Donna Parisi, partner at Shearman & Sterling LLP, discusses how the jurisdictional provisions of the Dodd-Frank Act may impact market participants around the world. Comments from a DerivSource podcast: “Extraterritoriality of Dodd-Frank: Legal Perspective & Update.”
Overview
Sections 722 and 772 of the Dodd-Frank Act (Dodd-Frank) establish the territorial scope of the CFTC’s and SEC’s jurisdiction over the swaps and security-based swaps market. Section 722 provides that the CFTC’s jurisdiction will not extend to activities outside of the U.S. unless they have a direct and significant connection with activities in, or effect on, commerce of the U.S.. Section 772 provides that the SEC’s regulations do not apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the U.S.. Both Section 722 and 772 have an anti-evasion component as well. Unlike other U.S. statutes and regulations which provide geographic scope by defining entity-related terms such as U.S. person, Title VII of Dodd-Frank does not contain such a definition and seemingly has been designed to reach more broadly by focusing on whether the activities of a person or entity have a significant nexus to the U.S. rather than on the geographic location of organization of the person or entity itself.
Over the past few months, there has been little guidance from the CFTC and SEC on the territorial scope provisions but the CFTC has indicated that it expects to provide some interpretive guidance sometime this spring. Due to the fact that many market participants expect to be dually-registered with the CFTC and SEC as dealers or major swap participants, many market participants have expressed concern about the increased uncertainty given that the CFTC and SEC may interpret their jurisdictional reach somewhat differently.
Registration of Dealers and Major Swap Participants
The CFTC recently finalized its rules on the registration process for swap dealers and major swap participants. Entities that believe that they will be captured by these definitions may register on a provisional basis with the National Futures Association pending completion of the key definitional rules. The CFTC did not explicitly address issues of extraterritoriality in its adopting release for the registration rules and it is unlikely that the CFTC will provide any such guidance prior to the adoption of final rules relating to the product and entity definitions. Accordingly, market participants that may potentially qualify as dealers and major swap participants may be forced to register in order to meet certain compliance deadlines without having the necessary guidance to determine whether registration is in fact required. As a practical matter, this uncertainty and lack of guidance on extraterritoriality will force market participants to make judgment calls as to which entities in their corporate structure may be required to register and could result in unnecessary costs and expense. In addition, market participants with global operations may attempt to insulate some portion of their business from the reach of U.S. rules by using separate entities outside of the U.S. to transact with non-U.S. persons. This notion of “subsidiarization” may lead to some significant challenges including, among other things, the creation of separate collateral pools between trading subsidiaries and increased difficulties for cross and portfolio margining.
Clearing and Trading Requirements
On the one hand, the concept of mandatory central clearing for certain standardized products has received broad global consensus and has been a consistent theme in the global regulatory reform efforts. On the other hand, however, the mandatory trading requirement is an area that has not received uniform consensus and remains the subject of some debate especially in Europe. As a practical matter, the issue that market participants may face is how central clearing will work in practice in a global trading market, including the process by which the CFTC can exempt a derivatives clearing organization from registration in the U.S.. Under Section 725 of Dodd-Frank, the CFTC can exempt a derivatives clearing organization from registration in the U.S. if it can demonstrate that it is subject to comparable regulation and supervision by a supervisory authority in its home jurisdiction. For such an exemption, however, the CFTC would need to undertake a comparability analysis to make such a determination and, given the volume of matters it needs to address in the near term, such determinations are unlikely to be addressed as a priority given the CFTC’s resources. As a result, this means that there will be many derivatives clearing organizations that may potentially be organized under different legal regimes. Due to the differences in legal regimes, market participants can expect different asset protection regimes for collateral posted in connection with cleared swaps. In addition, as swap trading moves toward a clearing environment and trades are funneled through clearing intermediaries for clearing services, market participants have expressed some concerns that these intermediaries may be subject to different regulatory regimes in different jurisdictions.
Looking Ahead
The extraterritorial debate will be subject to a significant amount of political and other influences which will ultimately help shape the territorial scope of the Title VII requirements. The requirements under Title VII and the related proposed and final implementing regulations in the U.S. are among some of the most strict that we’ve seen as the global regulatory landscape has been developing in addressing issues relating to derivatives. A key political issue, which may become even more important given that it is an election year, is the issue of jobs and whether the U.S. derivatives industry and related jobs could potentially be driven offshore. For the U.S. this means that unless the regulators take a broad application of Dodd-Frank and capture non-U.S. market participants and related business, the U.S. may run a risk of losing jobs to jurisdictions that may be implementing less onerous regulatory requirements.
