The cross-border application of CFTC rules under Dodd-Frank has long been uncertain. Recently however, the CFTC adopted the final cross-border guidance and exemptive order and agreed a ‘path forward’ with the European Commission. In a Q&A, Felix Shipkevich of Shipkevich PLLC explains some of the main elements of the final cross-border rules including U.S. person definition, registration requirements, substitute compliance and timeframes.
U.S. Person Definition
Q. In the exemptive release, the CFTC did not include investment vehicles under the definition of a U.S. person. However, the interpretive guidance and policy statement includes pools and investment vehicles if it is organized in the US or the fund’s principal place of business is in the U.S. How will this be determined?
A. To determine the principal place of business, the U.S. Commodity Futures Trading Commission (CFTC) says they are relying on the Supreme Court’s decision in Hertz Corp. v. Friend, in which the Court determined that a corporation’s principal place of business is the “place where the corporation’s high level officers direct, control, and coordinate the corporations activities.” This is otherwise referred to by many Courts of Appeals as the “nerve center.” The CFTC has also indicated that they will further scrutinize investment vehicles and pools, because “direct, control, and coordinate” of the investment firm may have different meanings for different pools depending on their investment goals. For instance, in conservative funds, in which the main goal is capital preservation, the main focus will be on the place where the risk managers and portfolio directors conduct their business. For other firms, the CFTC may look towards the chief investment officer is located. Generally, the commission will determine the principal place of business of a collective investment vehicle to be in the United States if the senior personnel responsible for either (1) the formation and promotion of the collective investment vehicle or (2) the implementation of the vehicle’s investment strategy are located in the United States, depending on the facts and circumstances that are relevant to determining the center of direction, control and coordination of the vehicle.
Q. What is the ownership threshold for a company to be considered a U.S. Person?
A. Where the structure of an entity is such that the US owners are ultimately liable for the entity’s obligations and liabilities, the connection to activities in, or effect on, U.S. commerce would satisfy CEA section 2(i), and thus they will fall under these rules. This is what the CFTC refers to as the “look through” aspect of the interpretation. In the Commission’s view, entities that are directly majority-owned by U.S. person(s) will be covered, but entities that have negligible U.S. ownership will not be covered. Where one or more US owners has unlimited responsibility for losses or nonperformance by its majority-owned affiliate they will be covered.
Q. How will ownership of an investment vehicle be determined and what is the threshold to be deemed a U.S. person?
A. In the proposed rule, the CFTC was going to require firms to monitor both direct and indirect ownership of the fund. However, in the final order the CFTC is removing the indirect ownership prong, after many market participants commented that it would be extremely onerous, if not impossible, for funds to monitor both their own indirect ownership and that of their counterparties. Under the final order, any commodity pool, pooled account, investment fund or other collective vehicle that is majority-owned by one or more U.S. person(s) will be deemed a U.S. person. Majority owned means more than 50% of the equity or voting interests in the collective investment vehicle. The Commission expects that investment vehicles will both determine whether its direct beneficial owners are U.S. persons (as described under this rule) and to “look through” the beneficial ownership of any other legal entity invested in the collective investment vehicle that is controlled by or under common control with the collective investment vehicle in determining whether the collective vehicle is majority-owned by US persons. In response to market commentators about the difficulty in funds requiring looking through to the owners of a fund-of-fund that invests in them, the CFTC will not require a fund to look through to the owners of a fund that invests in it. Instead they can reasonably rely on written representations from the unrelated investment vehicle whether it is a U.S. person.
Q. What amount of due diligence must a company perform to determine whether or not their counterparty is a U.S. person?
A. The Commission, responding to a large amount of market concern about the burden of monitoring counterparty status, will allow parties to rely on the written representation of their counterparties whether or not they are U.S. persons. However, the Commission is still requiring parties to conduct “reasonable” due diligence before they can rely on the counterparty’s representation. What is “reasonable” will depend on the facts and circumstances of each situation.
Q. When will non-U.S. Affiliates of U.S. persons have to register?
A. Broadly, a person is required to register as a Swap Dealer (SD) if its swap dealing activities over the preceding 12 months exceeds the de minimus threshold of swap dealing. All U.S. persons that reach the threshold have to register, regardless of the designation of their counterparty. In addition, the swap dealing activities of a non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person, or that is an “affiliate conduit” of a U.S. person should also count all of their swap dealing activities towards the de minimus threshold. However, more analysis must be made for non-U.S. persons that are not guaranteed affiliates of conduit affiliates of U.S. persons. In this situation, the non-U.S. person should only count its swap dealing transactions with U.S. persons and with guaranteed affiliates towards the de minimus threshold.
Q. How should entities count the swap dealing activities of their affiliates towards the de minimus threshold?
A. Generally, the Commission’s policy will be to interpret the aggregation requirement in a manner that applies the same aggregation principles to all affiliates in a corporate group, whether they are U.S. or non-U.S. persons. Further, the Commission will generally apply the aggregation principle such that, in considering whether a person is engaged in more than a de minimus level of swap dealing, a person should generally include all relevant dealing swaps of all its U.S. and non-U.S. affiliates under common control, except that swaps of an affiliate that is a registered swap dealer are excluded. This basically allows both U.S. and non-U.S. persons in an affiliate group to engage in swap dealing activities up to the de minimus threshold. When the affiliated group meets the threshold in the aggregate, one or more affiliate(s) would generally have to register as SDs so that the relevant SD activity of the unregistered affiliates remains below the threshold. In counting the swap dealing activity of non-U.S. persons that are not guaranteed affiliates or conduit affiliates of U.S. Persons, the entity does not need to count transactions with (1) a foreign branch of a U.S .SD; (2) a guaranteed affiliate of a U.S. person that is a SD; or (3) a guaranteed affiliate that is not a swap dealer and itself engages in de minimus swap dealing activity and which is affiliated with a SD.
