Developments of Note
- FinCEN to Hold Public Hearings on Proposal to Require Banks and Other Financial Institutions to Establish Customer Due Diligence Programs
- CFTC and SEC Approve Product Definition Rules for Swaps and Security-Based Swaps; Rules Trigger Compliance Obligations Under Certain CFTC Regulations
- CFTC Issues No Action Relief for Newly-Formed Commodity Pools, Denies Other Requested Relief
- CFTC Approves Final Rule on End-User Exception to Clearing Requirement for Swaps
- CFTC Reopens Comment Period for Proposed Rule on Margin Requirements for Uncleared Swaps
- FDIC Issues Letter Cautioning Depository Institutions Against Passing On Fees to Customers as "Deposit Insurance Fees," "FDIC Fees" or Other Similarly Described Fees
- Regulation of Non-European Firms under Financial Instruments Directive II – A Progress Report
- FFIEC Issues Statement on Cloud Computing Services
- FINRA Sets Effective Date for New Rules Consolidating and Amending NASD and NYSE Rules and Interpretations Relating to Communications with the Public
- Goodwin Procter Alert: SEC Adopts Final Rules on Listing Standards for Compensation Committee and Compensation Adviser Independence
DEVELOPMENTS OF NOTE
FinCEN to Hold Public Hearings on Proposal to Require Banks and Other Financial Institutions to Establish Customer Due Diligence Programs
As previously discussed in the February 29, 2012 Financial Services Alert, the Financial Crimes Enforcement Network ("FinCEN") issued an advance notice of proposed rulemaking (the "Advance Notice") in which it sought comment on a proposal to expressly require that financial institutions, including initially banks, brokers or dealers in securities, mutual funds, futures commission merchants and introducing brokers in commodities conduct customer due diligence ("CDD"), including by collecting beneficial ownership information for all customers, with limited exceptions. On July 9, 2012, FinCEN issued a notice of public hearing and request for comment (the "Notice") in which it announced that, on July 31, 2012, it will hold the first in an intended series of public hearings to obtain detailed clarification on the following issues:
(1) How and when financial institutions currently obtain beneficial ownership information;
(2) Whether and how financial institutions currently verify beneficial ownership information obtained from their customers;
(3) The costs associated with obtaining beneficial ownership information under current practices, versus the expected costs associated with obtaining beneficial ownership information as discussed in the Advance Notice;
(4) The costs associated with verifying beneficial ownership information (to the extent done under current practices), versus the expected costs associated with verifying beneficial ownership information as discussed in the Advance Notice;
(5) Potential definitions of "beneficial owner" alternative to the definition set forth in the Advance Notice (and why such alternatives would be preferable from a financial institution's perspective);
(6) How identifying beneficial owners enhances a financial institution's ability to manage risk, as well as the circumstances and account relationships in which beneficial ownership information may not be relevant in managing risk;
(7) As a result of commenters' suggestions that financial institutions be required to obtain beneficial ownership information on a risk-based basis: (i) how financial institutions would expect to assess risk in determining whether to obtain beneficial ownership information; (ii) specific examples of any customer or account relationships or red f1ags that would be considered of higher risk or lower risk for purposes of obtaining and verifying beneficial ownership information; (iii) how financial institutions would obtain and verify and beneficial ownership information on a risk basis; and (iv) for financial institutions that already obtain beneficial ownership information on a risk basis, detailed information as to when they obtain it;
(8) The abilities and limitations of a financial institution in mitigating risk associated with its customer's underlying clients in the context of intermediated accounts;
(9) How financial institutions currently conduct due diligence on trust accounts, including how they assess risk and what information they obtain;
(10) The differences in obtaining beneficial ownership information from foreign legal entity customers compared to domestic legal entity customers; and
(11) Whether and how financial institutions identify whether legal entity customers are "shell companies."
Requests to attend the hearing or to provide oral comments, as well as written outlines of oral comments, must be received by FinCEN by July 24, 2012. The information that must accompany such requests as well as information regarding where to send such requests is available on Pages 3 to 4 of the Notice.
CFTC and SEC Approve Product Definition Rules for Swaps and Security-Based Swaps; Rules Trigger Compliance Obligations Under Certain CFTC Regulations
The CFTC and SEC approved joint final rules and interpretive guidance further defining the terms "swap," "security-based swap," and "security-based swap agreement," as well as establishing regulations applicable to "mixed swaps." The SEC vote was unanimous. The CFTC vote was 4-1.
