STROOCK SPECIAL BULLETIN

Transcription

1 STROOCK & STROOCK & LAVAN LLP STROOCK SPECIAL BULLETIN CFTC Cross-Border Margin Proposal July 20, 2015 On June 29, 2015, the Commodity Futures Trading Commission ( CFTC ) issued a proposed rule 1 (the Proposed Rule ) on the cross-border application of the margin requirements with respect to uncleared swaps to be adopted by the CFTC pursuant to Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2 (the Dodd-Frank Act ). When the CFTC issued a proposed rule containing such margin requirements on October 3, 2014, the CFTC also issued an Advance Notice of Proposed Rulemaking ( ANPR ) containing three alternative approaches with respect to the potential cross-border application of the proposed margin requirements. 3 The Proposed Rule is distinct from all three approaches set forth in that ANPR. Although the Proposed Rule was unanimously approved, two of the four Commissioners expressed skepticism as to its merits. 4 4 Commissioner Mark P. Wetjen stated that: I am comfortable supporting today s release, but for the reasons discussed below, continue to harbor some doubts as to whether we have selected the approach that best balances the Commission s interests in protecting the financial system and U.S. taxpayers, meeting its statutory mandate to preserve an appropriate competitive landscape for participants in the global swaps market, and adopting policies whose costs to those affected do not exceed their benefits Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants Cross-Border Application of the Margin Requirements, 80 Fed. Reg (July 14, 2015), available at 14/pdf/ pdf. Pub. L , 124 Stat (2010). Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg (Oct. 3, 2014). Commissioner J. Christopher Giancarlo stated that: The Commission s proposal for the cross-border application of margin requirements for uncleared swaps is a highly complicated labyrinth. I look forward to the jolt to U.S. economic growth that will occur in the 3rd quarter of 2015 as a result of the thousands of billable hours that will be expended by lawyers and other professionals, who will have to read, interpret and respond to this tangled regulatory construct.... Despite my many questions and concerns, I support issuing the proposed rule only so that the public may provide thorough analysis and thoughtful comment. My vote to issue the proposal for public comment should not signal, however, my agreement with it. STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI WASHINGTON, DC 180 MAIDEN LANE, NEW YORK, NY TEL FAX

2 The Proposed Rule imposes varying compliance obligations on uncleared swap transactions depending on whether one or both counterparties thereto qualifies as: a U.S. person; or a non-u.s. person: (1) whose obligations are guaranteed by a U.S. person; (2) that is a Foreign Consolidated Subsidiary of a U.S. person; or (3) acting through or by a U.S. branch. Swaps between two non-u.s. persons who do not meet any of these three criteria would qualify for an exclusion from the CFTC s proposed margin requirements. This Stroock Special Bulletin will describe the proposed compliance obligations set forth in the proposal, as well as the proposed tests to determine the status of a counterparty to a swap. Scope of Margin Requirements Proposed on October 3, 2014 The Proposed Rule sets forth criteria for determining whether and to what extent particular entities would be subject to margin requirements with respect to particular uncleared swap transactions. However, the Proposed Rule does not change the substantive proposals for how the margin requirements with respect to covered swap transactions would apply. The most recent CFTC guidance on that issue was set forth in its October 3, 2014 proposed rule. 5 A brief summary of that proposed rule is provided below. 5 The October 3, 2014 proposed rule may need to be revised as a result of the Business Risk Mitigation and Price Stabilization Act of 2015, which amends the requirements set forth in sections 731 and 764 of the Dodd-Frank Act to provide that rules with respect to initial and variation margin requirements adopted by the CFTC, SEC and Prudential Regulators shall not Initial Margin Requirements Minimum initial margin requirements would apply to uncleared swaps between: o a covered swap entity ( CSE ) a swap dealer ( SD ) or major swap participant ( MSP ) for which there is not a prudential regulator and o an SD, MSP or financial end user (certain specified types of financial entities) with material swaps exposure (combined daily aggregate notional amount of uncleared derivatives exposure of an entity and its affiliates with all counterparties for a specified three months of the applicable calendar year exceeds $3 billion). Initial margin could be calculated based on a quantitative model that receives written approval from the CFTC or the applicable Prudential Regulator, or on a standardized margin schedule set forth in the proposals. Initial margin would only need to be collected when the aggregate credit exposure of all uncleared swaps or security-based swaps between the CSE and its affiliates and the covered counterparty and its affiliates exceeds $65 million. Initial margin would need to be held by a custodian who is: (1) not an affiliate of either counterparty; and (2) prohibited from rehypothecating, repledging, reusing or otherwise transferring the held funds or other apply to entities that qualify for: (1) the end-user exception to the mandatory clearing requirement set forth in sections 2(h)(7)(A) of the Commodity Exchange Act and 3C(g)(1) of the Securities Exchange Act; (2) the exception to the mandatory clearing requirement, set forth in sections 2(h)(7)(D) of the Commodity Exchange Act and 3C(g)(4) of the Securities Exchange Act, for certain affiliates of entities that qualify for the end-user exception; and (3) the cooperative exemption from mandatory clearing set forth in 17 CFR

