SEC Re-Proposes Rules on Arranging, Negotiating or Executing Security-Based Swaps

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. The following post is based on a Davis Polk client memorandum; the complete publication, including appendices, is available here.

On May 13, 2015, the SEC published proposed amendments and re-proposed rules on the application of certain Title VII requirements to cross-border security-based swap activities of non-U.S. persons based on U.S. conduct. The proposed rules would modify numerous prior SEC proposals and final rules, including the May 2013 proposed rules on the cross-border application of security-based swap regulations, the August 2014 final cross-border definitions and de minimis rules and the March 2015 reporting final rules. [1]

Notably, the proposed rules would:

  • replace the SEC’s prior proposed cross-border conduct standard—“transactions conducted within the United States”—with a standard based on dealing activity of non-U.S. persons that is arranged, negotiated or executed by personnel (or personnel of an agent) located in a U.S. branch or office (“U.S.-Located Personnel”);
  • amend the SEC’s final rules on calculating the de minimis threshold to incorporate the revised cross-border conduct standard to determine whether a non-U.S. person engaged in dealing activity must register as a security-based swap dealer;
  • generally apply the proposed external business conduct rules (other than those relating to diligent supervision) to non-U.S. persons based on location of conduct, while applying risk-based rules, such as mandatory clearing and trade execution, based on the identity of the counterparties holding the risk; and
  • amend the scope of the security-based swap reporting rules to include certain transactions involving non-U.S. persons that are: (i) entered into by non-U.S. persons in connection with dealing activity and that are arranged, negotiated or executed by a party’s personnel located in the United States, (ii) executed on U.S.-located trading platforms, and (iii) effected by or through registered broker-dealers, including registered security-based swap execution facilities (“SBSEFs”).

The SEC emphasized that it consulted with CFTC staff when drafting the proposed rules and reviewed comment letters submitted in response to the CFTC’s request for comment on CFTC Staff Advisory 13-69, which generally requires compliance with CFTC “transaction-level requirements” for swaps between a non-U.S. swap dealer and non-U.S. persons where the dealer has personnel located in the United States regularly involved in arranging, negotiating or executing swaps, and is the first place that the phrase “arrange, negotiate or execute” appeared in this context. [2] Given the other contexts in which this new phrase is used, including the Volcker Rule, interested parties will be watching the CFTC and the other Volcker regulators closely to see whether their interpretations of this phrase will be similar to the SEC’s interpretation in this proposal.

Comments on the proposed rules are due by July 13, 2015.

Arrange, Negotiate or Execute

In short, the proposed rules would apply some—but not all—SEC Title VII rules to the security-based swap transactions of non-U.S. persons that are “arranged, negotiated, or executed” by U.S.-Located Personnel, particularly when that U.S. conduct is in a dealing capacity. Unlike CFTC Staff Advisory 13-69, the SEC’s August 2014 final cross-border rule and the Volcker Rule, the SEC provides interpretive guidance in the adopting release to the proposed rules regarding when the activities of the personnel of a non-U.S. person that is a potential or registered security-based swap dealer or its agent would and would not be considered “arranging, negotiating or executing” security-based swap transactions. The table below describes examples the SEC provided of these activities.

Activities that would be considered arranging, negotiating or executing security-based swap transactions by U.S.-Located Personnel:
  • engaging in market-facing activity by sales or trading personnel in connection with a particular transaction, including interactions with counterparties or their agents;
  • engaging in a market-facing act that causes the potential or registered security-based swap dealer to become irrevocably bound under the security-based swap under applicable law;
  • responding to counterparty solicitations to enter into a dealing transaction or actively seeking out such counterparties;
  • arranging or negotiating the economic terms of a specific security-based swap transaction;
  • arranging, negotiating or executing security-based swap transactions in a dealing capacity using U.S.-Located Personnel to respond to inquiries from a non-U.S.-person counterparty outside business hours in the counterparty’s jurisdiction; and
  • directing other personnel to arrange, negotiate or execute a particular security-based swap.
Activities that would not be considered arranging, negotiating or executing security-based swap transactions by U.S.-Located Personnel:
  • submitting a security-based swap for clearing or reporting the security-based swap to a swap data repository in the United States;
  • engaging in activities related to collateral management, such as the exchange of margin, either in the United States or involving U.S. banks or custodians;
  • engaging in transactions that incidentally occur in the United States, such as activity of a non-U.S. employee of a potential or registered security-based swap dealer assigned to a non-U.S. office who happens to be traveling in the United States;
  • engaging in activity that involves U.S. personnel performing internal functions, such as the processing of trades or other back-office activities;
  • designing a security-based swap from within the United States, provided that (i) there is no communication with the counterparty regarding the contract in connection with a specific transaction, and (ii) the person designing the specific security-based swap does not execute any trades in the contract;
  • preparing underlying documentation for a security-based swap, including negotiating a master agreement and related documentation or performing ministerial or clerical tasks in connection with the security-based swap transaction, provided that the person is not negotiating the specific economic terms of a particular security-based swap; and
  • involving a U.S.-based attorney in negotiations regarding the terms of the transaction.

In contrast to the approach taken in the proposed rules, the SEC’s May 2013 proposal looked to whether a transaction was “conducted within the United States,” which would have required a non-U.S. person that is a potential or registered security-based swap dealer to look at its U.S. conduct as well as that of its counterparty in determining the application of security-based swap rules to a particular transaction. Under the proposed rules, a non-U.S. person that is a potential or registered security-based swap dealer would not need to look to the location of conduct of its counterparty in determining whether security-based swap rules would apply to a transaction; however, it would need to monitor the activities of its own agents, regardless of whether the agent is an affiliate. In this regard, the SEC does not explicitly provide that a party may rely on the representations of its agent with respect to the location of its conduct.

