Extraterritoriality: CFTC rules ‘confusing and inconsistent’

The US Commodity Futures Trading Commission published its proposals on extraterritoriality in June, but last-minute rewrites have left the guidance littered with inconsistencies. Dealers also complain the conditions for applying foreign rules are too limited and complex. By Matt Cameron

Bankers may have breathed a sigh of relief when flicking through the US Commodity Futures Trading Commission’s (CFTC) take on the cross-border reach of the Dodd-Frank Act. The interpretative guidance, published on June 29, initially appeared to take a much softer stance than the industry had feared, declaring that non-US swaps entities and foreign branches, affiliates and subsidiaries of US banks would be able to comply with foreign rules in certain circumstances – an approach known as substituted compliance, which means overseas derivatives entities wouldn’t have to apply multiple sets of regulations.

On closer examination, though, the document throws up a host of issues that are worrying globally active banks. For one thing, lawyers say the rules are ambiguous – or outright contradictory – in places. For another, the CFTC will only allow substituted compliance on a case-by-case basis – an ultra-granular approach that will involve each swap dealer, even those domiciled overseas, filing a detailed comparison of the various US and foreign requirements, lawyers say. Where local rules are not comparable, the CFTC will require the Dodd-Frank Act to be applied instead, raising the possibility of a confusing mix-and-match approach between foreign and US legislation.

“In broad strokes, it’s rational as to the big-picture items – for example, allowing for rule-comparability through substituted compliance. So, at the highest level, it is an important step forward. But when you get down into the weeds, it is very confusing, internally inconsistent and not thought through with the level of precision it deserves given the nature of the subject matter,” says Lenny Schwartz, partner at law firm Davis Polk & Wardwell in New York.

That subject matter is vital, participants say. Given the guidance essentially sets out whether and to what extent foreign dealers, as well as foreign branches, affiliates and subsidiaries of US firms, have to apply Dodd-Frank, it is absolutely crucial to their preparations, they say. It’s particularly urgent given the fact the CFTC finalised its swap definition rules on July 10. From the moment the rules are published in the Federal Register, companies have just 60 days before they need to register as swap dealers – a requirement that will be tough given the complexity of the cross-border guidance, and the fact the document is up for consultation for 45 days. It’s not just dealers that are worried – the Swiss banking regulator has already voiced some of these concerns in a letter to the CFTC (see page 1).

“This is really troubling,” says a derivatives lawyer at a US bank in New York. “The product definitions have been approved, and once they are published in the Federal Register, we have 60 days until we all have to start registering as swap dealers. This guidance will in no way be finished before then, so what do we do? Do we guess which entities will have to register, based on this document? This is putting the cart before the horse.”

At the highest level, it is an important step forward. But when you get down into the weeds, it is very confusing, internally inconsistent and not thought through with the level of precision it deserves

Some participants put inconsistencies in the guidance down to a flurry of last-minute changes that occurred in the weeks before publication. The proposals were shared with the five CFTC commissioners on June 1 – and surprised some with a hard-line approach that tried to capture a broad spectrum of overseas entities, according to a senior CFTC source. In a statement given when the proposals were published, commissioner Jill Sommers described the June 1 draft as being guided by the “intergalactic commerce clause” of the US constitution, with the extraterritorial application of US law being “extra statutory and extra constitutional”.

That triggered a frantic back-and-forth negotiation between commissioners that eventually led to the proposals being watered down – but not before a scheduled vote on June 21 was delayed. The CFTC source claims the public meeting was delayed because Gary Gensler, CFTC chairman, realised he didn’t have enough support from commissioners – a claim Gensler denies (Risk 25 July 2012, pages 57–59).

Nonetheless, the paper that finally emerged on June 29 contained some major differences from the original proposals, says the CFTC source. “If the original document was published as it was, it would have significantly disadvantaged US banks versus their foreign peers. It wouldn’t have allowed branches to have substituted compliance in some instances, and it would have required foreign banks to count transactions with foreign branches of US banks towards the exposures for determining whether or not to register as a swap dealer. So it underwent significant work and last-minute changes, and in the haste it turned out to be a bit schizophrenic, as some of the original language remained with new language inserted around it,” says the source.

