Registration Process for Security-Based Swap Entities

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1 Registration Process for Security-Based Swap Entities SEC Proposes Rules on Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants SUMMARY On October 12, 2011, the SEC proposed rules on registration with the SEC of security-based swap dealers ( SBS Dealers ) and major security-based swap participants ( Major SBS Participants and together with SBS Dealers, SBS Entities ), as required by Section 764 of the Dodd-Frank Act. 1 Under the proposed rules, in order to register, an SBS Entity must file the following with the SEC: A completed application form including information about its business, management and ownership; A certification from a senior officer certifying that the applicant has the operational, financial, and compliance capabilities to act as an SBS Entity; and A certification to the effect that none of the personnel involved with the SBS Entity s securitybased swap business is statutorily disqualified. The proposed rules provide for three different forms of registration applications depending upon the regulatory status of the applicant: Form SBSE, which is based on Form BD, for unregulated entities; Form SBSE-A for applicants registered with the CFTC as a swap dealer or major swap participant; and Form SBSE-BD for applicants registered with the SEC as broker-dealers. The proposed rules anticipate that SBS Entities will conditionally register prior to the effectiveness of the full suite of security-based swap rules. Registration applications would be considered complete upon the New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 filing of a senior officer certification prior to the effective date of the rules governing SBS Entities, and ongoing registration would become effective once registration is granted by the SEC. The SEC requested comments on all aspects of the proposed rules. Comments are due December 19, BACKGROUND AND TIMING OF REGISTRATION Section 764 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) makes it unlawful for a person to act as an SBS Entity 2 unless such person is registered as an SBS Entity with the SEC. Originally, Section 764 had an effective date of July 16, However, in June 2011, the SEC confirmed that the effectiveness of Section 764 would be delayed until the SEC had adopted final rules for SBS Entity registration. In the release proposing the rules the SEC stated that upon proposing all of the key rules under Title VII, [it] intends to seek public comment on a detailed implementation plan that will permit a roll-out of the new security-based swap requirements in a logical, progressive, and efficient manner, while minimizing unnecessary disruption and costs to the markets. 3 In considering the costs of the proposed rules the SEC estimates: Approximately 50 entities will need to register as SBS Dealers; Approximately five entities will need to register as Major SBS Participants; 35 SBS Entities will need to register with the CFTC as swap dealers or major swap participants; 12 registered broker-dealers will need to register as SBS Entities; Eight firms not otherwise registered with the SEC or CFTC will need to register as SBS Entities; and Approximately 40% of the registering SBS Entities will be organized outside the United States. The SEC is proposing a two-step registration process for SBS Entities. Prior to the latest date (to be designated by the SEC in future rule-making) by which SBS Entities must comply with the initial rules regarding registration and regulation of SBS Entities (the Last Compliance Date ), SBS Entities would file for and receive conditional registration as SBS Entities. After the Last Compliance Date, each SBS Entity must receive ongoing registration to operate as an SBS Entity. For SBS Entities that register prior to the Last Compliance Date, the senior officer s certification would need to be filed prior to the Last Compliance Date. For SBS Entities registering after the Last Compliance Date, it must be filed within four months of the submission of their applications. The reason for this two-step process appears to be the SEC s belief that until the rules are finalized and applicants can implement appropriate policies, procedures and systems, the senior officers will be unwilling and unable to deliver their compliance certificates. -2-