The SEC emphasized that the proposal’s approach in focusing on the activities of potential or registered security-based swap dealers—and not on all market participants, generally—is based on its analysis of empirical data on the nature and liquidity of the North American single-name CDS market, which showed dealer involvement in approximately 99% of price forming transactions in 2014.

Security-Based Swap Dealer De Minimis Counting for Non-U.S. Persons

The proposal adds some cross-border security-based swaps to those which a potential non-U.S. person must count toward its de minimis threshold. These are in addition to the types of transactions required to be counted under the SEC’s August 2014 final cross-border rules, which are described more fully in the Appendix to the complete publication. Under the proposal, a non-U.S. person would need to count toward its de minimis threshold any security-based swap dealing transaction that is arranged, negotiated or executed by U.S.-Located Personnel, regardless of whether the transaction was entered into anonymously on a registered SBSEF or national securities exchange and cleared. This change would remove an exception from counting security-based swap dealing transactions of a non-U.S. person that is not a conduit affiliate that are entered into anonymously on a registered SBSEF or national securities exchange and cleared. The SEC states that this exception is now unnecessary as the non-U.S. potential security-based swap dealer need not look to its counterparty in determining whether a security-based swap must be included in its own de minimis calculation.

The SEC estimates that approximately 50 entities will ultimately have to register as security-based swap dealers, of which 22 are expected to be non-U.S. persons.

External Business Conduct Requirements

Consistent with its previous proposal, the SEC proposes to apply the external business conduct requirements (other than those relating to diligent supervision) only to the “U.S. business” of a registered security-based swap dealer, not to its “foreign business,” each as defined in the accompanying sidebar. The proposed rules would revise the proposed definition of “U.S. business” in relation to non-U.S. security-based swap dealers, to account for the change in application from “transactions conducted within the United States” to transactions that are arranged, negotiated or executed by U.S.-Located Personnel. In addition, the SEC states that substituted compliance may be available for these transactions, pending further rulemaking and a comparability determination by the SEC.

The Appendix to the complete publication compares the application of the SEC’s external business conduct rules with the CFTC’s current regime.

Security-Based Swap Reporting and Public Dissemination Requirements

The proposed rules would amend Regulation SBSR’s reporting requirements to add to the types of security-based swap transactions subject to reporting and public dissemination under final Regulation SBSR. Under the proposal, a security-based swap meeting any one of the following conditions would need to be reported to a security-based swap data repository and publicly disseminated, even if both counterparties to the transaction are non-U.S. persons:

  • executed on a platform having its principal place of business in the United States;
  • effected by or through a registered broker-dealer (including a registered SBSEF); or
  • connected with a non-U.S. person’s security-based swap dealing activity that is arranged, negotiated or executed by U.S.-Located Personnel.

The “reporting side” for these security-based swap transactions would be determined as described in the accompanying sidebar. The SEC notes that the transaction types listed here would be eligible for substituted compliance, should the SEC grant a comparability determination covering the relevant jurisdiction,

New Impact on Registered Broker-Dealers

Registered broker-dealers (including registered SBSEFs) would be required to report and publicly disseminate any security-based swap that is effected by or through the registered broker-dealer, if both counterparties to the transaction are non-U.S. persons that are not registered security-based swap dealers or major security-based swap participants that did not arrange, negotiate or execute the transaction using U.S.-Located Personnel. As a result, these broker-dealers would be required to become participants of a security-based swap data repository. In addition, they would need to establish, maintain and enforce written policies and procedures reasonably designed to ensure compliance with their reporting obligations, which must be reviewed and updated at least annually.

Unlike the CFTC’s approach in CFTC Staff Advisory 13-69—which looked to apply mandatory clearing and trade execution requirements to a swap between a non-U.S. swap dealer and a non-U.S. person if personnel of the swap dealer located in the United States were regularly involved in arranging, negotiating or executing swaps—the SEC recognized that mandatory clearing is a counterparty credit risk management measure, and that conduct in the United States alone does not implicate the underlying policy rationale for applying the clearing requirement to security-based swap transactions between non-U.S. person counterparties. As a result, the SEC states that mandatory clearing would not apply to a security-based swap transaction between two non-U.S. persons where neither counterparty’s obligations are guaranteed by a U.S. person, solely because one or both counterparties arrange, negotiate, or execute the security-based swap using U.S.-Located Personnel. As mandatory trade execution follows mandatory clearing, under the proposal, the requirements would be applied consistently.

Mandatory Clearing and Trade Execution Requirements

The SEC noted, however, that it would continue to monitor developments in the security-based swap market and may reconsider this proposed approach in the future.

Endnotes:

[1] See also Davis Polk’s prior memoranda on the cross-border regulation of swaps and security-based swaps: SEC Proposed Cross-Border Security-Based Swap Rules (May 16, 2013); SEC Adopts Security-Based Swap Cross-Border Definitional Rule (July 3, 2014); CFTC Finalizes Cross-Border Swaps Guidance and Establishes Compliance Schedule (July 30, 2013); and CFTC Issues Cross-Border Substituted Compliance Determinations, Provides Limited Phase In for Some Swap Requirements (Jan. 7, 2014).
(go back)

[2] Compliance with CFTC Staff Advisory 13-69 is currently delayed by no-action relief until September 30, 2015; see CFTC Letter No. 14-140 (Nov. 14, 2014).
(go back)

Both comments and trackbacks are currently closed.