Under the proposals, non-US swap dealers and major swap participants will be able to apply their own, home-country capital and risk management regulations at the entity level, so long as they are comparable with the Dodd-Frank requirements. That will come as a big relief to foreign banks, which feared they might collide with their home regulations by complying with US capital rules.

There are also a number of requirements that apply at the transactional level – for instance, clearing and swap processing, margin and segregation, trade execution and real-time reporting. In a nutshell, non-US swap dealers and major swap participants would need to apply Dodd-Frank transaction-level rules when trading with any US counterparty, other than foreign branches of US persons. However, non-US swap entities can apply equivalent home market rules when trading with non-US counterparties whose swap obligations are guaranteed by a US entity, and for trades with non-US affiliate conduits of a US firm. No requirements exist when a non-US swaps dealer or major swap participant trades with a non-US counterparty that is not guaranteed by a US person.

Foreign branches of US dealers would also be able to apply substituted compliance when trading with a non-US person, regardless of whether its obligations are guaranteed by a US person or not.

Substituted compliance is a possibility for foreign affiliates and subsidiaries of US persons in certain circumstances, too. If the affiliate is the legal counterparty but all swaps are guaranteed by a US person, it can still apply overseas transaction-level rules when trading with a non-US person whose obligations are guaranteed by a US person. Likewise, if the affiliate is the legal counterparty and the swaps are not guaranteed by a US person, it can use substituted compliance when trading with a non-US counterparty guaranteed by a US person. In both cases, the Dodd-Frank rules would not apply when trading with a non-US person not guaranteed by a US entity.

However, Dodd-Frank transaction-level requirements will apply to any swap conducted with a US person, regardless of the location of the transaction.

So far, so confusing. But it becomes doubly so when the definition of ‘US person’ is thrown into this mix – and this is where some of the inconsistencies emerge, say lawyers. At first glance, the definition of a US person seems a lot looser than the one used by US prudential regulators in their margin requirements for uncleared swaps proposals, issued in April 2011 (Risk June 2011, pages 24–27). A US person covers foreign branches or agencies of a US entity, but doesn’t include foreign affiliates or subsidiaries, even if their swap obligations are guaranteed by a US person.

However, there are a number of complexities in the detail, with two particular troublespots, lawyers claim. One of the definitions of a US person is a corporation, partnership or limited liability company that is organised under the laws of the US or has its principal place of business in the US. It is also defined as any commodity pool, pooled account or collective investment vehicle where the operator is required to register as a commodity pool operator under the Commodity Exchange Act.

Foreign banks are worried about what is meant by ‘principal place of business’, and fear it may capture any overseas firm that has significant operations in the US. The latter definition is likely to encompass a variety of overseas funds, which are required to register as commodity pool operators. In other words, some foreign entities might technically be defined as US persons, even though their home regulators think otherwise.

“The definition of US person is the fruit of the poisonous tree, because rules apply or do not apply depending on whether a person is a US person or not. It drives the scope of US jurisdiction. If the definition is so broad that counterparties are likely to be considered both US and European persons, which rules will have to apply? It could be a very messy situation,” says the US bank derivatives lawyer.

Another of the definitions, known as prong ii(B), has also caused some concern. A corporation, partnership or limited liability company is classed as a US person if the direct or indirect owners are responsible for the liabilities of that entity and one or more of those owners is a US person. However, the rules go on to specifically exempt a foreign affiliate or subsidiary of a US person, even if the swap obligations are guaranteed by a US person. Lawyers say the two statements are contradictory.

“Everyone is confused by those two statements. I have never seen language like prong ii(B) in any other regulatory context. If they didn’t say later in the release that foreign affiliates and subsidiaries that have their swaps obligations guaranteed by US persons are considered non-US persons, there is no way you would read prong ii(B) to reach that conclusion – you would reach precisely the opposite conclusion. There must be something very limited they are after, like a general partnership, but clarification is needed,” says John Williams, partner at law firm Allen & Overy in New York.

The CFTC source acknowledges the issue and says the agency will make technical edits to clear up the confusion.

Another major area of concern relates to the thresholds for swap dealer registration. Essentially, the guidance builds on an earlier rule-making by the CFTC, which states a firm must register as a swap dealer if its dealing activity breaches a certain level. Meanwhile, foreign banks must register as non-US swap dealers if they exceed a minimum notional amount of swap dealing activity with US persons.

