CFTC’s Final Exemptive Order and Further Proposed Guidance on Cross-Border Swaps

January 23, 2013

On December 21, 2012, the Commodity Futures Trading Commission ("Commission" or "CFTC") approved with a vote of 4-1 (Commissioner Sommers dissented) a final exemptive order entitled "Final Exemptive Order Regarding Compliance with Certain Swap Regulations," (the "Final Order")[1] granting temporary conditional relief from certain provisions of the Commodity Exchange Act ("CEA") and the Commission’s regulations with respect to non-U.S. persons and foreign branches of U.S. persons.  Under the same vote, the Commission approved further proposed guidance ("Further Proposed Guidance")[2] that requests additional comments on specific aspects of the definition of "U.S. person" and the aggregation provisions relating to non-U.S. persons.

In July 2012, the CFTC published two proposals for public comment relating to the cross-border application of Title VII of the CEA.  The CFTC published proposed guidance regarding the cross-border application of certain swaps provisions of the CEA and the CFTC’s interpretation of CEA section 2(i) (the "Proposed Guidance")[3] and, concurrently with the Proposed Guidance, the CFTC published a proposed order that, if adopted, would help foster an orderly transition and provide market participants with greater certainty regarding cross-border swap activities (the "Proposed Order").[4]  The Commission notes that the Final Order only takes action with respect to the Proposed Order and does not finalize or take further action with respect to the Proposed Guidance.[5]  Hence, one must take care in trying to divine from the Final Order the direction in which the final guidance is heading.

The Final Order is a time-limited exemptive order, issued pursuant to the CFTC’s exemptive authority under CEA section 4(c),[6] which is meant to continue the process and further the same purposes of the recent relief granted by the CFTC’s Division of Swap Dealer and Intermediary Oversight staff, "to promote continuity in the application of Dodd-Frank requirements and facilitate the transition to those requirements by enabling swap market participants to apply a uniform and readily ascertainable standard regarding which swaps must be included in the calculations under the [swap dealer ("SD")] and [major swap participant ("MSP")] definitions."[7]  The CFTC notes that the Final Order is in addition to any no-action relief issued or to be issued by Commission staff.  The Final Order is similar to the Proposed Order, although it adds provisions regarding registration and provides certain modifications to address public comments.  The Commission explains that it believes that "the Final Order strikes the proper balance between promoting an orderly transition to the new regulatory regime [under the Dodd-Frank Act], while appropriately tailoring relief to ensure that the Commission can responsibly discharge its statutory duties."[8]

This client alert summarizes and explains the Final Order and Further Proposed Guidance, including some of the key changes from the Proposed Order and staff letters, through discussion of the following topic areas:

I.          Final Order’s New Definition of "U.S. Person"

II.        Reasonable Reliance on Counterparty’s Representation as a "U.S. Person"

III.       End-User Concerns with Definition of "U.S. Person"

IV.       Final Order Does Not Delay Registration for SDs or MSPs

V.        SD and MSP Calculations for Non-U.S. Persons – Exclusion of Certain Transactions and Aggregation Relief

VI.       Entity-Level and Transaction-Level Relief for Non-U.S. SDs and MSPs

            A.        SDR Reporting and LTR Requirements for SDs and MSPs

B.        Final Order Does Not Provide Exemptive Relief for U.S. SDs

VII.     Compliance Plan Not Required to Claim Relief Under the Final Order

VIII.    CFTC’s Intent Not To Bring Enforcement Actions Against SDs and MSPs in Good-Faith Compliance

IX.       Further Comments Requested

            A.        "U.S. Person" Definition

            B.        Aggregation

            C.        Foreign Branches of U.S. SDs

The Final Order was effective upon approval by the Commission on December 21, 2012 and expires on July 12, 2013.  Comments on the Further Proposed Guidance must be received by the Commission on or before February 6, 2013. 