3 property (with a limited exception for substitution of other funds or property that would qualify as eligible collateral or reinvestment in assets that would qualify as eligible collateral). Eligible collateral would consist of gold, U.S. dollars, other major currencies, any currency in which payment obligations under the swap are required to be settled and certain specified types of debt and equity securities. Initial margin would be exchanged daily on a bilateral basis, with a minimum transfer amount of $650,000. Variation Margin Requirements Minimum variation margin requirements would apply to uncleared swaps between (1) a CSE and (2) an SD, MSP or financial end user. Netting would be allowed for variation margin owed with respect to uncleared swaps or security-based swaps executed pursuant to an eligible master netting agreement. Eligible collateral would consist only of U.S. dollars and any other currency in which payment obligations under the swap are required to be settled. Variation margin would be exchanged daily on a bilateral basis, with a minimum transfer amount of $650,000. Exclusion from Margin Rules The Proposed Rule excludes uncleared swap transactions from compliance with CFTC margin requirements if they are entered into between two non-u.s. persons: (1) whose obligations are not guaranteed by a U.S. person; (2) that are not Foreign Consolidated Subsidiaries of a U.S. person; and (3) that are not acting through or by a U.S. branch. The tests for whether entities would qualify for this exclusion (the Exclusion ) are described in further detail below. Treatment of Certain Swaps Entered into or Guaranteed by a U.S. Person Under the Proposed Rule, the regulatory obligations of (1) U.S. person CSE counterparties and (2) non-u.s. person CSE counterparties whose obligations under an uncleared swap are guaranteed by a U.S. person are both dependent on the nature of the particular counterparty to a specific uncleared swap transaction. If the counterparty would be another U.S. person or non-u.s. person whose obligations under the relevant swap would be guaranteed by a U.S. person (including any persons who are not CSEs, to the extent a transaction with such a person would be subject to the CFTC margin requirements), the uncleared swap transaction would be subject to the U.S. margin requirements in full. If the counterparty would be any non-u.s. person whose obligations under the uncleared swap would not be guaranteed by a U.S. person (whether or not such a person is a CSE), the uncleared swap transaction would be subject to the U.S. variation margin requirements in full. Such an uncleared swap would also be subject to the U.S. initial margin requirements with respect to the amount to be collected by the U.S. or U.S.- guaranteed CSE counterparty. With respect to the amount of initial margin to be posted by that counterparty, the U.S. initial margin requirements would apply as a baseline but with the possibility of substituted compliance (to the extent that the CFTC allows for such substituted compliance pursuant to the standard discussed below). 3