The cross-border guidance lays out what should be counted towards that notional amount. For example, it does not include any dealing transactions with foreign branches of US swap dealers, but would include the aggregate notional value of any swap-dealing transaction between US persons and any of its non-US affiliates under common control, as well as any transactions entered into by its non-US affiliates under common control where the obligations of those affiliates are guaranteed by US persons. A non-US person should not include transactions conducted by its US affiliates.

The guidance then goes on to say that all the affiliated non-US persons should aggregate the notional value of their swap dealing transactions with US persons and their trades with non-US entities where that entity’s obligations are guaranteed by a US person – a difference from the earlier explanation, which said trades conducted by the affiliates would be counted if the obligations of the affiliates themselves are guaranteed by a US person.

The CFTC source was not aware of the conflict until questioned by Risk, but after rereading the relevant passage admits it is a mistake, and that transactions with non-US entities where their obligations are guaranteed by US persons would not be counted towards the threshold amount.

There are other problems too, lawyers say. As a result of the aggregation rule, a European bank with five non-US affiliates that each has $2 billion in outstanding swaps with US customers could be caught by the regulation – meaning each entity might need to register as a swap dealer under Dodd-Frank. That may well be intended to ensure firms don’t circumvent the rule by splitting their business between multiple entities, but lawyers say more clarity is needed.

“The guidance is not clear on this point, but the way we read it is all the entities would have to register and that is ridiculous. They are so worried about us setting up hundreds of dealing entities to avoid registration, so they have this rule. But it just doesn’t make sense. It may force us to stop transacting with US persons from those entities,” says an in-house counsel at a European bank in New York.

There is also some criticism about a look-back period written into the registration rules. The CFTC has ruled that a dealer should consider its swap dealing activity over the prior 12-month period when determining whether it has breached the threshold. That means even if a foreign bank decides to reduce the US swaps trading activity conducted by its affiliates, lawyers say it might still be required to register them as swap dealers under Dodd-Frank – temporarily, at least.

“This represents one of the themes that ripple through everything the CFTC does. It has people responsible for the extraterritoriality and then people for the registration, and that’s all they do. There is nobody familiar with both of them to make sure they work together. So, if I have an affiliate overseas and it does a good deal of swaps business with US persons, it will probably have to register. If I don’t want it to and stop all business with US persons, it looks like it will nonetheless get caught by the 12-month look back at historical swaps activity. So we could find a situation where we register our affiliate and then de-register a few months later as the historical activity falls off the look-back,” says an in-house counsel at a US bank.

Another possible inconsistency centres on central booking models. Many firms use affiliates or branches to negotiate swap transactions, although the trade may ultimately be booked at the parent entity. The guidance states that the US entity would be required to register as a swap dealer, regardless of whether the swaps were booked directly by the US entity or indirectly via a back-to-back swap with the affiliate.

However, this appears to contradict the earlier CFTC regulation on swap dealer registration (the elegantly named 1.3(ggg)(6)(i)), which states an entity can disregard inter-affiliate trades with majority-owned affiliates when determining whether to register as a swap dealer.

“There may be some sort of clarification given, but I think it is likely the CFTC will clarify that the ultimate booking entity should register as a swap dealer, and rule 1.3(ggg)(6)(i) shouldn’t prevent that,” says David Felsenthal, partner at law firm Clifford Chance in New York.

Beyond the potential inconsistencies in language, the granting of substituted compliance will put a huge burden on each individual firm to prove its home country has comparable rules with Dodd-Frank, say bankers. The two sets of rules don’t have to be identical, and the final decision is left to the CFTC, but there could be instances where certain rules are deemed comparable, but other parts of the foreign rule-book are not – in which case, non-US dealers could be required to comply with an amalgam of the domestic rules and Dodd-Frank – a regulatory version of Frankenstein’s monster.

“If the CFTC is rational about substituted compliance and it doesn’t nit-pick between the rules, then it could work out well. But if it does nit-pick, then banks will find themselves in situations where they will be split between complying with different rules in different regimes, and that could end up looking like a dog’s breakfast,” says the derivatives counsel at the US bank.