I.   Final Order’s New Definition of "U.S. Person"

The Final Order provides market participants with a new (third) definition of the term "U.S. person" that differs from the versions set forth in the Proposed Guidance and in CFTC Letter 12-22.[9]  Further, the CFTC emphasizes that the "U.S. person" definition in the Final Order "should not be construed as an indication of, or a limitation on, the definition of the term ‘U.S. person’ that the Commission may adopt in final cross-border interpretive guidance,"[10] which indicates that market participants are likely to see a fourth definition of "U.S. person" when the CFTC releases the final cross-border guidance.

A determination that an entity is a "U.S. person" under the Final Order has certain implications, including: (i) swaps with U.S. persons would count towards the thresholds for determining SD or MSP status; (ii) entity-level requirements would apply to SDs and MSPs that are U.S. persons; (iii) transaction level requirements would apply to swaps with U.S. persons (with certain exceptions for foreign branches of U.S. persons as discussed in Section VI below); and (iv) U.S. persons (including non-financial end-users) that enter into swaps with non-U.S. non-registered counterparties would be required to report swap transaction data to an SDR as discussed in Section III below.  The definition of "U.S. person" in the Final Order applies to all swap counterparties (e.g., end-users, SDs, MSPs) with respect to Commission regulations promulgated under Title VII of the Dodd-Frank Act’s swap provisions.[11]  Under the Final Order, a "U.S. person" is an entity that meets one or more of the following five criteria.  Note that the strikethroughs and underlined text indicate changes from the "U.S. person" definition set forth in CFTC Letter 12-22:         

(i) A natural person who is a resident of the United States;

(ii) A corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing, in each case that is (A) organized or incorporated under the laws of a state or other jurisdiction in the United States or (B) effective as of April 1, 2013 for all such entities other than funds or collective investment vehicles, having its principal place of business in the United States;

(iii) A pension plan for the employees, officers or principals of the legal entity described in (ii) above, unless the pension plan is exclusively primarily for foreign employees of such entity;        

(iv) An estate of a decedent who was a resident of the United States at the time of death, or a trust, the income of which is subject to U.S. income tax, regardless of source 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; or

(v) An 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 (i) through (iv) above.

Perhaps the most significant change from the definition in CFTC Letter 12-22 involves the addition of "principal place of business" in the first prong of the test.  This addition will treat as a "U.S. person" a legal entity that is not incorporated in the United States but that nonetheless has its "principal place of business" in the United States.  The CFTC explains that it "will construe ‘principal place of business’ as referring to the single place where a corporation’s officers direct, control, and coordinate the corporation’s activities.  Typically, the principal place of business will be where the corporation maintains its headquarters."[12]  Accordingly, the addition of the term "principal place of business" would treat a corporate entity (including an end-user counterparty) that is incorporated outside the U.S. but has its principal place of business in the United States as a "U.S. person" for purposes of the Final Order.

The Commission will not treat entities incorporated or organized outside the United States and with a principal place of business in the United States as "U.S. persons" until April 1, 2013.  This delay is intended to provide market participants with time to adjust to the new regulatory requirements.  Additionally, due to the complex nature of the application of the "principal place of business" element to funds and collective investment vehicles, such element (i.e., prong (ii)(B) of the "U.S. person" definition) does not apply to funds or collective investment vehicles.

Additional changes to the Final Order’s definition of "U.S. person" include a clarification that pension plans need only be "primarily" for foreign employees of such entity in order to fall outside the definition, a clarification regarding the treatment of trusts and estates so that the treatment of an estate or trust for purposes of the Final Order does not depend on whether the income of the estate or trust is subject to U.S. income tax, and treatment of joint accounts in the same manner as individual accounts where a beneficial owner falls under one of the other prongs of the "U.S. person" definition.  