4 Definition of U.S. Person The Proposed Rule defines U.S. person in a manner that is distinct from how that term was defined under the Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations issued by the CFTC on July 26, 2013 (the Guidance ). 6 Notably, the Proposed Rule provides greater certainty as to the scope of the definition of U.S. person by omitting the prefatory language includes, but is not limited to that was included in the Guidance. Under the Proposed Rule, U.S. person is defined to include, inter alia, entities organized or incorporated in the United States, entities with a principal place of business in the United States, natural persons resident in the United States and accounts beneficially owned by any such persons. 7 Principal place of business would be defined to mean the location from which the officers, partners or managers of the legal person primarily direct, control, and coordinate the activities of the legal person[,] a definition intended to be consistent with a 2010 United States Supreme Court decision. 8 With respect to funds or other collective investment vehicles, because senior personnel that direct, control, and coordinate a fund s activities are generally... persons who work for the fund s investment adviser or the fund s promoter (rather than named directors or officers), the CFTC has stated that generally (but depending on the facts and circumstances) the principal place of business of a fund or other collective investment vehicle would be deemed to be the United States if the senior personnel for Fed. Reg (July 26, 2013). The definition is also distinct from the definition of U.S. person adopted by the Securities and Exchange Commission with respect to the regulatory treatment of certain cross-border security-based swap transactions. See 17 C.F.R a71-3(a)(4). The proposed U.S. person definition also includes certain estates, pension plans, trusts and legal entities for which U.S. persons bear unlimited responsibility with respect to obligations and liabilities. The full proposed definition defines a U.S. person as: (i) (ii) (iii) Any natural person who is a resident of the United States; Any estate of a decedent who was a resident of the United States at the time of death; Any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of entity similar to any of the foregoing (other than an entity described in subparagraph (iv) or (v) of this paragraph) (a legal entity), in each case that is organized or incorporated under the laws of the United States or having its principal place of business in the United States, including any branch of the legal entity; 8 (iv) (v) (vi) Any pension plan for the employees, officers or principals of a legal entity described in subparagraph (iii) of this paragraph, unless the pension plan is primarily for foreign employees of such entity; Any trust governed by the laws of a state or 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; Any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) owned by one or more persons described in subparagraph (i), (ii), (iii), (iv) or (v) of this paragraph who bear(s) unlimited responsibility for the obligations and liabilities of the legal entity, including any branch of the legal entity; and (vii) Any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in subparagraph (i), (ii), (iii), (iv), (v) or (vi). See Hertz Corp. v. Friend, 559 U.S. 77 (2010). 4

5 either (1) the formation and promotion of the fund or (2) the implementation of the fund s investment strategy are located in the United States[.] This interpretation is consistent with the approach in the Guidance, and the CFTC specifically referred to three specific examples provided in the Guidance as being illustrative as to how the CFTC would apply this test. 9 Under the Guidance, certain funds or other collective investment vehicles were classified as U.S. persons if such funds or other collective investment vehicles were majority-owned, directly or indirectly, by one or more U.S. persons. The Proposed Rule rejects that approach, pursuant to which the status of a fund or other collective investment vehicle could have changed (or yoyoed ) based upon a change in the percentage holdings of fund investors. The Proposed Rule s definition of U.S. person applies at an entity level, including any foreign branches of such entity. However, the status of a legal person as a U.S. person would not affect whether a separately incorporated or organized legal person in the affiliated corporate group is a U.S. person. Because the information necessary for a swap counterparty to accurately assess the status of its counterparties as U.S. persons may not be available, or may be available only through overly burdensome due diligence[,] the CFTC has stated that, under the Proposed Rule, a swap counterparty who conducts reasonable due diligence (under the facts and circumstances) is entitled to rely on its counterparty s written representation in determining whether the 9 See 78 Fed. Reg counterparty is within the definition of the term U.S. person. Definition of Guarantee The definition of guarantee in the Proposed Rule is similarly narrower than the definition proposed in the Guidance. Under the Proposed Rule, the existence of a guarantee of a U.S. person with respect to a non-u.s. person s obligations under an uncleared swap is determined based on whether the counterparty to such swap has rights of recourse against the U.S. person. Under the proposal, rights of recourse exist when such counterparty has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, the U.S. person in connection with the non-u.s. person s obligations under the swap[,]... regardless of[:] whether such right of recourse is conditioned upon the non-u.s. counterparty s insolvency or failure to meet its obligations under the relevant swap[;] whether the counterparty seeking to enforce the guarantee is required to make a demand for payment or performance from the non- U.S. counterparty before proceeding against the U.S. guarantor[;] and whether the U.S. guarantor is an affiliate of the non-u.s. CSE[.] So long as such a right of recourse is legally enforceable, the terms of the guarantee need not necessarily be included within the swap documentation or even otherwise reduced to writing[.] However, a number of financial arrangements would not be captured within the definition of a guarantee, such as keepwells and liquidity puts, 5