That is not a remote possibility. Much of the Dodd-Frank Act comes into force this year, but other countries are further behind in the rule-making process, meaning comparable foreign rules may not exist for several months – or longer. The US legislation is extremely broad, requiring standardised over-the-counter derivatives to trade on an exchange or electronic trading platform, for example – which is one of the global reforms agreed by the Group of 20 nations in September 2009 – but also including the Volcker rule ban on bank proprietary trading, for instance. Other countries have yet to include these elements in their rules. Europe will eventually have a trade execution requirement, but this will be included in the Markets in Financial Instruments Directive, likely to be published at least a year after the European Market Infrastructure Regulation, which covers clearing and reporting.

In other words, substituted compliance may look good from afar, but the reality at the moment is that many foreign firms could end up having to apply elements of Dodd-Frank at least, say lawyers. The other alternative is to avoid trading with US firms.

“The guidance remains a moving target – it will be difficult to implement and ultimately it creates a disincentive for foreign firms to trade with US banks. While it proposes to allow for substituted compliance, no jurisdiction outside the US is likely to impose comparable rules. If you are a non-US firm, all else being equal, the likelihood is you will seek to trade with non-US banks so as to avoid having to comprehend Dodd-Frank, much less try to comply with it,” says Steven Lochfie, partner at law firm Cadwalader, Wickersham & Taft in New York.

BOX: Dealing in emerging markets

There had been a concern that requiring foreign branches of US banks to apply the Dodd-Frank Act or comparable foreign-equivalents would put them at a major competitive disadvantage in certain emerging markets. As a result, the Commodity Futures Trading Commission (CFTC) has decided these entities can trade in emerging markets where comparable rules don’t exist without applying Dodd-Frank, so long as the aggregate notional value of the swaps of all foreign branches in these countries does not exceed 5% of the aggregate notional value of all swaps of the US swap dealer.

Banks had lobbied hard for this exemption, noting that foreign banks are required to conduct business through local branches in certain countries, and would be unable to set up other swap-dealing entities. With comparable rules in those jurisdictions some way off, dealers had complained that the extraterritorial reach of Dodd-Frank would immediately make them unattractive as counterparties.

However, lawyers and bankers have complained about the lack of clarity in the CFTC guidance – specifically, what it means by ‘emerging markets’. “This is a classic example of a concept that makes sense but seems like it was put in at the last minute, and there is a real lack of clarity as to exactly what it means. Firstly, it references emerging markets. Well, what is the definition of an emerging market? Is a non-Group of 20 country an emerging market? Would that mean that Indonesia or South Africa are not emerging markets? Also, it talks about the aggregate notional of the US swap dealer. Banks are likely to have at least two US swap dealers, so is it the aggregate of the one, both, or the aggregate of the holding company? This is what happens when you try to avoid the rule-making process, because when you write rules you have to think about how stuff is going to work. When you don’t, it lacks intellectual discipline,” says a derivatives counsel at a US bank in New York.

 

BOX: Guidance versus rule

The decision by the Commodity Futures Trading Commission (CFTC) to release the cross-border paper as interpretative guidance, rather than a rule, has been questioned by industry participants, who claim it is an attempt by the agency to avoid conducting a full cost-benefit analysis.

The CFTC is required to run an analysis of costs on any new rule, but this isn’t required for interpretative guidance. However, some of the language in the CFTC guidance reads like a rule, says Don Lamson, counsel at law firm Shearman & Sterling in Washington, DC.

“There is a possibility that because the language in the guidance serves to function as a rule, participants could allege the guidance itself functions like a rule, and therefore the CFTC should have, but did not, conduct a cost-benefit analysis. If the guidance has the effect of making me register as a swap dealer when I don’t want to, then it affects me and I have standing to challenge the guidance as a rule and to ask a court for relief and for the CFTC to rescind the guidance,” he says.

Bankers also say they are treating this guidance as a rule. “You can call this interpretative guidance to get around the administrative procedure rules, but this is a rule. This is more significant than any rule it has put out, so to call it guidance is a joke. This thing flows through everything,” says an in-house counsel at one US bank.

The US Chamber of Commerce, in a comment letter submitted to the CFTC on June 27, says conducting a full rule-making would be consistent with the law and the principles of sound government. “The extraterritorial application of the swap-dealing provision is a matter of great consequence, and the public interest should be carefully considered. As you know, President Obama has asked agencies to proceed through notice and comment, even in circumstances where not strictly required by law,” states the letter.