SEC Exemptive Relief in Connection with Effective Date of Title VII of Dodd-Frank SEC Issues Interim Final Rules and Order to Provide Relief from Certain Provisions That Would Be Effective on July 16, 2011 SUMMARY On July 1, the Securities and Exchange Commission issued interim final rules and an order providing temporary relief from certain requirements of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to security-based swaps ( SBS ) that would otherwise apply beginning on July 16, 2011 (the Statutory Effective Date ). Generally, the interim rules exempt SBS that: would have been, prior to the Statutory Effective Date, within the definition of security-based swap agreement under the Securities Act and the Exchange Act, and are entered into solely between eligible contract participants ( ECPs ) (as defined prior to the Statutory Effective Date) from all provisions of the Securities Act (other than the Section 17(a) antifraud provisions), the registration requirements of the Exchange Act, and the indenture provisions of the Trust Indenture Act. According to the SEC, the interim rules are intended to maintain the status quo with respect to the ability of market participants to engage in security-based swap agreements until the compliance date for final rules that the SEC adopts further defining the terms security-based swap and eligible contract participant. 1 The order provides exemptions to ECPs (as that term was defined on July 20, 2010, just prior to the enactment of Dodd-Frank), registered broker-dealers, exchanges and certain central counterparties from many of the consequences that would otherwise apply because of the inclusion of SBS in the definition of the term security in the Exchange Act on the Statutory Effective Date. The overall approach of the order is to maintain the status quo as Dodd-Frank is implemented through final rulemaking, by New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
preserving the application of particular Exchange Act requirements that already are applicable in connection with instruments that will be [SBS] following the [Statutory] Effective Date, but deferring the applicability of additional Exchange Act requirements in connection with those instruments explicitly being defined as securities as of the [Statutory] Effective Date. The interim rules 2 and order 3 are part of a series of actions the SEC is taking to clarify the requirements that will apply to SBS transactions, and persons transacting in SBS, as of the Statutory Effective Date. These actions include an order issued by the SEC on June 15, 2011, that made clear that many of Title VII s requirements applicable to SBS will not go into effect on the Statutory Effective Date. 4 Interim Rules The interim rules are as follows: Securities Act Rule 240 provides that the Securities Act (except for Section 17(a) thereof) does not apply to the offer or sale of any SBS that is: a security-based swap agreement, as defined in Section 2A of the Securities Act as in effect prior to the Statutory Effective Date; 5 and entered into between ECPs, as defined prior to the Statutory Effective Date, other than a person who is an ECP under Section 1a(12)(C) of the Commodity Exchange Act as in effect prior to the Statutory Effective Date. Exchange Act Rules 12a-11 and 12h-1(i) provide, respectively, that Sections 12(a) and 12(g) of the Exchange Act 6 shall not apply to any SBS offered and sold in reliance on Securities Act Rule 240. Trust Indenture Act Rule 4d-12 provides that any SBS offered and sold in reliance on Securities Act Rule 240, whether or not issued under an indenture, is exempt from the Trust Indenture Act. Implication of the Interim Rules The implications of the interim rules and the effect of the Statutory Effective Date are generally as follows: An ECP (as defined prior to the Statutory Effective Date) can continue to enter into securitybased swap agreements with other ECPs (as defined prior to the Statutory Effective Date) without registration under the Securities Act; Persons can enter into SBS that do not constitute security-based swap agreements without registration of the SBS under the Securities Act if both counterparties meet the definition of eligible contract participant in Dodd-Frank; and A person that does not meet either the definition of eligible contract participant in the Dodd- Frank Act or as in effect prior to the Statutory Effective Date may not enter into a SBS without registration under the Securities Act. 7 In applying these rules it is important to recognize that the statutory definition of SBS in Dodd-Frank is broader than the current definition of security-based swap agreement. It includes, among other things, certain insurance products, certain swaps based on the yield of a debt security or loan and certain loan participations. As previously noted, the SEC and CFTC have proposed rules and interpretations addressing the scope of the definition of SBS. Until those rules and interpretations are finalized, there will be no definitive guidance regarding what instruments constitute SBS. -2-
Effectiveness and Expiration of Interim Rules The interim rules will become effective upon publication in the Federal Register. They will remain in effect until the compliance date for the SEC s final rules further defining the terms security-based swap and eligible contract participants. While the rules will become effective upon publication in the Federal Register, the SEC is soliciting comments on the interim rules and will consider any comments in determining whether to revise the interim rules. Temporary Exemption for ECPs 8 Subject to the exclusions listed below, the order exempts any person meeting the definition of ECP (as in effect on July 20, 2010), other than a broker or dealer registered under Section 15(b) of the Exchange Act (other than paragraph (11) thereof 9 ) or a self-regulatory organization 10 as defined in Section 3(a)(26) of the Exchange Act from the provisions of the Exchange Act, and the rules and regulations thereunder, solely in connection with the person s activities involving SBS. The exemption will last until the compliance date for final rules further