6 certain types of indemnity agreements, master trust agreements, liability or loss transfer or sharing agreements[.] With respect to the practice of de-guaranteeing, the CFTC noted that it believes that the Proposed Rule s treatment of Foreign Consolidated Subsidiary swaps, discussed below, should ensure appropriate regulatory treatment and prevent any such swaps from qualifying for the Exclusion. 10 Treatment of Other Covered Swaps As noted above, under the Proposed Rule, the Exclusion applies to uncleared swap transactions entered into between two non-u.s. persons: (1) whose obligations are not guaranteed by a U.S. person; (2) that are not Foreign Consolidated Subsidiaries of a U.S. person; and (3) that are not acting through or by a U.S. branch. As also described above, uncleared swap transactions involving a U.S. person CSE or a non- U.S. person CSE whose obligations with respect to the swap are guaranteed by a U.S. person would generally be subject to the full CFTC margin requirements, though there would be a possibility for substituted compliance with respect to the initial margin to be posted (though not collected) by such a counterparty in a transaction with a non- U.S. person whose obligations under the uncleared swap are not guaranteed by a U.S. person. There are two additional categories of regulatory treatment for uncleared swaps under the Proposed 10 In drafting the Proposed Rule, the CFTC assumed that a non-u.s. CSE is likely to meet the definition of a Foreign Consolidated Subsidiary when it has been provided with financial arrangements or support from a U.S. person that do not fall within the term guarantee (as defined in the Proposed Rule)[.] The CFTC requested comment as to the correctness of this assumption. Rule, and both provide for CFTC margin requirements in full to apply as a baseline, with the possibility of substituted compliance for either or both of initial or variation margin requirements (to the extent that the CFTC allows for such substituted compliance pursuant to the standard discussed below). Such regulatory treatment would apply to any uncleared swap within the scope of the CFTC margin rules and entered into between: Counterparty 1 a non-u.s. person CSE whose obligations under the relevant swap are not guaranteed by a U.S. person but that is either o a Foreign Consolidated Subsidiary or o acting through or by a U.S. branch; and Counterparty 2 any non-u.s. person whose obligations under the relevant swap are not guaranteed by a U.S. person or any non-cse (1) U.S. person or (2) non-u.s. person whose obligations under the swap are guaranteed by a U.S. person. The same regulatory treatment would apply to any uncleared swap within the scope of the CFTC margin rules and entered into between: Counterparty 1 a non-u.s. person CSE whose obligations under the relevant swap are not guaranteed by a U.S. person and who is not o a Foreign Consolidated Subsidiary or o acting through or by a U.S. branch; and 6