As of the date of this publication, the CFTC has posted the final rules on its website, but the final rules have not been published in the Federal Register. This summary is based on a fact sheet and "Q&A" published by the CFTC as well as a press release issued by the SEC. It is subject to the final rules as published.
The rules will become effective 60 days after their forthcoming publication in the Federal Register.
Swap and Security-Based Swap
The terms "swap" and "security-based swap" were defined in the Dodd-Frank Act, and the joint final rules further develop and clarify those definitions. The release uses the term "Title VII Instrument" (referring to the relevant portion of the Dodd-Frank Act) to collectively refer to swaps, security-based swaps, and "mixed swaps," which are discussed below.
The rules state that whether a Title VII Instrument is a swap, security-based swap, or mixed swap (discussed below) is determined prior to the execution of such instrument and will remain the same throughout the life of the instrument, unless it is amended or modified in a material respect. The rules also provide a process through which any person may petition the CFTC and the SEC to provide a joint interpretation of whether a particular instrument is a swap, security-based swap, or mixed swap.
What Is Included
The rules specify that the following are Title VII Instruments: foreign exchange swaps and forwards, certain foreign currency options, commodity options, non-deliverable forwards in foreign exchange, currency and cross-currency swaps, forward rate agreements, contracts for differences, options to enter into swaps, and forward swaps.
The rules clarify that Title VII Instruments based on interest rates and other monetary rates are swaps, but those based on "yields," in which "yield" is a proxy for the price or value of a debt security, loan, or narrow-based security index, generally are security-based swaps. A total return swap ("TRS") on a single security, loan, or narrow-based security index will usually be a security-based swap, while a TRS based on a broad-based security index will typically be a swap. Futures generally are swaps, but those based on security futures are security-based swaps.
Credit default swaps ("CDS") based on a security index may either be swaps or security-based swaps. CDS based on a broad-based security index are classified as swaps (but see the discussion of security-based swap agreements, below), while those based on a single security or a narrow-based security index are classified as security-based swaps. The rules provide extensive criteria, guidance, and rules on the terms and factors relevant to the distinction between a broad-based security index and a narrow-based security index.
Under the rules, transactions that are willfully structured to evade the requirements of the Dodd-Frank Act will be treated as swaps. The rules provide interpretive guidance regarding what may and may not constitute evasion.
What Is Excluded
The rules also clarify that certain products are not Title VII Instruments. For example, the rules offer a safe harbor regarding insurance products, excluding from the definition of "swap" and "security-based swap" the products that are enumerated in the rules and those that satisfy two tests, the "Product Test" and the "Provider Test." The Product Test establishes requirements for the product, such as requiring that the beneficiary has an insurable interest and carries the risk of loss, that the loss must occur, and that the contract must not be traded separately from the insured interest. The "Provider Test" requires the provider fall into a list of categories, including a person subject to supervision by a state or federal insurance commissioner. In addition, certain enumerated products, such as life insurance and property and casualty insurance, if offered by persons who meet the Provider Test, will not be Title VII Instruments. Furthermore, pre-existing insurance contracts that meet the Provider Test are grandfathered and are not "swaps" or "security-based swaps."
Certain consumer transactions entered into by natural persons primarily for personal, family, or household purposes also are not Title VII Instruments. Such transactions include contracts for the acquisition or lease of real or personal property, contracts to purchase products and services for personal, family, or household purposes at a fixed price and at a future date or over a certain time period (such as a consumer's agreement to purchase home heating fuel for personal use at a future date for a fixed price), and interest rate caps or locks on a consumer loan or mortgage.
Also excluded from the definitions of "swap" and "security-based swap" are certain commercial transactions, such as employment contracts, sales or distribution arrangements, merger agreements, sales or leases of assets such as equipment or intellectual property, and certain commercial loans entered into by banks and non-banks. Traditional loan participations generally are excluded as well.
The definition of "swap" included in the Dodd-Frank Act excludes forward contracts in nonfinancial commodities. The final rules clarify how the CFTC will interpret this exclusion. For example, provisions such as liquidated damages and renewal/evergreen provisions will not disqualify a transaction from the forward exclusion, and fuel delivery agreements and physical exchange transactions will not be swaps. Furthermore, "booked-out" transactions in nonfinancial commodities entered into by commercial participants in connection with their business, which meet the requirements in the CFTC's Brent Interpretation regarding forwards and are effectuated through a subsequent, separately-negotiated agreement, will qualify for the forward exclusion from the swap definition.
