United States: CFTC Cross-Border Margin Proposal

On June 29, 2015, the Commodity Futures Trading Commission ("CFTC") issued a proposed rule¹ (the "Proposed Rule") on the cross-border application of the margin requirements with respect to uncleared swaps to be adopted by the CFTC pursuant to Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act² (the "Dodd-Frank Act"). When the CFTC issued a proposed rule containing such margin requirements on October 3, 2014, the CFTC also issued an Advance Notice of Proposed Rulemaking ("ANPR") containing three alternative approaches with respect to the potential cross-border application of the proposed margin requirements.³ The Proposed Rule is distinct from all three approaches set forth in that ANPR. Although the Proposed Rule was unanimously approved, two of the four Commissioners expressed skepticism as to its merits.⁴

The Proposed Rule imposes varying compliance obligations on uncleared swap transactions depending on whether one or both counterparties thereto qualifies as:

• a U.S. person; or
• a non-U.S. person: (1) whose obligations are guaranteed by a U.S. person; (2) that is a "Foreign Consolidated Subsidiary" of a U.S. person; or (3) acting through or by a U.S. branch.

Swaps between two non-U.S. persons who do not meet any of these three criteria would qualify for an exclusion from the CFTC's proposed margin requirements. This Stroock Special Bulletin will describe the proposed compliance obligations set forth in the proposal, as well as the proposed tests to determine the status of a counterparty to a swap.

Scope of Margin Requirements Proposed on October 3, 2014

The Proposed Rule sets forth criteria for determining whether and to what extent particular entities would be subject to margin requirements with respect to particular uncleared swap transactions. However, the Proposed Rule does not change the substantive proposals for how the margin requirements with respect to covered swap transactions would apply. The most recent CFTC guidance on that issue was set forth in its October 3, 2014 proposed rule.⁵ A brief summary of that proposed rule is provided below.

Initial Margin Requirements

• Minimum initial margin requirements would apply to uncleared swaps between:
  
  
  • a "covered swap entity" ("CSE")—a swap dealer ("SD") or major swap participant ("MSP") for which there is not a prudential regulator—and
  • an SD, MSP or "financial end user" (certain specified types of financial entities) with "material swaps exposure" (combined daily aggregate notional amount of uncleared derivatives exposure of an entity and its affiliates with all counterparties for a specified three months of the applicable calendar year exceeds $3 billion).
• Initial margin could be calculated based on a quantitative model that receives written approval from the CFTC or the applicable Prudential Regulator, or on a standardized margin schedule set forth in the proposals.
• Initial margin would only need to be collected when the aggregate credit exposure of all uncleared swaps or security-based swaps between the CSE and its affiliates and the covered counterparty and its affiliates exceeds $65 million.
• Initial margin would need to be held by a custodian who is: (1) not an affiliate of either counterparty; and (2) prohibited from rehypothecating, repledging, reusing or otherwise transferring the held funds or other property (with a limited exception for substitution of other funds or property that would qualify as eligible collateral or reinvestment in assets that would qualify as eligible collateral).
• Eligible collateral would consist of gold, U.S. dollars, other major currencies, any currency in which payment obligations under the swap are required to be settled and certain specified types of debt and equity securities.
• Initial margin would be exchanged daily on a bilateral basis, with a minimum transfer amount of $650,000.

Variation Margin Requirements

• Minimum variation margin requirements would apply to uncleared swaps between (1) a CSE and (2) an SD, MSP or financial end user.
• Netting would be allowed for variation margin owed with respect to uncleared swaps or security-based swaps executed pursuant to an eligible master netting agreement.
• Eligible collateral would consist only of U.S. dollars and any other currency in which payment obligations under the swap are required to be settled.
• Variation margin would be exchanged daily on a bilateral basis, with a minimum transfer amount of $650,000.

Exclusion from Margin Rules

The Proposed Rule excludes uncleared swap transactions from compliance with CFTC margin requirements if they are entered into between two non-U.S. persons: (1) whose obligations are not guaranteed by a U.S. person; (2) that are not "Foreign Consolidated Subsidiaries" of a U.S. person; and (3) that are not acting through or by a U.S. branch. The tests for whether entities would qualify for this exclusion (the "Exclusion") are described in further detail below.