3 REGISTRATION PROCESS The proposed rules provide for electronic registration via EDGAR on one of three application forms: For SBS Entities registered or registering with the SEC as broker-dealers, Form SBSE-BD, which is a brief form requiring basic information about the applicant. For SBS Entities registered or registering with the CFTC as swap dealers or major swap participants and not registered or registering with the SEC as broker-dealers, Form SBSE-A, which is a longer form than SBSE-BD, requiring relatively extensive information about the business, management and ownership of the applicant. An applicant using this form would also be required to provide the SEC with a copy of the application it files with the CFTC. For SBS Entities not described in the two preceding bullet points, Form SBSE, which is based on the SEC s broker-dealer registration Form BD and requires extensive information about the business, management and ownership of the applicant. 4 Under the proposed rules, if an SBS Entity finds that the information contained in its application for registration, or in any amendment thereto, is or has become inaccurate for any reason (whether or not material), the SBS Entity must promptly file an amendment with the SEC to correct such information. This obligation, however, would not apply to the senior officer certification discussed below; an SBS Entity would not be required to have a senior officer update that certification after the SBS Entity s ongoing registration is approved. All applications would be filed electronically, publicly available and tagged in a machine-readable format. The SEC indicates that this would increase competition among SBS Entities and enable counterparties to more efficiently obtain and compile information on SBS Entities. Senior Officer Certification The most onerous, and we expect controversial, requirement in the proposed registration process is the senior officer s certification. As proposed, each SBS Entity must have a senior officer certify in its registration that: after due inquiry, he or she has reasonably determined that the applicant has the operational, financial and compliance capabilities to act as an SBS Entity; and he or she has documented the process by which he or she reached that determination. According to the SEC, this certification is intended to address many of the same considerations that arise during the in-depth review by the [SEC] and its staff, or, in some cases, [self-regulatory organizations], prior to granting registration to certain applicants and to maintain orderly and efficient markets and protect investors by helping to ensure that the [SEC] only grants registration to SBS Entities that can attest that they possess... [the] capabilities to conduct business as an SBS Entity. The SEC acknowledges that this type of certification is relatively new and appears to be unprecedented in scope. -3-

4 The SEC did not define several important terms included in the senior officer certification requirement. For example, the proposed rules do not define due inquiry, and the SEC noted that some SBS Entities may rely on a third-party review process. In addition, the proposed rules do not define operational, financial, and compliance capabilities, but the SEC requested comment on the phrase and offered some guidance: Operational Capability. The SEC indicated that operational capability would include an assessment of infrastructure, technology and human resources, and it expects that a key foundation for the [certification] would be the capability of an SBS Entity to comply with the obligations that would be imposed by the [SEC s proposed rules regarding trade acknowledgement and verification by SBS Entities], if adopted, other legal obligations applicable to the operations of an SBS Entity, and the capability of the SBS Entity to conduct its business as represented in the SBS Entity s application for ongoing registration. Financial Capability. The SEC characterized financial capability as an SBS Entity possessing sufficient working capital and liquidity for its security-based swap business consistent with regulatory requirements and as needed to respond to market conditions. The SEC expects that an SBS Entity s ability to comply with the SEC s yet-to-be-proposed capital rules for SBS Entities would be fundamental for this certification. Compliance Capability. The SEC said that it expects that development and implementation of a compliance regime as required by the SEC s proposed business conduct rules for SBS Entities would be fundamental for this certification. While the SEC did not specify how the senior officer would document his or her determination, the SEC did discuss two alternatives: a sub-certification process, used by many public companies in the context of the certifications relating to internal controls over financial reporting and disclosure controls and procedures, and a third-party report. The SEC estimates a third-party report would cost $600,000; it is unclear who would be able to provide such a report and how reasonable this estimate is. Commissioner Paredes, who opposed the proposed rules, stated that this certification requirement is too vague, would potentially require the senior officer to certify that the applicant conforms to more stringent standards than those required by law or regulation, and could result in unfair hindsight critiques of a particular certification. He encouraged comments on an alternative, more objective certification contained in the proposing release by which the senior officer would certify, to the best of his or her knowledge, after due inquiry, that the SBS Entity has developed and implemented written policies and procedures reasonably designed to prevent violation of federal securities laws, the rules thereunder and applicable self-regulatory rules. Associated Persons Pursuant to the Exchange Act, an SBS Entity generally may not permit any of its associated persons 5 to effect or be involved in effecting security-based swap transactions on behalf of the SBS Entity, if the SBS Entity knew, or in the exercise of reasonable care should have known, that the associated person was subject to a statutory disqualification. 6 Each of the registration forms discussed above includes a required certification from the applicant s chief compliance officer, or his or her designee, that the SBS Entity: -4-