7 Counterparty 2 any non-cse (1) U.S. person or (2) non-u.s. person whose obligations under the swap are guaranteed by a U.S. person. Definition of Foreign Consolidated Subsidiary Under the Proposed Rule, a Foreign Consolidated Subsidiary is defined to include certain non-u.s. person CSEs that are part of a consolidated group of companies in which there is a U.S. person ultimate parent entity (defined to mean a parent entity in which none of the other entities in the consolidated group has a controlling interest, in accordance with U.S. generally accepted accounting principles ( GAAP )). Specifically, Foreign Consolidated Subsidiary would include any such CSE in which the U.S. person 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 accordance with U.S. GAAP The CFTC requested comment as to whether the definition of Foreign Consolidated Subsidiary should also encompass: (1) non-u.s. CSEs whose U.S. ultimate parent entity uses a different standard than U.S. GAAP in determining whether a parent entity must consolidate an entity for financial reporting purposes[;] and/or (2) non-u.s. CSEs whose U.S. ultimate parent entity is not required to prepare consolidated financial statements under any accounting standard or for any other reason (e.g., the U.S. ultimate parent entity is not a public company under federal securities laws and is not required to prepare consolidated financial statements by private investors or debtholders as a condition to investing or financing), but which would consolidate the non- U.S. CSE if it were required to prepare consolidated financial statements in accordance with U.S. GAAP[.] Definition of Acting Through a U.S. Branch The Proposed Rule does not contain a definition for U.S. branch or explicit guidance on when an uncleared swap transaction qualifies as having been conducted through or by a U.S. branch of a non-u.s. CSE such that the Exclusion does not apply to the transaction. 12 However, the CFTC requested comments as to whether it should base the determination of whether the swap activity is conducted at a U.S. branch of a non-u.s. CSE for purposes of applying the Commission s margin rules on a cross-border basis on the same analysis as is used in the Volcker rule[,] i.e., whether personnel at the U.S. branch arrange, negotiate, or execute the uncleared swap According to the CFTC, applying the Exclusion to such uncleared swap transactions would provide an unwarranted advantage when dealing with non-u.s. clients relative to other CSEs operating within the United States (i.e., U.S. CSEs). 13 See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg & n (Jan. 31, 2014). This aspect of the Volcker Rule is discussed in the Stroock Special Bulletin, Final Regulations Implementing the Volcker Rule: Proprietary Trading at 18 & n.31 (Mar. 21, 2014), available at On April 29, 2015, the Securities and Exchange Commission ( SEC ) proposed to use the arrange, negotiate, or execute standard to determine whether certain regulations would apply to particular securitybased swaps. See 80 Fed. Reg (May 13, 2015). In that proposal, the SEC provided additional analysis on the conduct that it would deem to constitute arrangement, negotiation or execution. The SEC s proposed arrange, negotiate, or execute test is described in further detail in the Stroock Special Bulletin, SEC Cross-Border Security- 7

8 This same standard was adopted in CFTC Staff Advisory 13-69, which has been the subject of significant controversy and has had its implementation date delayed four separate times (it is currently set to go into effect on September 30, 2015, pursuant to CFTC No-Action Letter ). Commissioner Giancarlo stated that he was troubled by the CFTC potentially requiring at least substituted compliance with respect to uncleared swaps when the only U.S. nexus to the swaps is that personnel at a U.S. branch arranged, negotiated or executed the swaps, arguing as follows: the elevator rule [CFTC Staff Advisory 13-69] is causing many overseas trading firms to consider cutting off all activity with U.S.-based trade support personnel to avoid subjecting themselves to the CFTC s flawed swaps trading rules. The Staff Advisory, if it goes into effect, will jeopardize the role of bank sales personnel in U.S. financial centers like Boston, Charlotte, Chicago, New Jersey and New York. It will likely have a ripple effect on technology staff supporting U.S. electronic trading systems, along with the thousands of jobs tied to the vendors who provide food services, office support, custodial services and transportation for the U.S. financial series industry. With this proposal, rather than recognizing the myriad of problematic issues arising from the Staff Advisory, the Commission is proposing to expand its scope from trading rules to margin rules. Based Swap Proposal (May 13, 2015), available at CrossBorderSecurityBased.pdf. Standard for Substituted Compliance The Proposed Rule sets forth a proposed outcome-based comparability standard to determine whether a foreign jurisdiction s margin rules for uncleared swaps qualify for substituted compliance. The Proposed Rule lists 11 nonexclusive factors that would guide the CFTC in determining whether the margin requirements in the foreign jurisdiction achieve the same regulatory objectives set forth in the Dodd-Frank Act and whether such requirements are consistent with the September 2, 2013 version of the international framework Margin requirements for non-centrally cleared derivatives (the International Framework ) issued by the Basel Committee on Banking Supervision (the Basel Committee ) and the International Organization of Securities Commissions ( IOSCO ). 14 The determination would be made on an element-by-element basis, so it is possible, e.g., that a foreign jurisdiction s variation margin requirements would qualify for substituted compliance, but that its segregation and rehypothecation requirements would not. 15 Applications for comparability determinations would be able to be made individually or collectively by counterparties and/or foreign jurisdiction regulators. Any comparability 14 The CFTC expects that approximately 21 non-u.s. person CSEs would be subject to the proposed margin rules for uncleared swaps. Only one such non-u.s. person CSE is domiciled in a jurisdiction that did not participate[] in the development of the BCBS-IOSCO framework. 15 The CFTC noted that some emerging markets may lack[] legal or operational infrastructure in order to implement provisions comparable to certain of the CFTC s proposed margin requirements with respect to uncleared swaps. 8