Treatment of Certain Swaps Entered into or Guaranteed by a U.S. Person

Under the Proposed Rule, the regulatory obligations of (1) U.S. person CSE counterparties and (2) non-U.S. person CSE counterparties whose obligations under an uncleared swap are guaranteed by a U.S. person are both dependent on the nature of the particular counterparty to a specific uncleared swap transaction.

If the counterparty would be another U.S. person or non-U.S. person whose obligations under the relevant swap would be guaranteed by a U.S. person (including any persons who are not CSEs, to the extent a transaction with such a person would be subject to the CFTC margin requirements), the uncleared swap transaction would be subject to the U.S. margin requirements in full.

If the counterparty would be any non-U.S. person whose obligations under the uncleared swap would not be guaranteed by a U.S. person (whether or not such a person is a CSE), the uncleared swap transaction would be subject to the U.S. variation margin requirements in full. Such an uncleared swap would also be subject to the U.S. initial margin requirements with respect to the amount to be collected by the U.S. or U.S.-guaranteed CSE counterparty. With respect to the amount of initial margin to be posted by that counterparty, the U.S. initial margin requirements would apply as a baseline but with the possibility of substituted compliance (to the extent that the CFTC allows for such substituted compliance pursuant to the standard discussed below).

Definition of "U.S. Person"

The Proposed Rule defines "U.S. person" in a manner that is distinct from how that term was defined under the Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations issued by the CFTC on July 26, 2013 (the "Guidance").⁶ Notably, the Proposed Rule provides greater certainty as to the scope of the definition of "U.S. person" by omitting the prefatory language "includes, but is not limited to" that was included in the Guidance.

Under the Proposed Rule, "U.S. person" is defined to include, inter alia, entities organized or incorporated in the United States, entities with a principal place of business in the United States, natural persons resident in the United States and accounts beneficially owned by any such persons.⁷

"Principal place of business" would be defined "to mean the location from which the officers, partners or managers of the legal person primarily direct, control, and coordinate the activities of the legal person[,]" a definition intended to be consistent with a 2010 United States Supreme Court decision.⁸ With respect to funds or other collective investment vehicles, because "senior personnel that direct, control, and coordinate a fund's activities are generally . . . persons who work for the fund's investment adviser or the fund's promoter" (rather than named directors or officers), the CFTC has stated that "generally" (but depending on the facts and circumstances) the principal place of business of a fund or other collective investment vehicle would be deemed to be the United States "if the senior personnel for either (1) the formation and promotion of the fund or (2) the implementation of the fund's investment strategy are located in the United States[.]" This interpretation is consistent with the approach in the Guidance, and the CFTC specifically referred to three specific examples provided in the Guidance as being illustrative as to how the CFTC would apply this test.⁹

Under the Guidance, certain funds or other collective investment vehicles were classified as "U.S. persons" if such funds or other collective investment vehicles were majority-owned, directly or indirectly, by one or more U.S. persons. The Proposed Rule rejects that approach, pursuant to which the status of a fund or other collective investment vehicle could have changed (or "yo-yoed") based upon a change in the percentage holdings of fund investors.

The Proposed Rule's definition of "U.S. person" applies at an entity level, including any foreign branches of such entity. However, "the status of a legal person as a U.S. person would not affect whether a separately incorporated or organized legal person in the affiliated corporate group is a U.S. person."

Because "the information necessary for a swap counterparty to accurately assess the status of its counterparties as U.S. persons may not be available, or may be available only through overly burdensome due diligence[,]" the CFTC has stated that, under the Proposed Rule, a swap counterparty who conducts reasonable due diligence (under the facts and circumstances) is entitled to "rely on its counterparty's written representation in determining whether the counterparty is within the definition of the term 'U.S. person.'"

Definition of "Guarantee"

The definition of "guarantee" in the Proposed Rule is similarly narrower than the definition proposed in the Guidance. Under the Proposed Rule, the existence of a "guarantee" of a U.S. person with respect to a non-U.S. person's obligations under an uncleared swap is determined based on whether the counterparty to such swap has "rights of recourse" against the U.S. person.

Under the proposal, "rights of recourse" exist when such counterparty "has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, the U.S. person in connection with the non-U.S. person's obligations under the swap[,] . . . regardless of[:]"

• "whether such right of recourse is conditioned upon the non-U.S. counterparty's insolvency or failure to meet its obligations under the relevant swap[;]"
• "whether the counterparty seeking to enforce the guarantee is required to make a demand for payment or performance from the non-U.S. counterparty before proceeding against the U.S. guarantor[;]" and
• "whether the U.S. guarantor is an affiliate of the non-U.S. CSE[.]"