5 has performed background checks on all of its associated persons who effect or are involved in effecting, or who will effect or be involved in effecting, security-based swaps on its behalf ; and has determined that no such person is subject to a statutory disqualification. In the proposing release, the SEC said that it believes persons who effect or are involved in effecting security-based swaps: would include, but not be limited to, persons involved in drafting and negotiating master agreements and confirmations, persons recommending security-based swap transactions to counterparties, persons on a trading desk actively involved in effecting security-based swap transactions, persons pricing security-based swap positions and managing collateral for the SBS Entity, and persons assuring that the SBS Entity s security-based swap business operates in compliance with applicable regulations. In short, the term would encompass persons engaged in functions necessary to facilitate the SBS Entity s security-based swap business. This broad interpretation would appear to include persons whose functions are ministerial in nature, such as persons determining the need for collateral calls and valuing collateral. Surprisingly, despite the breadth of this interpretation, the SEC estimates that 25 persons in each SBS Entity would be associated persons that effect or are involved in effecting securities transactions. In order to support the SBS Entity s certification, the SBS Entity must obtain a questionnaire or employment application executed by each of its associated persons who effects or is involved in effecting security-based swaps on behalf of the SBS Entity that will serve as a basis for a background check of such person. The questionnaire or application must include at least the following: The person s name, address, date of birth, social security number and the starting date of his or her employment or other association with the SBS Entity; A complete, consecutive statement of all the person s business connections for at least the preceding 10 years, including whether the employment was part-time or full-time; A record of any denial of membership or registration, and of any disciplinary action taken, or sanction imposed, upon the person by any federal or state agency, by any national securities exchange or national securities association, or by any foreign financial regulatory authority including any finding that the person either aided or abetted or was a cause of any disciplinary action or had violated any law; A record of any denial, suspension, expulsion or revocation of membership or registration of any broker, dealer or SBS Entity with which the person was associated in any capacity when such action was taken; A record of any permanent or temporary injunction entered against the person or any broker, dealer or SBS Entity with which the person was associated in any capacity at the time such injunction was entered; A record of any arrest or indictment for any felony, or any misdemeanor pertaining to securities (including security-based swaps), futures or commodities (including swaps), banking, insurance or real estate (including, but not limited to, acting or being associated with a broker-dealer, investment company, investment adviser, futures sponsor, bank, or savings -5-

6 and loan association), fraud, false statements or omissions, wrongful taking of property or bribery, forgery, counterfeiting or extortion, and the disposition of the foregoing; and A record of any other name or names by which the person has been known or which the person has used. This information is similar to the information broker-dealers are required to obtain from their associated persons pursuant to Exchange Act Rule 17a-3(a)(12). To help ensure that the required information is collected, the SBS Entity s chief compliance officer (or his or her designee) must review and sign each questionnaire or application. If an SBS Entity has obtained the required information but its chief compliance officer (or designee) has not yet signed each questionnaire or application, the SEC has said that such SBS Entity could nevertheless be conditionally registered. Conditional Registration As discussed above, the proposed rules contemplate conditional and ongoing registration. Conditional registration would allow for the registration of an SBS Entity prior to the submission of the senior officer certification and would be available to SBS Entities prior to the Last Compliance Date, at which time the senior officer certification must be filed in order to extend the conditional registration for an additional 30 days. After the Last Compliance Date, conditional registration would continue to remain available only for Major SBS Participants (not SBS Dealers). Such conditional registration would have a term of four months, at which time the senior officer certification must be filed in order to extend the conditional registration for an additional 30 days. 7 Accordingly, if a Major SBS Participant completes its application (except for the senior officer certification) prior to the Last Compliance Date, it would be required to submit the senior officer certification on the Last Compliance Date, no matter the amount of time between the date on which it completed the application and the Last Compliance Date. In contrast, if it completes an application (except for the senior officer certification) after the Last Compliance Date, it will have four months to submit the senior officer certification. In all cases, the SEC could extend conditional registration for good cause. Under the proposed rules, the SEC would grant conditional registration if it finds that the SBS Entity s application is complete, provided that the SEC could institute proceedings to determine whether conditional registration should be denied if the applicant is subject to a statutory disqualification as discussed above or if the SEC is aware of inaccurate statements in the application. Such proceedings would include notice of the grounds for denial and the opportunity for a hearing. When a conditional registration of an SBS Entity is granted, the SEC would make information regarding the registration status of the SBS Entity publicly available. -6-