defining the terms security-based swap and eligible contract participants. Exclusions From Exemption The exemption provided by the order is subject to a number of significant exclusions, including the following: The antifraud and anti-manipulation provisions of Sections 9(a)(2)-(5), 10(b), 15(c)(1), 20(d) and 21A(a)(1) of the Exchange Act, as well as underlying rules prohibiting fraud, manipulation or insider trading (but not prophylactic reporting or recordkeeping requirements), and any provision of the Exchange Act related to the SEC s enforcement authority in connection with violations or potential violations of such provisions. All Exchange Act provisions related to SBS added or amended by subtitle B of Title VII, including the amended definition of security in the Exchange Act. The broker registration requirements of section 15(a)(1) of the Exchange Act, and the other requirements of the Exchange Act and the rules and regulations thereunder that apply to a broker that is not registered with the SEC; provided that this exclusion applies only to broker activities by persons that are members of a clearing agency that functions as a central counterparty for SBS and that hold customer funds or securities in connection with SBS. Otherwise, the exemption will be available in connection with broker activities involving SBS by persons other than registered broker-dealers or self-regulatory organizations. The dealer registration requirements of section 15(a)(1) of the Exchange Act, and the other requirements of the Exchange Act and the rules and regulations thereunder that apply to a dealer that is not registered with the SEC. This exclusion will not apply in connection with, and the exemption will be available for, dealing activities involving SBS with counterparties that meet the definition of ECP (as in effect on July 20, 2010). The following additional sections of the Exchange Act and the rules and regulations thereunder: Paragraphs (42), (43), (44), and (45) of Section 3(a) (which paragraphs regard definitions related to government securities ); Section 5 (which generally prohibits broker-dealers from transacting on unregistered exchanges); -3-
Section 6 (which sets forth registration and regulation requirements for national securities exchanges); Section 12 (which imposes securities registration requirements); Section 13 (which imposes periodic reporting requirements); Section 14 (which regulates the solicitation of proxies and tender offers); Paragraphs (4) and (6) of Section 15(b) (which grants the SEC authority to impose sanctions on broker-dealers and associated persons); Section 15(d) (which requires periodic reporting for issuers with registered securities); Section 15C (which regulates transactions in government securities ); Section 16 (which imposes reporting requirements and short-swing profit recovery with respect to officers, directors and principal shareholders of reporting issuers); and Section 17A (which regulates the clearance and settlement of securities transactions). Implications of Relief for ECPs While the SEC indicates that the order is intended to maintain the status quo, it is unclear the order accomplishes this goal entirely. The order excludes from the scope of the exemption the anti-fraud provisions of the Exchange Act. Moreover, some instruments that may fall under the broad definition of SBS in the Dodd-Frank Act have historically been traded on the private side of ethical walls, in some cases based on big boy letters. As discussed above, the SEC and CFTC have proposed, but not adopted, rules and interpretations addressing the scope of the definition of SBS. The proposed rules and interpretations would exclude many of these instruments from the definition of SBS and thus from the definition of security. Temporary Exemption for Registered Brokers and Dealers Subject to the same exclusions listed above applicable to the ECP exemptions, the order exempts brokers or dealers registered under Section 15(b) of the Exchange Act (other than paragraph (11) thereof) from the following sections of the Exchange Act and rules or regulations thereunder in connection with SBS solely to the extent that those provisions or rules do not apply to the person s SBS positions or activities as of July 15, 2011: Section 7(c) (which imposes margin and collateral requirements); Section 15(c)(3) (which grants the SEC authority to establish custody and deposit rules applicable to broker-dealers); Section 17(a) (which imposes recordkeeping and maintenance requirements); Section 17(b) (which authorizes the SEC to examine records maintained pursuant to Section 17(a)); Regulation T (which governs extensions of credit by broker-dealers); Rule 240.15c3-1 (which imposes net capital requirements); Rule 240.15c3-3 (which provides controls for customer protection) 11 ; Rule 240.17a-3 (which imposes recordkeeping requirements); -4-
Rule 240.17a-4 (which imposes record preservation requirements); Rule 240.17a-5 (which imposes reporting requirements); Rule 240.17a-8 (which imposes recordkeeping and reporting requirements for currency and foreign transactions); and Rule 240.17a-13 (which imposes quarterly security counting requirements). This exemption will last until the compliance date for final rules further defining the terms security-based swap and eligible contract participants. Scope of Temporary Exemption for Registered Brokers and Dealers Like the temporary exemption for ECPs, the temporary exemption for registered broker-dealers excludes the anti-fraud provisions of the Exchange Act from the order and, therefore, creates an issue as to the trading of instruments that may be SBS on the private side of an ethical wall. Further, the exclusion of Section 14 from the temporary exemption has the effect of subjecting SBS to the tender offer rules under Section 14 (although it is unclear whether or how the tender offer rules would apply to the close out or early termination of SBS). It is unclear why the SEC would choose to subject SBS to this regulatory regime only with respect to non-ecps and broker-dealers. (ECPs would have exemptions from Section 14 under the temporary exemption described