II.   Reasonable Reliance on Counterparty’s Representation as a "U.S. Person"

The Final Order explains that an entity entering into a swap can reasonably rely on its counterparty’s representation in determining whether the counterparty is a "U.S. person."  The CFTC explains that, in order to meet the "reasonable" standard, a party to a swap should conduct reasonable due diligence on its counterparties and what is reasonable in a particular situation will depend on the relevant facts and circumstances.  The CFTC further explains that the "reasonable" standard for purposes of the Final Order is similar to the "reasonable reliance" standard in the SD and MSP external business conduct standard rules in that "an SD or MSP may rely on the written representations of a counterparty in performing its due diligence.  However, an SD or MSP cannot rely on a written representation and continue to claim the exemptive relief if it has information that would cause a reasonable person to question the accuracy of the [counterparty’s] representation."[13]

Accordingly, non-SD and non-MSP counterparties (e.g., end-users) may be asked by their non-U.S. SD and non-U.S. MSP counterparties to confirm in writing whether or not they are "U.S. persons" as defined in the Final Order so that the non-U.S. SDs and non-U.S. MSPs can claim the exemptive relief granted in the Final Order.

III.   End-User Concerns with Definition of "U.S. Person"

An end-user (whether financial or non-financial) should determine whether it is a "U.S. person" and whether its counterparties are "U.S. persons".   Such a determination is necessary to ascertain whether or not an end-user has reporting obligations and to answer potential inquiries from its counterparties as described in Section II above.  End-users should note the changes to the "U.S. person" definition in the Final Order (as described in Section I above), including the addition of the "principal place of business" requirement, in making such determinations and when engaging in discussions with their counterparties.

If an end-user that is a "U.S. person" enters into an off-facility uncleared swap (i.e., not executed on a swap execution facility or designated contract market) with a non-U.S. person that is not registered as an SD or MSP, the U.S. person end-user would be required to report data pertaining to such swaps to a swap data repository beginning on April 10, 2013.  For example, an end-user that falls within the definition of "U.S. person" may enter into an off-facility uncleared swap with a non-U.S. person that is engaged in swap dealing activities but is not required to register with the CFTC because its transactions with U.S. persons do not exceed the de minimis threshold required for registration.  In this example, pursuant to Parts 45 and 46 of the CFTC’s regulations, the U.S. end-user would be required to report new swap data and historical swap data for all swaps with the non-U.S. non-SD/non-MSP counterparty.[14]

IV.   Final Order Does Not Delay Registration for SDs or MSPs      

The Final Order does not delay the registration requirement for non-U.S. SDs and MSPs (or for U.S. SDs and MSPs).  However, the Commission explained that many concerns of commenters should be addressed by the Commission’s decision to provide time-limited exemptive relief with respect to the swap dealing transactions that must be included in the de minimis calculation that applies for purposes of the SD definition and other relief in the Final Order.  Accordingly, once an SD or MSP exceeds the appropriate de minimis threshold, taking into account the relief provided in the Final Order and CFTC Letters, such SD or MSP would be required to register with the CFTC in accordance with CFTC regulations.

V.   SD and MSP Calculations for Non-U.S. Persons – Exclusion of Certain Transactions and Aggregation Relief

The Final Order provides relief for non-U.S. persons (regardless of whether the non-U.S. persons’ swap obligations are guaranteed by U.S. persons) with respect to the swaps required to be counted for purposes of (i) the calculation of the de minimis test under CFTC regulation 1.3(ggg)(4) for SD purposes; and (ii) the calculation of the MSP test under CFTC regulation 1.3(hhh).  The CFTC explains that such non-U.S. persons (whether or not guaranteed by U.S. persons) may exclude and not consider from such calculations, the aggregate notional value of:

(1) Any swap where the counterparty is a non-U.S. person;[15] 

(2) Any swap where the counterparty is a foreign branch of a U.S. person, where such U.S. person either (i) is registered as an SD; or (ii) represents that it intends to register[16] as an SD by March 31, 2013;[17] and        

(3) For purposes of SD registration only, any swap to which it is not a party because the swap is entered into by an affiliated central booking entity.