The rules acknowledge that the Dodd-Frank Act gives the Secretary of the Treasury the option to determine that foreign exchange forwards or foreign exchange swaps should not be regulated as swaps. However, the rules require that such products will still be subject to reporting requirements, while swap dealers and major swap participants engaging in such transactions will still be required to meet business conduct standards.
"Mixed swaps" are products that meet the definitions of both swap and security-based swap. Mixed swaps are defined in the Dodd-Frank Act as security-based swaps that are also based on the value of one or more interest or other rates, currencies, commodities, or certain other variables. The rules state that this is intended to be a narrow category and offer only a few examples of mixed swaps. For example, this category includes TRS based on a single security or a narrow-based security index and embedding interest-rate optionality or a non-securities component, such as the price of oil. It also includes broad-based CDS that require mandatory physical settlement.
The Dodd-Frank Act requires the CFTC and SEC to jointly prescribe regulations pertaining to mixed swaps. Mixed swaps generally will be subject to the entirety of both the CFTC and SEC regulatory regimes. However, bilateral uncleared mixed swaps entered into by at least one person that is both a swap dealer and security-based swap dealer, or a major swap participant or major security-based swap participant, will be subject to certain "key" provisions of the two regulatory regimes. For all other mixed swaps, the rules provide a mechanism by which a person who desires or intends to list, trade, or clear such mixed swap may petition the CFTC and SEC for a joint order permitting such persons (as well as any other person that subsequently lists, trades, or clears that class of mixed swap) to comply, as to parallel provisions only, with only the specified provisions of the Commodity Exchange Act or the Securities Exchange Act of 1934 and related regulations.
Security-Based Swap Agreement
A "security-based swap agreement" is a type of swap involving securities over which the CFTC has full regulatory and enforcement authority, but for which the SEC also has antifraud and enforcement authority. The SEC also is given access to information from certain CFTC-regulated entities involved with security-based swap agreements. The rules clarify that the books and records requirements regarding security-based swap agreements are the same as those the CFTC has adopted for swaps.
Security-based swap agreements include swaps on broad-based security indexes as well as swaps on exempted securities (other than municipal securities), such as U.S. Treasury bonds.
Rules Trigger Compliance Obligations Under Certain CFTC Rules
The publication of the product definition rules in the Federal Register will trigger compliance obligations under a number of other CFTC regulations affecting swaps and the parties to swap transactions. These obligations and their timing are discussed in the following paragraphs and summarized in the charts at the link below.
"Position Limits for Futures and Swaps," 76 FR 71626, became effective on January 17, 2012. These rules establish position limits for certain physical commodity futures and options contracts as well as physical commodity swaps that are economically equivalent to such contracts. The compliance commencement date for most provisions of these rules is 60 days after the product definition rules are published in the Federal Register. For more information on this rule see "CFTC Adopts Final Rules on Position Limits Which ISDA and SIFMA Challenge in Federal District Court".
"Commodity Options," 77 FR 25320, became effective on June 26, 2012. These rules repeal and replace the CFTC's existing regulations regarding commodity options. The compliance commencement date for these rules is 60 days after the product definition rules are published in the Federal Register.
"Swap Data Repositories: Registration Standards, Duties and Core Principles," 76 FR 54538, establishes registration requirements, statutory duties, core principles, and certain compliance obligations for registered swap data repositories. These rules became effective on October 31, 2011, and permit prospective swap data repositories to apply for registration as such starting on that date. However, the compliance commencement date for provisions involving mandatory registration and compliance with these registration rules is the effective date of the swap definition rulemaking, which is 60 days after the product definition rules are published in the Federal Register.
The rules entitled "Registration of Swap Dealers and Major Swap Participants," 77 FR 2613, went effective on March 19, 2012. As indicated by the title, these rules govern the registration of entities as "swap dealers" and "major swap participants." The rules require swap dealers and major swap participants, and those who intend to engage in business as such, to apply for registration as such by no later than the latest effective date of the entity definition rules and the product definition rules. In practice, this means that registration will be required by the effective date of the product definition rules, which is 60 days after such rules are published in the Federal Register. Compliance with certain other rules, discussed below, is tied to the date by which swap dealers and major swap participants are required to register, and therefore to the effective date of the product definition rules.
"Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties," 77 FR 9734, became effective on April 17, 2012. The rules require swap dealers and major swap participants to meet a number of external business conduct standards. The compliance commencement date is the later of (1) 180 days after the effective date of the rule and (2) the date on which swap dealers or major swap participants are required to apply for registration. In practice, this means that compliance will commence on October 14, 2012 because swap dealers and major swap participants are required to register no later than 60 days after the product definition rules are published in the Federal Register,which is likely to happen prior to August 15, 2012. (We note that October 14, 2012 will be a Sunday, with the preceding business day being October 12, 2012.)
"Swap Dealer and Major Swap Participant Recordkeeping and Reporting, Duties, and Conflicts of Interest Policies and Procedures; Futures Commission Merchant and Introducing Broker Conflicts of Interest Policies and Procedures; Swap Dealer, Major Swap Participant, and Futures Commission Merchant Chief Compliance Officer," 77 FR 20128 (the "Duties, Conflicts, and CCO Rules") are complex rules consisting of a number of largely independent provisions. Compliance with certain provisions of these rules is already required, but the compliance commencement dates for other provisions depends upon factors, including the dates on which swap dealers and major swap participants are required to register with the CFTC (which, in turn, is based on when the product definition rules are published in the Federal Register). For example, the compliance start date for several provisions of the Duties, Conflicts, and CCO Rules is the date that is the later of (1) 90 days after the publication of the Duties, Conflicts, and CCO Rules in the Federal Register (which was July 2, 2012 because the Duties, Conflicts, and CCO Rules were published 90 days earlier on April 3, 2012) and (2) the date on which swap dealers and major swap participants are required to apply for registration. Therefore, the date on which swap dealers and major swap participants are required to register will be the latter date, which (as mentioned above) is 60 days following the publication of the product definition rules in the Federal Register. The provisions of the Duties, Conflicts, and CCO Rules for which compliance is triggered on this timeline include the monitoring of position limits, diligent supervision, conflicts of interest, general information, and antitrust provisions applicable to all swap dealers and major swap participants. On the same date, compliance requirements commence for the recordkeeping, reporting limits, and risk management provisions applicable to those swap dealers and major swap participants that are currently regulated by a U.S. prudential regulator or are registrants of the SEC. Finally, with respect to futures commissions merchants, the compliance requirements begin on this same timeframe with respect to clearing activities provisions.
The compliance start date for further provisions of the Duties, Conflicts, and CCO Rules is the date that is the later of (1) 180 days after the publication of the Duties, Conflicts, and CCO Rules in the Federal Register and (2) the date on which swap dealers and major swap participants are required to apply for registration. As noted above, the Duties, Conflicts, and CCO Rules were published on April 3, 2012, so the date that is 180 days later is September 30, 2012. (We note that September 30, 2012 will be a Sunday, with the preceding business day being September 28, 2012.) It seems likely that the products definition rules will be published in the Federal Register during the month of July, in which case September 30, 2012 will be the later date and, therefore, the date on which the compliance period begins. (Again, we note that September 30, 2012 will be a Sunday, with the preceding business day being September 28, 2012.) The relevant provisions of the Duties, Conflicts, and CCO Rules for which compliance requirements commence include the business continuity, disaster recovery, and Chief Compliance Officer provisions for those swap dealers and major swap participants that are currently regulated by a U.S. prudential regulator or are registrants of the SEC. The compliance requirements commence at the same time with respect to the recordkeeping, reporting limits, and risk management provisions for those swap dealers and major swap participants that are not currently regulated by a U.S. prudential regulator and are not registrants of the SEC. Finally, the same compliance start date applies, with respect to the Chief Compliance Officer provisions, to futures commissions merchants that are both (1) registered with the CFTC as of the effective date of the Duties, Conflicts, and CCO Rules (which was June 4, 2012) and (2) currently regulated by a U.S. prudential regulator or are registrants of the SEC.
The compliance start date for additional provisions of the Duties, Conflicts, and CCO Rules is the date that is the later of (1) 270 days after the publication of the Duties, Conflicts, and Chief Compliance Officer Rules in the Federal Register and (2) the date on which swap dealers and major swap participants are required to apply for registration. As noted above, the Duties, Conflicts, and CCO Rules were published on April 3, 2012, so the date that is 270 days later is December 29, 2012. (We note that December 29, 2012 will be a Saturday, with the preceding business day being December 28, 2012.) This is virtually certain to be the later date and therefore the date on which the compliance period begins with respect to the applicable provisions of the Duties, Conflicts, and CCO Rules. Provisions for which the compliance requirements commence on this date include the business continuity and disaster recovery provisions applicable to those swap dealers and major swap participants that are not regulated by a U.S. prudential regulator and are not registered with the SEC.