9 determination reached by the CFTC would apply for all entities or transactions in that jurisdiction to the extent provided in the Proposed Rule and the determination, subject to any conditions specified by the Commission. Further Regulatory Action The CFTC has requested comments on all aspects of its proposal. The CFTC has asked for such comments to be submitted on or before September 14, The CFTC s October 3, 2014 proposed rule on margin for uncleared swaps called for a staged implementation process modeled after the implementation schedule from the September 2, 2013 version of the International Framework. Under the proposed implementation process set forth in the CFTC s October 3, 2014 proposed rule, the compliance date for the requirement to exchange variation margin would be on December 1, 2015, and the requirement to exchange initial margin would be phased in, with the first compliance date set on December 1, 2015, and subsequent compliance dates on December 1 of 2016, 2017, 2018 and The applicable phasein date would be based on the aggregate notional amount of uncleared derivatives exposure of an entity and its affiliates and the aggregate notional amount of uncleared derivatives exposure of the counterparty and its affiliates. On March 18, 2015, the Basel Committee and IOSCO revised the International Framework to propose a phase-in arrangement for the requirement to exchange variation margin, with the first implementation date set for September 1, 2016, and a subsequent implementation date on March 1, The implementation dates for the requirement to exchange initial margin would each be pushed back nine months, with the first implementation date set for September 1, 2016, and subsequent implementation dates on September 1 of 2017, 2018, 2019 and The CFTC has not yet announced whether it intends to adopt this revised implementation schedule. 16 By the Commodities and Derivatives Practice Group of Stroock & Stroock & Lavan LLP. For More Information Conrad G. Bahlke Marvin J. Goldstein cbahlke@stroock.com mgoldstein@stroock.com Scott M. Le Bouef Mark N. Rae slebouef@stroock.com mrae@stroock.com Jeffrey Daniel Christopher Guhin jdaniel@stroock.com cguhin@stroock.com 16 This implementation schedule is analyzed in further detail in the Stroock Special Bulletin, Update: Implementation Schedule of Margin Requirements for Uncleared Derivatives (Mar. 30, 2015), available at ateimplementationschedule.pdf. 9

10 New York 180 Maiden Lane New York, NY Tel: Fax: Los Angeles 2029 Century Park East Los Angeles, CA Tel: Fax: Miami Southeast Financial Center 200 South Biscayne Boulevard, Suite 3100 Miami, FL Tel: Fax: Washington, DC 1875 K Street NW, Suite 800 Washington, DC Tel: Fax: This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan LLP 2015 Stroock & Stroock & Lavan LLP. All rights reserved. Quotation with attribution is permitted. This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome. Stroock & Stroock & Lavan LLP, with more than 300 attorneys in New York, Los Angeles, Miami and Washington, DC, is a law firm providing transactional, regulatory and litigation guidance to leading financial institutions, multinational corporations, investment funds and entrepreneurs in the U.S. and abroad. Our emphasis on excellence and innovation has enabled us to maintain long-term relationships with our clients and made us one of the nation s leading law firms for almost 140 years. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Senior Director-Legal Publications, at