The Final Order provides temporary relief for non-U.S. persons with respect to aggregation of swap dealing activities for purposes of calculating the de minimis threshold for swap dealing activity by providing that the non-U.S. person may exclude and not consider the aggregate notional value of: 

(1) any swap dealing transaction of its U.S. affiliates under common control; and           

(2) if any of its affiliates under common control are registered as SDs, any swap dealing transaction of the SD’s non-U.S. affiliates that (i) are engaged in swap dealing activities with U.S. persons as of December 21, 2012 (i.e., the effective date of the Final Order) or (ii) are registered as SDs.[18]

Below is a summary of whether a particular type of transaction would count towards the de minimis threshold for purposes of determining whether or not an entity must register as an SD.  Note that the Final Order, much like CFTC Letter 12-22, provides relief with respect to non-U.S. persons guaranteed by U.S. persons by excluding swaps with non-U.S. persons from the de minimis calculation until July 12, 2013.  On the other hand, the Proposed Guidance would require that non-U.S. persons guaranteed by U.S. persons count the aggregate notional amount of all swap dealing activity regardless of whether such swaps are with non-U.S. persons.  The chart below compares the requirements from the Final Order to those in the Proposed Guidance.

VI.   Entity-Level and Transaction-Level Relief for Non-U.S. SDs and MSPs

The Final Order, like the Proposed Order, divides the Dodd-Frank swap provisions into Entity-Level Requirements (applying to all the firm’s activities or transactions)[21] and Transaction-Level Requirements (applying on a transaction-by-transaction basis).[22] A non-U.S. SD or non-U.S. MSP may delay compliance with respect to Entity-Level Requirements in effect as of December 21, 2012 (i.e., the effective date of the Final Order), subject to certain conditions relating to swap data repository ("SDR") reporting and large trader reporting ("LTR") requirements (discussed in Section VI.A. below).  With respect to transactions by non-U.S. SDs and non-U.S. MSPs with non-U.S. counterparties (including foreign branches of U.S. registrants),[23] non-U.S. SDs and non-U.S. MSPs must comply with Transaction-Level Requirements as may be required by the local jurisdiction of such registrants; however, if non-U.S. SDs or non-U.S. MSPs enter into transactions with U.S. counterparties, then they must comply with all such Transaction-Level Requirements that are in effect for all such swaps.

A. SDR Reporting[24] and LTR[25] Requirements for SDs and MSPs

The CFTC takes substantially the same position in the Final Order as in the Proposed Order with respect to SDR reporting and LTR requirements.  The Final Order explains that (i) non-U.S. SDs and non-U.S. MSPs are required to comply with SDR reporting and LTR requirements for all swaps with U.S. counterparties; and (ii) non-U.S. SDs and non-U.S. MSPs that are part of an affiliated group in which the ultimate parent entity is a U.S. SD, U.S. MSP, U.S. bank, U.S. financial holding company, or U.S. bank holding company are required to comply with SDR reporting and LTR requirements for all swaps with non-U.S. counterparties.  However, pursuant to the Final Order, non-U.S. SDs and non-U.S. MSPs that are not part of an affiliate group would be permitted to delay compliance for SDR reporting and LTR requirements until July 12, 2013. 

The CFTC notes that staff has recently granted no-action relief with respect to certain reporting requirements and, in light of such relief provided by Commission staff, it would not advance the public interest or the purposes of the CEA to further delay compliance with the SDR reporting or LTR requirements for non-U.S. registrants.[26] 

B. Final Order Does Not Provide Exemptive Relief for U.S. SDs

The CFTC explains that it would be contrary to the public interest and the purposes of the CEA to diminish the regulatory requirements that apply to swaps activities in the United States.  Accordingly, the Final Order does not provide exemptive relief for U.S. SDs.  The CFTC explains this position by stating that where appropriate, the CFTC and staff has delayed compliance with certain requirements and provided no-action relief to both U.S. and non-U.S. registrants.[27]

VII.   Compliance Plan Not Required to Claim Relief Under the Final Order

The Proposed Order required the person seeking exemptive relief to submit to the National Futures Association a compliance plan addressing how it plans to comply with applicable requirements under the CEA and the Commission’s regulations.  The Final Order eliminates this requirement and the Commission affirmatively states that the submission of a compliance plan is not necessary to claim relief under the Final Order.[28]