Additional provisions of the Duties, Conflicts, and CCO Rules have a fourth and later compliance start date: specifically, the later of (1) 360 days after the publication of the Duties, Conflicts, and CCO Rules in the Federal Register and (2) the date on which swap dealers and major swap participants are required to apply for registration. The compliance date for these provisions therefore is March 29, 2013. Such provisions include the Chief Compliance Officer provisions with respect to swap dealers and major swap participants that are not currently regulated by a U.S. prudential regulator and are not registrants of the SEC, as well as futures commission merchants that were registered with the CFTC on the effective date of the Duties, Conflicts, and CCO Rules (which was June 4, 2012) and are not currently regulated by a U.S. prudential regulator and are not registrants of the SEC.
Three reporting rules phase in compliance, keying off of the publication of the product definition rules in the Federal Register. "Real-Time Public Reporting of Swap Transaction Data," 77 FR 1182 ("Real Time Reporting Rules"), went effective on March 9, 2012. Those rules govern the public reporting of certain swap transaction data. The rules entitled "Swap Data Recordkeeping and Reporting Requirements," 77 FR 2136 ("Swap Data Recordkeeping Rules"), went effective on March 13, 2012 and require parties to adhere to certain requirements regarding recordkeeping and reporting of swap data. "Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps," 77 FR 35200 ("Swap Data Recordkeeping (Pre-Enactment/Transition) Rules"), becomes effective on August 13, 2012 and requires parties to adhere to certain requirements regarding the recordkeeping and reporting of data pertaining to swaps that precede, but remain effective after, the date on which Dodd-Frank was enacted, as well as swaps executed on or after that date but before the compliance date of the rule.
Each of these three reporting rules has three compliance start dates. In each case, the first commencement date applies to credit swaps and interest rate swaps and is 60 days after the publication of the product definition rules in the Federal Register. The Real Time Reporting Rules apply to swap execution facilities, designated contracts markets, swap data repositories, swap dealers, and major swap participants; the Swap Data Recordkeeping Rules apply to derivatives clearing organizations as well as each of the aforementioned entities, while the Swap Data Recordkeeping (Pre-Enactment/Transition) Rules apply only to swap dealers and major swap participants. Commencing on the second compliance date for these reporting rules, which is 90 days after the first compliance start date (or 150 days following publication of the product definition rules in the Federal Register), these same entities will be required to comply with respect to equity, foreign exchange, and "other commodity" asset classes. Finally, from the third compliance date, 90 days after the second compliance start date (or 180 days after the first compliance date and 240 days after publication of the product definition rules in the Federal Register), all parties subject to these reporting rules will be required to comply with the Real Time Reporting Rules for all publicly reportable swap transactions in all asset classes. From that same date, all other counterparties (i.e., other than swap dealers and major swap participants, which, by such date, are already subject to the compliance obligations) will also be required to comply with Swap Data Recordkeeping Rules and Swap Data Recordkeeping (Pre-Enactment/Transition) Rules.
Additionally, a number of rules enacted under the Dodd-Frank Act are affected by the final product definitions of the term "swap" or its related entity definitions. For example, "Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations," 77 FR 11252, became effective on April 24, 2012. These rules amend a number of regulations relevant to commodity pool operators and commodity trading advisors, and the definition of "swap" is relevant to determining certain exemptions. These rules require that registered commodity pool operators with at least $5 billion in assets under management attributable to commodity pools must submit reports to the CFTC on Form CPO-PQR by November 29, 2012 (60 days following the calendar quarter ending after September 15, 2012). All remaining registered commodity pool operators must submit reports to the CFTC on Form CPO-PQR by March 29, 2013 (88 days following the end of the calendar year; 90 days following the end of the calendar year falls on a Sunday). The rules require that all registered commodity trading advisors submit reports to the CFTC on Form CTA-PR by February 14, 2013 (45 days after the end of the fiscal year). Compliance is required for all remaining provisions of the rule by December 31, 2012. Entities that had been exempt from registering as commodity pool operators and commodity trading advisors pursuant to Section 4.13(a)(4) and 4.14(a)(8), respectively, that will be required to register with the CFTC by December 31, 2012 as a result of the rules will not be required to comply with the reporting rules described in this paragraph until they are registered as commodity pool operators or commodity trading advisors.