Q. The CFTC broke down the regulations into different categories, and requires different compliance for each category. Can you explain more about these different requirements?
A. Firstly, the compliance requirements are broken down into entity level requirements and transaction level requirements. The entity-level requirements are composed of two subcategories: First category and Second Category. The first category is comprised of capital adequacy, designation of chief compliance officer, maintaining risk management procedures (including internal conflicts of interest procedures) and swap data recordkeeping. The second category is comprised of Swap Data Repository (SDR) reporting, swap data recordkeeping relating to complaints and marketing and sales materials and large trader reporting. The transaction level reporting is also broken down into Category A, which includes required clearing and swap processing; margining and segregation for uncleared swaps; mandatory trade execution; swap trading relationship documentation; portfolio reconciliation and compression; real-time public reporting; trade confirmation; and daily reading records. Part B includes the external business conduct standards (excluding internal conflicts of interest procedures, which has been moved up to entity level requirements). The Commission will apply its policies differently depending on the category or sub-category.
Since the first category is comprised of market risk monitors and controls, the Commission has a stronger incentive to regulate this area, and will mandate that non-U.S. SDs and Major Swap Participants (MSPs) will have to comply with all of the first Category of Entity level requirements (although substituted compliance may be available). With respect to the Second Category of the Entity-Level Requirements, substituted compliance will only be available where the counterparty is a non-U.S. person. The Commission grants more leeway with regards to Transaction level requirements. These rules are geared more towards customer protection, and thus other jurisdictions have a strong interest in regulating these requirements. The Commission believes that entities can rely on substituted compliance for these requirements.
Q. How will these requirements be applied to SDs and MSPs?
A The Commission believes that US SDs and MSPs will have to comply with all of the requirements, whether or not the counterparty is a US person or not, without substituted compliance available.
Non-US branches of US swap dealers will also be required to comply with these requirements, but will generally be able to satisfy the requirements through “substituted compliance” (compliance with the comparable requirements of another jurisdiction) with respect to transactions with non-U.S. persons if the transaction has a “bona fide” connection to the non-US branch. The CFTC will determine whether a particular category of requirements of another jurisdiction are comparable to the Dodd-Frank requirements using an outcomes-based approach. The CFTC issued a no-action letter on July 11, 2013 indicating that certain risk mitigation requirements of the European Market Infrastructure Regulation (EMIR) (confirmation, portfolio compression, portfolio risk valuation, and portfolio compression requirements) are substantially identical to the Dodd-Frank requirements.
Non-U.S. swap dealers will be required to comply with the transaction-level requirements with respect to transactions with U.S. persons and with non-U.S. affiliates guaranteed by a U.S. person. However, Non-U.S. swap dealers will be able to rely on substituted compliance to satisfy the requirements with respect to transactions with non-U.S. affiliates guaranteed by a U.S. person.
Q. Please explain the concept of Substituted Compliance?
A. The CFTC will require non-U.S. SDs/MSPs to comply with all of the substantive requirements of Dodd-Frank. However, the CFTC understands that non-U.S. entities will also need to comply with their local laws, which will subject these firms to multiple regulatory regimes. In order to ease the burden on these firms, the CFTC will permit a non-U.S. SD or MSP to substitute compliance with the home jurisdiction’s laws and regulations in lieu of compliance with the attendant Entity-Level and/or Transaction Level requirements, as long as the CFTC finds that the regulations are comparable and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the CFTC’s regulations.
Q. How will the Commission determine whether or not a foreign jurisdiction’s laws are comparable and as comprehensive?
A. The Commission is going to take an outcomes based approach to determine whether these requirements achieve the same regulatory objectives as Dodd-Frank. This will require the Commission to determine whether or not the foreign regime wishes to accomplish the same goals as Dodd-Frank, without requiring them to have identical laws. In addition, the Commission is going to make a determination on a requirement-by-requirement basis, rather than on the basis of the foreign regime as a whole.
In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive, the Commission will take into account all relevant factors, including but not limited to, the comprehensiveness of those requirements, the scope and objectives of the relevant regulatory requirements, the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.
There are certain criticisms to this approach. This granular approach can lead to non-U.S. SDs/MSPs having to comply with both Dodd-Frank and their home jurisdiction’s regulations for certain rules, while being able to rely on substituted compliance for other requirements. Additionally, as Commissioner Scott O’Malia pointed out recently, there may be difficulty determining whether or not specific requirements (such as SDR reporting) that are not exactly the same as the CFTC’s will still be considered “substantially the same” or not. For instance, if another jurisdiction doesn’t require SDs to report to SDRs in the same format as that required under Dodd-Frank, will the CFTC still consider it “substantially the same” as our own regulations.
Q, When will firms need to come into compliance with the new rules?
A. Parties can continue to rely on the previous temporary cross border guidance (The CFTC order effective December 21, 2012) until 75 days after the final guidance is published in the Federal Register.