So long as such a right of recourse is legally enforceable, "the terms of the guarantee need not necessarily be included within the swap documentation or even otherwise reduced to writing[.]"

However, a number of financial arrangements would not be captured within the definition of a guarantee, such as "keepwells and liquidity puts, certain types of indemnity agreements, master trust agreements, liability or loss transfer or sharing agreements[.]"

With respect to the practice of de-guaranteeing, the CFTC noted that it believes that the Proposed Rule's treatment of "Foreign Consolidated Subsidiary" swaps, discussed below, should ensure appropriate regulatory treatment and prevent any such swaps from qualifying for the Exclusion.¹⁰

Treatment of Other Covered Swaps

As noted above, under the Proposed Rule, the Exclusion applies to uncleared swap transactions entered into between two non-U.S. persons: (1) whose obligations are not guaranteed by a U.S. person; (2) that are not "Foreign Consolidated Subsidiaries" of a U.S. person; and (3) that are not acting through or by a U.S. branch.

As also described above, uncleared swap transactions involving a U.S. person CSE or a non-U.S. person CSE whose obligations with respect to the swap are guaranteed by a U.S. person would generally be subject to the full CFTC margin requirements, though there would be a possibility for substituted compliance with respect to the initial margin to be posted (though not collected) by such a counterparty in a transaction with a non-U.S. person whose obligations under the uncleared swap are not guaranteed by a U.S. person.

There are two additional categories of regulatory treatment for uncleared swaps under the Proposed Rule, and both provide for CFTC margin requirements in full to apply as a baseline, with the possibility of substituted compliance for either or both of initial or variation margin requirements (to the extent that the CFTC allows for such substituted compliance pursuant to the standard discussed below).

Such regulatory treatment would apply to any uncleared swap within the scope of the CFTC margin rules and entered into between:

Counterparty 1

• a non-U.S. person CSE whose obligations under the relevant swap are not guaranteed by a U.S. person but that is either
  
  
  • a "Foreign Consolidated Subsidiary" or
  • acting through or by a U.S. branch; and

Counterparty 2

• any non-U.S. person whose obligations under the relevant swap are not guaranteed by a U.S. person or
• any non-CSE (1) U.S. person or (2) non-U.S. person whose obligations under the swap are guaranteed by a U.S. person.

The same regulatory treatment would apply to any uncleared swap within the scope of the CFTC margin rules and entered into between:

Counterparty 1

• a non-U.S. person CSE whose obligations under the relevant swap are not guaranteed by a U.S. person and who is not
  
  
  • a "Foreign Consolidated Subsidiary" or
  • acting through or by a U.S. branch; and

Counterparty 2

• any non-CSE (1) U.S. person or (2) non-U.S. person whose obligations under the swap are guaranteed by a U.S. person.

Definition of "Foreign Consolidated Subsidiary"

Under the Proposed Rule, a "Foreign Consolidated Subsidiary" is defined to include certain non-U.S. person CSEs that are part of a consolidated group of companies in which there is a U.S. person "ultimate parent entity" (defined to mean a parent entity "in which none of the other entities in the consolidated group has a controlling interest, in accordance with" U.S. generally accepted accounting principles ("GAAP")).

Specifically, "Foreign Consolidated Subsidiary" would include any such CSE in which the U.S. person ultimate parent entity "includes the non-U.S. CSE's operating results, financial position and statement of cash flows in the U.S. ultimate parent entity's consolidated financial statements, in accordance with U.S. GAAP."¹¹

Definition of Acting Through a U.S. Branch

The Proposed Rule does not contain a definition for "U.S. branch" or explicit guidance on when an uncleared swap transaction qualifies as having been conducted "through or by a U.S. branch of a non-U.S. CSE" such that the Exclusion does not apply to the transaction.¹²

However, the CFTC requested comments as to whether it should "base the determination of whether the swap activity is conducted at a U.S. branch of a non-U.S. CSE for purposes of applying the Commission's margin rules on a cross-border basis on the same analysis as is used in the Volcker rule[,]" i.e., whether personnel at the U.S. branch "arrange, negotiate, or execute" the uncleared swap.¹³