The foregoing timeline focuses on CFTC regulations. For a discussion of the SEC's proposed timeline for issuing regulations pertaining to security-based swaps and related matters, see "SEC Releases Statement on Anticipated Sequencing of Dodd-Frank Rules for Security-Based Swaps" and the SEC's posting of its proposed timeline.
CFTC Issues No Action Relief for Newly-Formed Commodity Pools, Denies Other Requested Relief
The CFTC's Division of Clearing and Intermediary Oversight (the "Division") published a no-action letter on July 13, 2012 (the "Letter") that provides temporary relief from CFTC registration requirements to general partners and advisors of commodity pools formed between July 11, 2012 and December 31, 2012. The Letter denied other relief sought by industry groups related to CFTC registration obligations. The Letter allows entities that are commodity pool operators ("CPOs") and commodity trading advisors ("CTAs") under CFTC regulations to avail themselves of the "QEP Exemption" (and the corresponding exemption for CTAs) with respect to commodity pools launched after the issuance of the Letter (the Letter is dated July 10, 2012) and December 31, 2012. To obtain relief, entities must file a claim with the CFTC. The QEP Exemption (and the corresponding exemption for CTAs) expires on December 31, 2012. Final rules issued by the CFTC on February 9, 2012 rescinded the QEP Exemption with respect to commodity pools formed before April 24, 2012, effective on December 31, 2012.
The Letter responds to two letters from industry groups. In addition to the temporary relief granted by the Letter, the Managed Funds Association, the Investment Adviser Association and the Alternative Investment Management Association in a letter dated April 30, 2012 and the Investment Company Institute, in a letter dated May 21, 2012, had also requested an extension of time during which (i) a CPO could claim an exemption from registration under 17 CFR 4.13(a)(3) (the "De Minimis Exemption") and 17 CFR 4.5 (the "Regulated Entity Exemption") without including swaps in the CPO's calculations to determine whether it qualifies for the De Minimis Exemption or the Regulated Entity Exemption and (ii) entities may rely on the QEP Exemption. The Division denied these requests.
At this point, it appears unlikely that the CFTC will provide further relief related to the rescission of the QEP Exemption or the new restrictions associated with the De Minimis Exemption. In providing the temporary relief to newly formed commodity pools that expires on December 31, 2012, the Letter states "[t]he Division believes that setting a specific compliance date that applies to all similarly situated CPOs and CTAs is appropriate." Therefore, advisors to private funds or accounts that hold commodities and that presently rely on the QEP Exemption in order to avoid registering with the CFTC should turn their attention at this time to determining whether they are eligible for the De Minimis Exemption. If they are not, they will need to begin the CFTC registration process soon in order to achieve registration by December 31, 2012.
CFTC Approves Final Rule on End-User Exception to Clearing Requirement for Swaps
The CFTC unanimously approved a final rule on the end-user exception to the clearing requirement for swaps. The rule further develops a provision of the Dodd-Frank Act that requires swaps to be submitted for clearing to a derivatives clearing organization unless one of the counterparties to a swap is not a financial entity, is using the swap to hedge or mitigate commercial risk, and notifies the CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps.
The rule sets out the reporting requirements that apply if the counterparties choose to avail themselves of the exception. In contrast to the proposed rule, which would have required reporting on a swap by swap basis, the final rule adds the option of annual reporting. It also establishes criteria for determining whether a swap is "hedging or mitigating commercial risk." Finally, the rule establishes a "small financial institution exemption" that exempts banks, savings associations, farm credit system institutions, and credit unions with total assets of $10 billion or less from the definition of "financial entity," thereby potentially allowing them to use the end-user exception.
The rule will become effective 60 days after its forthcoming publication in the Federal Register.
CFTC Reopens Comment Period for Proposed Rule on Margin Requirements for Uncleared Swaps
The CFTC reopened the comment period for its proposed rule, published in the Federal Register on April 28, 2011, that would establish initial and variation margin requirements on uncleared swaps for swap dealers and major swap participants. Reopening the comment period is intended to give interested parties the opportunity to comment in light of recent international efforts to harmonize margin requirements for uncleared swaps.
Comments are due by September 14, 2012.
