f initial margin posted by Applicable CSE to Swap Counterparty 3. CFTC Rules: Applicable Substituted Compliance: Yes, but only f initial margin collected by Applicable CSE from Swap Counterparty 4. CFTC Rules: Applicable Substituted Compliance: Yes 5. CFTC Rules: Not Applicable Substituted Compliance: N/A

13 PAGE 13 ANNEX B Definition of U.S. Person 6 CFTC Margin Proposal CFTC Cross-Bder Guidance SEC Cross-Bder Definition U.S. person means: The Commission s interpretation of the term Except as provided in paragraph (a)(4)(iii) U.S. person would generally include, but of this section [relating to supranational not be limited to: ganizations], U.S. person means any person that is: (i) A natural person who is a resident of the United States; (ii) An estate of a decedent who was a resident of the United States at the time of death; (iii) A cpation, partnership, limited liability company, business other trust, association, joint-stock company, fund any fm of entity similar to any of the fegoing (other than an entity described in paragraph (a)(10)(iv) (v) of this section) (a legal entity ), in each case that is ganized incpated under the laws of the United States having its principal place of business in the United States, including any branch of such legal entity; (i) any natural person who is a resident of the United States; (vii) an estate trust, the income of which is subject to U.S. income tax regardless of source (ii) any cpation, partnership, limited liability company, business other trust, association, joint-stock company, fund any fm of enterprise similar to any of the fegoing, in each case that is either (A) ganized incpated under the laws of the United States having its principal place of business in the United States (legal entity) (B) in which the direct indirect owners thereof are responsible f the liabilities of such entity and one me of such owners is a U.S. person; (iv) any commodity pool, pooled account, collective investment vehicle (whether not it is ganized incpated in the United States) of which a majity ownership is held, directly indirectly, by a U.S. person(s); (v) any commodity pool, pooled account, (A) A natural person resident in the United States; (D) An estate of a decedent who was a resident of the United States at the time of death (B) A partnership, cpation, trust, investment vehicle, other legal person ganized, incpated, established under the laws of the United States having its principal place of business in the United States; 6 To facilitate comparison with the Margin Proposal, we redered the U.S. person elements of both the Cross Bder Guidance and the SEC Cross-Bder definitions (without changing their iginal numbering/lettering).

14 (iv) A pension plan f the employees, officers principals of a legal entity described in paragraph (a)(10)(iii) of this section, unless the pension plan is primarily f feign employees of such entity; (v) A trust governed by the laws of a state other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) A legal entity (other than a limited liability company, limited liability partnership similar entity where all of the owners of the entity have limited liability) that is owned by one me persons described in paragraphs (a)(10)(i) through (v) of this section and f which such person(s) bears unlimited responsibility f the obligations and liabilities of the legal entity, including any branch of the legal entity; (vii) An individual account joint account (discretionary not) where the beneficial owner ( one of the beneficial owners in the case of a joint account) is a person described in paragraphs (a)(10)(i) through (vi) of this section. collective investment vehicle the operat of which would be required to register as a commodity pool operat under the CEA; (vi) a pension plan f the employees, officers principals of a legal entity with its principal place of business inside the United States; (iii) any individual account (discretionary not) where the beneficial owner is a U.S. person; (C) An account (whether discretionary non-discretionary) of a U.S. person; PAGE 14

15 PAGE 15 If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually wk, Nathan A. Howell Partner Ellen P. Pesch Partner Michael S. Sackheim Partner Elizabeth M. Schubert Partner William Shirley Counsel Azad Assadipour Associate Derivatives Practice Sidley s derivatives lawyers in numerous offices wldwide advise clients on a broad range of domestic and international derivatives transactions involving swaps, commodity futures contracts and options. Our clients, located in the U.S. and outside the U.S., include commercial banks, investment banks, insurance companies, hedge funds and mutual funds and their advisers, commodity and options exchanges, clearing ganizations and other participants in the OTC and exchange-traded derivatives markets. In serving our derivatives clients, our internationally-based group utilizes the extensive experience of lawyers in Sidley s other practice areas, including tax, banking, insurance, investment funds, litigation, bankruptcy, employee benefits, securitization and financial regulaty practices. We act f our clients in a wide variety of settings, including initial transaction and product structuring, negotiation and execution; post-trade operation, modification, wk-out, dispute resolution, remedies and recovery; practice befe regulaty authities; and general consultation. To receive Sidley Updates, please subscribe at BEIJING BOSTON BRUSSELS CENTURY CITY CHICAGO DALLAS GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at