This same standard was adopted in CFTC Staff Advisory 13-69, which has been the subject of significant controversy and has had its implementation date delayed four separate times (it is currently set to go into effect on September 30, 2015, pursuant to CFTC No-Action Letter 14-140). Commissioner Giancarlo stated that he was "troubled" by the CFTC potentially requiring at least substituted compliance with respect to uncleared swaps when the only U.S. nexus to the swaps is that personnel at a U.S. branch arranged, negotiated or executed the swaps, arguing as follows:

Standard for Substituted Compliance

The Proposed Rule sets forth a proposed "outcome-based" comparability standard to determine whether a foreign jurisdiction's margin rules for uncleared swaps qualify for substituted compliance. The Proposed Rule lists 11 non-exclusive factors that would guide the CFTC in determining "whether the margin requirements in the foreign jurisdiction achieve the same regulatory objectives" set forth in the Dodd-Frank Act and whether such requirements are consistent with the September 2, 2013 version of the international framework "Margin requirements for non-centrally cleared derivatives" (the "International Framework") issued by the Basel Committee on Banking Supervision (the "Basel Committee") and the International Organization of Securities Commissions ("IOSCO").¹⁴

The determination would be made on an element-by-element basis, so it is possible, e.g., that a foreign jurisdiction's "variation margin requirements" would qualify for substituted compliance, but that its "segregation and rehypothecation requirements" would not.¹⁵

Applications for comparability determinations would be able to be made individually or collectively by counterparties and/or foreign jurisdiction regulators. Any comparability determination reached by the CFTC would "apply for all entities or transactions in that jurisdiction to the extent provided in the Proposed Rule and the determination, subject to any conditions specified by the Commission."

Further Regulatory Action

The CFTC has requested comments on all aspects of its proposal. The CFTC has asked for such comments to be submitted on or before September 14, 2015.

The CFTC's October 3, 2014 proposed rule on margin for uncleared swaps called for a staged implementation process modeled after the implementation schedule from the September 2, 2013 version of the International Framework.

Under the proposed implementation process set forth in the CFTC's October 3, 2014 proposed rule, the compliance date for the requirement to exchange variation margin would be on December 1, 2015, and the requirement to exchange initial margin would be phased in, with the first compliance date set on December 1, 2015, and subsequent compliance dates on December 1 of 2016, 2017, 2018 and 2019. The applicable phase-in date would be based on the aggregate notional amount of uncleared derivatives exposure of an entity and its affiliates and the aggregate notional amount of uncleared derivatives exposure of the counterparty and its affiliates.

On March 18, 2015, the Basel Committee and IOSCO revised the International Framework to propose a phase-in arrangement for the requirement to exchange variation margin, with the first implementation date set for September 1, 2016, and a subsequent implementation date on March 1, 2017. The implementation dates for the requirement to exchange initial margin would each be pushed back nine months, with the first implementation date set for September 1, 2016, and subsequent implementation dates on September 1 of 2017, 2018, 2019 and 2020.

The CFTC has not yet announced whether it intends to adopt this revised implementation schedule.¹⁶

Footnotes

1. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements, 80 Fed. Reg. 41376 (July 14, 2015), available at http://www.gpo.gov/fdsys/pkg/FR-2015-07-14/pdf/2015-16718.pdf.

2. Pub. L. 111-203, 124 Stat. 1376 (2010).

3. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59898 (Oct. 3, 2014).

4. Commissioner Mark P. Wetjen stated that: "I am comfortable supporting today's release, but for the reasons discussed below, continue to harbor some doubts as to whether we have selected the approach that best balances the Commission's interests in protecting the financial system and U.S. taxpayers, meeting its statutory mandate to preserve an appropriate competitive landscape for participants in the global swaps market, and adopting policies whose costs to those affected do not exceed their benefits."

Commissioner J. Christopher Giancarlo stated that: "The Commission's proposal for the cross-border application of margin requirements for uncleared swaps is a highly complicated labyrinth. I look forward to the jolt to U.S. economic growth that will occur in the 3rd quarter of 2015 as a result of the thousands of billable hours that will be expended by lawyers and other professionals, who will have to read, interpret and respond to this tangled regulatory construct. . . . Despite my many questions and concerns, I support issuing the proposed rule only so that the public may provide thorough analysis and thoughtful comment. My vote to issue the proposal for public comment should not signal, however, my agreement with it."