FDIC Issues Letter Cautioning Depository Institutions Against Passing On Fees to Customers as "Deposit Insurance Fees," "FDIC Fees" or Other Similarly Described Fees
The FDIC issued a Financial Institution Letter (FIL-33-2012), the "Letter") in which the FDIC discouraged insured depository institutions ("IDIs") from passing on fees to customers as "deposit insurance fees," "FDIC fees" or other similarly described fees. The FDIC said in the Letter that while IDIs are not prohibited from passing on the costs of deposit insurance to customers, they should refrain from "specifically designating that a customer fee is for deposit insurance" and from stating or implying that the FDIC is charging such a fee [to the customer]. The FDIC further stated in the Letter that by passing on FDIC fees to customers, an IDI could violate the prohibition against disclosure of confidential examination and supervisory information, as the fees imposed by the FDIC reflect its risk-based supervisory evaluation of the applicable IDI. Moreover, fees labeled as "FDIC fees" may be misleading if "they are not reasonably related to the proportional cost of deposit insurance allocable to a particular customer..." Generally, IDIs that take steps to recoup the costs of deposit insurance impose such charges on business customers and do not charge the fees to consumer accounts.
Regulation of Non-European Firms under Financial Instruments Directive II – A Progress Report
The Current Position in Europe
Any non-European firm carrying on any investment service with European clients or counterparties currently operates under a patchwork of different national regulatory regimes, ranging from the liberal (e.g., the UK where all cross border business is permitted except with retail investors) through to the restricted (e.g., Germany where all solicitation and marketing is technically prohibited but an unofficial tolerated practice appears to have developed that allows institutional business to carry on in a gray zone).
The European Commission's Proposals
The European Commission in October 2011, therefore, set out proposals (amongst many other things) to harmonize the European regulatory regime for non-European firms dealing with Europeans. These proposals, if they are enacted in this form, will prohibit a non-European person from carrying on any regulated financial services business with a European person except:
(1) where a firm itself has established an authorized branch in the European Union (subsidiaries or branches of other group firms will not be sufficient);
(2) neither the specific business nor the relevant client relationship has been solicited by the non-European firm (the so-called "reverse solicitation test"); or
(3) the business is undertaken only with "eligible counterparties" – in effect banks, brokers, investment managers, insurance companies, etc. To use this exemption, the firm would have to be included on a list maintained by the European Securities and Markets Authority – a quasi-European supra-regulatory authority.
This has, rightly, been referred to as "Fortress Europe," and we are monitoring its possible consequences for US firms carefully as the proposals pass through the various stages.
The Official Response
The Presidency of the Council of the European Union (the representative of Member States' governments) has recently published a progress report on the MiFID II legislative proposals.The aim of the progress report is to provide an update on the status of the various discussions and issues that have arisen from MiFID II. Although the report states that there is, "in principle," agreement on a number of the proposals, it is also clear that a number of issues are still to be resolved, some even potentially requiring discussion at a political level.
The report notes that "several Member States have expressed serious concerns and have strong reservations" about the Commission's proposal on third countries. The Member States' view is that the proposal is "unnecessary and disproportionate." The report, though, appears to indicate that the substance of the proposals should in due course be amenable to agreement by the relevant countries.
The United Kingdom's House of Lords European Committee scrutinizing the draft text is more critical, however, calling the proposal "deeply flawed" and urging the UK government to ensure that the final version of the text does not close the European financial market to non-European firms: http://www.publications.parliament.uk/pa/ld201213/ldselect/ldeucom/28/28.pdf.
So where does this leave us? There is clearly considerable opposition to the proposal to close European markets to third country firms. The only question, though, is how effective this opposition will be given that the same argument was lost in the final position of the Alternative Investment Fund Managers Directive. Under this directive, from 2018, non-European managers will be prohibited from promoting funds to European investors unless that manager is also authorized in the European Union.
It is expected that agreement on these issues should reached by the end of the year, with the Directive not coming into force before 2015.
FFIEC Issues Statement on Cloud Computing Services
On July 11, 2012, the federal financial regulatory agencies, through the Federal Financial Institutions Examination Council ("FFEIC"), issued a joint interagency statement (the "Statement") on the use of cloud computing services by financial institutions. In particular, the statement focused on the risks associated with such services. Cloud computing provides its users with information technology ("IT") services through the internet, rather than through owned or leased IT servers or platforms. This outsourcing of IT services offers many benefits to users, including increased operational efficiencies, lower costs and better backup services. However, the FFIEC warns that use of cloud computing involves many of the same risks as traditional IT outsourcing, as well as certain risks that are particular to cloud computing.
The Statement first focuses on the due diligence that a financial institution should perform before outsourcing any significant IT functions to a cloud computing vendor. A financial institution should understand how the vendor encrypts data, segregates the data of its various users, and backs up the data in the cloud. The Statement also recommends confirming with the cloud computing vendor that it is aware that a financial institution, as a client, has particular regulatory requirements for safeguarding its customer data. The vendor should be able to meet such requirements, and adapt its services should any of the requirements change.