VIII.   CFTC’s Intent Not To Bring Enforcement Actions Against SDs and MSPs in Good-Faith Compliance

The CFTC explains that it does not intend to bring an enforcement action against an SD or MSP for failing to fully comply with the application of the Dodd-Frank requirements until July 12, 2013, provided that:

(1) There is "a practical or technical impediment to compliance that results in an inability to comply with relevant compliance deadlines, or uncertainty in interpreting, particular Dodd-Frank requirement(s)"; and

(2) The SD or MSP is "acting reasonably and in good faith to fully comply with the applicable Dodd-Frank requirements," including, at a minimum: 

(i) material progress toward timely implementation and compliance;

(ii) identification of any implementation or interpretive issue as soon as reasonably possible;

(iii) timely elevation of such issue(s) to the SD’s or MSP’s senior management for consideration and resolution; and

(iv) timely consultation with other industry participants and the Commission as necessary to seek resolution of such issue(s). 

However, the CFTC notes that this expression of intent not to bring an enforcement action "does not confer upon any party any rights or defenses in any investigation or in any action that may be brought by the [CFTC]."[29] 

IX.   Further Comments Requested

The Further Proposed Guidance specifically requests comment which will be taken into account by the Commission when issuing final cross-border guidance.  The 30-day public comment period will end on February 6, 2013.

A. "U.S. Person" Definition 

The Proposed Guidance provides a seven-pronged definition of the term "U.S. Person" that differs from the definition set forth in the Final Order.[30]  The Further Proposed Guidance provides alternatives for prong (ii)(B) and prong (iv) of the definition of "U.S. person" found in the Proposed Guidance.[31]  The alternative prong (ii)(B) is meant to exclude from the definition an entity that is a limited liability company or limited liability partnership where partners have limited liability and would avoid capturing those legal entities that have negligible U.S. ownership interests.  The alternative to prong (iv) would clarify that it applies regardless of whether the collective investment vehicle is in the United States and that a commodity pool, fund or other collective investment vehicle that is publicly traded will be deemed a U.S. person only if it is offered, directly or indirectly, to U.S. persons.  The CFTC requests comments on all aspects of the alternative prongs.

B. Aggregation

The CFTC explains that under Commission regulation 1.3(ggg)(4), "any affiliate of a person that is registered as an SD will also have to register if it engages in any swap dealing transactions, even if the aggregate amount of such swap dealing transactions among all the unregistered affiliates is below the de minimis threshold."[32]  The Further Proposed Guidance provides an alternative interpretation of the aggregation requirement for the SD calculation in Commission regulation 1.3(ggg)(4).  Under the alternative interpretation, a non-U.S. person would be required to include the aggregate notional value of swap dealing transactions entered into by all affiliates under common control (i.e., U.S. and non-U.S. affiliates), but would not be required to include any swap dealing transactions of any non-U.S. affiliate under common control that is registered as an SD.  The CFTC requests comments on all aspects of this alternative approach and asks several specific questions, including whether this alternative interpretation should apply to non-U.S. persons guaranteed by U.S. persons.

C. Foreign Branches of U.S. SDs          

In addition to the requests for comment on the Further Proposed Guidance described in Sections IX.A and B above, the Final Order requests comment on the requirements for determining what entities are foreign branches of U.S. persons.  The Final Order provides three criteria that must be satisfied for a swap to be considered a swap with a foreign branch of a U.S. person (as opposed to a swap with a "U.S. person").[33]  The Final Order requests comment on additional or alternative requirements for an entity to determine whether a swap is with a "foreign branch of a U.S. person" or with a "U.S. person".  The CFTC suggests that the requirements could include: (i) that the foreign branch is the location of employment of the employees negotiating the swap for the U.S. person, or if the swap is executed electronically, the employees managing the execution of the swap; (ii) that the U.S. person treats the swap as a swap with the foreign branch for tax purposes; (iii) that the foreign branch operates for valid business reasons and is not only a representative office of the U.S. person; and (iv) that the branch is engaged in the business of banking or financing and is subject to substantive regulation in the jurisdiction where it is located.[34]