above.) Temporary Exemption from Sections 5 and 6 of the Exchange Act The order also grants the following exemptions from Sections 5 and 6 of the Exchange Act: Any person other than a clearing agency acting as a central counterparty in SBS will be exempt from the requirements to register as a national securities exchange under Sections 5 and 6 of the Exchange Act and the rules and regulations thereunder solely in connection with the person s activities involving SBS. A broker or dealer will be exempt from Section 5 of the Exchange Act solely in connection with its activities involving SBS that it effects or reports on an exchange that is exempted from registration pursuant to the exemption discussed in the previous bullet point. Subject to certain conditions, each of ICE Trust U.S. LLC, Chicago Mercantile Exchange Inc. and ICE Clear Europe, Limited (each a CDS CCP ) 12 will be exempt from the requirements of Sections 5 and 6 of the Exchange Act and the rules and regulations thereunder solely in connection with its calculation of mark-to-market prices for open positions in any credit default swap that is a SBS that is submitted (or offered, purchased, or sold on terms providing for submission) to a CDS CCP and is offered only to, purchased only by, and sold only to persons that meet the definition of ECP (as in effect on July 20, 2010) and in which the reference entity or index meets certain criteria (such a credit default swap, a Cleared CDS ). Any member of a CDS CCP shall be exempt from the requirements of Section 5 of the Exchange Act solely to the extent such member uses any facility of the CDS CCP to effect any transaction in Cleared CDS, or to report any such transaction, in connection with the CDS CCP s clearance and risk management process for Cleared CDS. This exemption will last until the earliest compliance date set forth in any of the final rules regarding registration of SBS execution facilities. -5-
Legal Certainty for SBS Contracts Concerns have been raised that SBS entered into after the Statutory Effective Date could be void or voidable under Section 29(b) of the Exchange Act for failure to comply with the various requirements of Title VII. While the SEC does not believe that Section 29(b) would apply to provisions for which it is providing exemptive relief in the order, in order to eliminate any possible legal uncertainty or market disruption, the SEC provided in the order that no contract entered into on or after the Statutory Effective Date shall be void or considered voidable by reason of Section 29(b) because any person that is a party to the contract violated a provision of the Exchange Act for which the SEC provided exemptive relief in the order. This relief expires at such time as the underlying exemptive relief expires. * * * Copyright Sullivan & Cromwell LLP 2011-6-
ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 The SEC and CFTC have proposed, but not yet adopted, definitions of these terms. For securitybased swap, see our Memorandum to Clients, dated May 12, 2011, Proposed Product Definitions Under Title VII of Dodd-Frank available at http://www.sullcrom.com/proposed- Product-Definitions-Under-Title-VII-of-Dodd-Frank/. For eligible contract participant, see our Memorandum to Clients, dated December 14, 2010, Proposed Swap Definitions Under Title VII of the Dodd-Frank Act available at http://www.sullcrom.com/proposed-swap-definitions-under- Title-VII-of-the-Dodd-Frank-Act/. Release Nos. 33-9231, 34-64794 and 39-2475, available at http://www.sec.gov/rules/interim/2011/33-9231.pdf. Release No. 34-64795, available at http://www.sec.gov/rules/exorders/2011/34-64795.pdf. See our Memorandum to Clients, dated June 22, 2011, SEC Exemptive Relief in Connection with Effective Date of Title VII of Dodd-Frank available at http://www.sullcrom.com/sec- Exemptive-Relief-in-Connection-with-Effective-Date-of-Title-VII-of-Dodd-Frank-06-22-2011/, and our Memorandum to Clients, dated June 10, 2011, SEC Announces Steps to Address July 16 Effective Date available at http://www.sullcrom.com/title-vii-of-the-dodd-frank-act-06-10-2011/. A security-based swap agreement is currently defined as a swap agreement of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein. Generally, Section 12(a) prohibits broker-dealers from transacting in any security listed on a national securities exchange until an Exchange Act registration is effective for that security, and Section 12(g) requires registration for issuers with total assets exceeding $1,000,000 and a class of equity securities held by greater than 500 persons. New Section 5(d) of the Securities Act eliminates the ability to rely on the private placement exemption to registration of SBS. In the Release accompanying the order, the SEC indicated that it expects the Financial Industry Regulatory Authority to file a proposed rule change related to the application of its rules to SBS. Paragraph (11) addresses broker-dealer registration related to security futures products. The temporary exemption is available to registered securities associations solely with respect to their obligations under Section 19(g)(1)(B) of the Exchange Act to enforce compliance with provisions of their rules (and provisions of the rules of the Municipal Securities Rulemaking Board) that do not apply to positions or activities involving SBS as of July 15, 2011. The exemption from Rule 15c3-3 is not available for activities and positions of the registered broker or dealer related to cleared SBS, to the extent that the registered broker or dealer is a member of a clearing agency that functions as a central counterparty for SBS, and holds customer funds or securities in connection with cleared SBS. The SEC is granting these entities the exemption described because of the nature of their activities acting as central counterparties for cleared credit default swaps and because they are already subject to a number of temporary exemptions relating to cleared credit default swaps. See generally Release Nos. 34-60372, 34-61973, 34-63389, 34-59578, 34-61164, 34-61803, 34-63388, 34-59527, 34-61119, 34-61662 and 34-63387. -7-
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