5. The October 3, 2014 proposed rule may need to be revised as a result of the Business Risk Mitigation and Price Stabilization Act of 2015, which amends the requirements set forth in sections 731 and 764 of the Dodd-Frank Act to provide that rules with respect to initial and variation margin requirements adopted by the CFTC, SEC and Prudential Regulators "shall not apply" to entities that qualify for: (1) the end-user exception to the mandatory clearing requirement set forth in sections 2(h)(7)(A) of the Commodity Exchange Act and 3C(g)(1) of the Securities Exchange Act; (2) the exception to the mandatory clearing requirement, set forth in sections 2(h)(7)(D) of the Commodity Exchange Act and 3C(g)(4) of the Securities Exchange Act, for certain affiliates of entities that qualify for the end-user exception; and (3) the cooperative exemption from mandatory clearing set forth in 17 CFR § 50.51.

6. 78 Fed. Reg. 45292 (July 26, 2013). The definition is also distinct from the definition of "U.S. person" adopted by the Securities and Exchange Commission with respect to the regulatory treatment of certain cross-border security-based swap transactions. See 17 C.F.R. § 240.3a71-3(a)(4).

7. The proposed "U.S. person" definition also includes certain estates, pension plans, trusts and legal entities for which U.S. persons bear unlimited responsibility with respect to obligations and liabilities. The full proposed definition defines a "U.S. person" as:

8. See Hertz Corp. v. Friend, 559 U.S. 77 (2010).

9. See 78 Fed. Reg. 45311-45312.

10. In drafting the Proposed Rule, the CFTC assumed "that a non-U.S. CSE is likely to meet the definition of a 'Foreign Consolidated Subsidiary' when it has been provided with financial arrangements or support from a U.S. person that do not fall within the term 'guarantee' (as defined in the Proposed Rule)[.]" The CFTC requested comment as to the correctness of this assumption.

11. The CFTC requested comment as to whether the definition of "Foreign Consolidated Subsidiary" should also encompass: (1) "non-U.S. CSEs whose U.S. ultimate parent entity uses a different standard than U.S. GAAP in determining whether a parent entity must consolidate an entity for financial reporting purposes[;] and/or (2) "non-U.S. CSEs whose U.S. ultimate parent entity is not required to prepare consolidated financial statements under any accounting standard or for any other reason (e.g., the U.S. ultimate parent entity is not a public company under federal securities laws and is not required to prepare consolidated financial statements by private investors or debtholders as a condition to investing or financing), but which would consolidate the non-U.S. CSE if it were required to prepare consolidated financial statements in accordance with U.S. GAAP[.]"

12. According to the CFTC, applying the Exclusion to such uncleared swap transactions would provide "an unwarranted advantage when dealing with non-U.S. clients relative to other CSEs operating within the United States (i.e., U.S. CSEs)."

13. See Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5927 & n.1526. (Jan. 31, 2014). This aspect of the Volcker Rule is discussed in the Stroock Special Bulletin, "Final Regulations Implementing the Volcker Rule: Proprietary Trading" at 18 & n.31 (Mar. 21, 2014), available at http://www.stroock.com/siteFiles/Pub1457.pdf.

On April 29, 2015, the Securities and Exchange Commission ("SEC") proposed to use the "arrange, negotiate, or execute" standard to determine whether certain regulations would apply to particular security-based swaps. See 80 Fed. Reg. 27444 (May 13, 2015). In that proposal, the SEC provided additional analysis on the conduct that it would deem to constitute arrangement, negotiation or execution. The SEC's proposed "arrange, negotiate, or execute" test is described in further detail in the Stroock Special Bulletin, "SEC Cross-Border Security-Based Swap Proposal" (May 13, 2015), available at http://www.stroock.com/siteFiles/Publications/SECCrossBorderSecurityBased.pdf.

14. The CFTC expects that approximately 21 non-U.S. person CSEs would be subject to the proposed margin rules for uncleared swaps. Only one such non-U.S. person CSE is domiciled in a jurisdiction that did not "participate[] in the development of the BCBS-IOSCO framework."

15. The CFTC noted that some "emerging markets" may "lack[] legal or operational infrastructure" in order to implement provisions comparable to certain of the CFTC's proposed margin requirements with respect to uncleared swaps.

16. This implementation schedule is analyzed in further detail in the Stroock Special Bulletin, "Update: Implementation Schedule of Margin Requirements for Uncleared Derivatives" (Mar. 30, 2015), available at http://www.stroock.com/siteFiles/Publications/UpdateImplementationSchedule.pdf.

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