The Statement also discusses the internal adjustments that a financial institution needs to make to use cloud computing properly. Auditing practices should be updated to be able to determine if a vendor's internal controls are sufficient. A financial institution may also need to provide its internal auditors with additional training or hire additional personnel to ensure sufficient experience with shared environments and virtualized technologies.
The Statement also recommends that financial institutions using cloud computing revise their information security policies and practices. Maintaining data privacy is still ultimately the financial institution's responsibility, so additional monitoring and data inventory may be required to ensure compliance. Lastly, financial institutions need to review the legal, regulatory and reputational considerations that must be addressed when a financial institution uses cloud computing. Financial institutions should also revise their business continuity plans to reflect the use of such new services.
FINRA Sets Effective Date for New Rules Consolidating and Amending NASD and NYSE Rules and Interpretations Relating to Communications with the Public
FINRA issued a Regulatory Notice announcing that the effective date for new rules consolidating and amending NASD and NYSE Communications Rules and Interpretations is February 4, 2013. The new rules, which were approved by the SEC on March 29, 2012, are as follows:
- 2210 – Communications with the Public
- 2212 – Use of Investment Companies Rankings in Retail Communications
- 2213 – Requirements for the Use of Bond Mutual Fund Volatility Ratings
- 2214 – Requirements for the Use of Investment Analysis Tools
- 2215 – Communications with the Public Regarding Security Futures
- 2216 – Communications with the Public about Collateralized Mortgage Obligations
The SEC approved FINRA's proposal to adopt the new rules by release dated March 29, 2012. The content of the SEC release approving the new rules was discussed in the April 24, 2012 Financial Services Alert.
In announcing the effective date of the new rules, FINRA also provided guidance with respect to the application of the new rules. Among the topics covered in the guidance are the following:
Reason to Believe Standard. Noting that the definition of "institutional investor" in both new Rule 2210(a)(4) and in the prior rules require that "[n]o member may treat a communication as having been distributed to an institutional investor if the member has reason to believe that the communication or any excerpt thereof will be forwarded or made available to any retail investor[,]" FINRA confirmed that this standard does not impose an affirmative obligation on the member to inquire as to whether an institutional investor intends to distribute the communication to retail investors. Additionally, FINRA confirmed that this standard does not create an obligation for a fund underwriter to supervise the associated persons of recipient broker-dealers, and provided guidance on how a member should respond in the event that it becomes aware that a recipient institutional investor, is or may be, distributing the communication to retail investors.
Exemptive Relief. Noting that new Rule 2210(b)(1)(E) and new Rule 2210(c)(9) allow FINRA to grant exemptive relief with respect to pre-use approval requirements and concurrent-with-use filing requirements, respectively, FINRA clarified that it only intends to grant such relief in unique circumstances on a case-by-case basis. Furthermore, FINRA clarified that any such relief will apply only to the firms that have applied for the relief. If FINRA determines that similar relief is warranted for similarly situated members, it will file a proposed rule change.
Illustrations of Impact of Tax Decisions. Noting that new Rule 2210(d)(4)(C) adds new language concerning comparative illustrations of the mathematical principles of tax-deferred versus taxable compounding, FINRA describes in detail the required content of such illustrations and confirms that the standards contained in the new rule apply to any illustration of tax-deferred versus taxable compounding, regardless of whether it appears in a communication promoting variable insurance products or some other communication, such as one discussing the benefits of investing through a 401(k) retirement plan or individual retirement account.
Social Media. FINRA notes that under new Rule 2210(c)(7)(M) communications that are posted on an online interactive electronic forum, such as an electronic bulletin board or an interactive forum that is contained on a social media website, are considered retail communications; however, they are excluded from new Rule 2210's filing obligations.
Goodwin Procter Alert: SEC Adopts Final Rules on Listing Standards for Compensation Committee and Compensation Adviser Independence
Goodwin Procter's Capital Markets Practice issued a client alert describing final rules adopted by the SEC pursuant to the Dodd-Frank Act which: (1) direct the national securities exchanges to adopt listing standards regarding the independence of compensation committees and the engagement and independence of compensation advisers, and (2) impose additional proxy statement disclosure requirements regarding the use of compensation consultants.
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.
This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2012 Goodwin Procter LLP. All rights reserved.