7 Ongoing Registration In order to obtain ongoing registration, an SBS Entity would have to submit a completed application and the senior officer certification. A conditionally registered SBS Entity would not have to submit a new application but would have to make any amendments necessary to correct any inaccuracies in its original application. Under the proposed rules, the SEC may grant or deny an ongoing registration based on the SBS Entity s application and certification, and the SEC would grant such registration if it finds that the requirements of the Exchange Act are satisfied. The SEC could institute proceedings to determine whether ongoing registration should be denied if it does not determine that such requirements are satisfied, if the applicant is subject to a statutory disqualification as discussed above, or if the SEC is aware of inaccurate statements in the application. Such proceedings would include notice of the grounds for denial and the opportunity for a hearing. In the proposing release, the SEC indicated that the SEC s Office of Compliance Inspections and Examinations and its Division of Trading and Markets intend jointly to perform a substantive review of applications and Senior Officer Certifications received for registration of SBS Entities to determine whether additional [SEC] action is appropriate and to evaluate potential registrants risk for purposes of prioritizing examinations. When an ongoing registration of an SBS Entity is granted, the SEC would make information regarding the registration status of the SBS Entity publicly available. PROVISIONS APPLICABLE TO NON-RESIDENT SBS ENTITIES A non-resident SBS Entity would be required to: obtain a written irrevocable consent and power of attorney appointing an agent in the United States for service of process, pleadings or other papers in any action against such SBS Entity prior to seeking registration as an SBS Entity; and certify, and provide an opinion of counsel confirming, that the non-resident SBS Entity can, as a matter of law, provide the SEC with prompt access to its books and records and can, as a matter of law, submit to onsite inspection and examination by the SEC. In the event of any changes in the legal or regulatory framework that would impact the non-resident SBS Entity s ability to provide, or the manner in which it provides, the SEC with prompt access to its books and records, or impacts the SEC s ability to inspect and examine the non-resident SBS Entity, the SBS Entity would be required, within 90 days of such change, to recertify, and provide a revised opinion of counsel to the effect, that the non-resident SBS Entity can, as a matter of law, provide the SEC with prompt access to its books and records and submit to onsite inspection and examination by the SEC. The SEC indicated that an inability to provide the certifications and opinion of counsel (or to recertify or provide an updated opinion of counsel) may be a basis for the SEC to deny (or revoke) the non-resident SBS Entity s registration. -7-

8 A non-resident SBS Entity would include: In the case of a corporation, one incorporated in or having its principal place of business in any place not in the United States; or In the case of a partnership or other unincorporated organization or association, one having its principal place of business outside the United States. * * * Copyright Sullivan & Cromwell LLP 2011 ENDNOTES The proposed rules and the SEC s proposing release are available at The Dodd-Frank Act generally defines an SBS Dealer as any person that (i) holds itself out as a dealer in security-based swaps, (ii) makes a market in security-based swaps, (iii) regularly enters into security-based swaps with counterparties in the ordinary course of its business for its own account, or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or marketmaker in security-based swaps. A Major SBS Participant is defined in the Dodd-Frank Act as any person, other than an SBS Dealer, that (i) maintains a substantial position in security-based swaps for any of the major security-based swap categories as determined by the SEC (excluding positions held for hedging or mitigating commercial risk and positions maintained by any employee benefit plan (or any contract held by such a plan) as defined in paragraphs (3) and (32) of Section 3 of ERISA for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan), (ii) has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets, or (iii) is a financial entity that is not subject to capital requirements imposed by any federal banking agency, is highly leveraged relative to the amount of capital it holds and maintains a substantial position in outstanding security-based swaps in any major security-based swap category. In a joint release with the CFTC in December 2010, the SEC proposed rules and provided further guidance with respect to these and other definitions. See our memorandum to clients, dated December 14, 2010, entitled Proposed Swap Definitions Under Title VII of the Dodd-Frank Act: CFTC and SEC Propose Rules and Guidance to Further Define the Terms Swap Dealer, Security-Based Swap Dealer, Major Swap Participant, Major Security-Based Swap Participant and Eligible Contract Participant. In addition to the proposed rules regarding the definition of SBS Dealer and Major SBS Participant (discussed in footnote 2 above), the SEC has proposed rules with respect to business conduct standards for SBS Entities, and the provision and verification by SBS Entities of trade acknowledgments. The SEC has yet to propose rules regarding capital, margin, segregation and recordkeeping requirements for SBS Entities, but has indicated that it expects to propose such rules in the near future. See our memorandum to clients, dated July 8, 2011, entitled SEC Proposes Business Conduct Standards Under Title VII of Dodd-Frank: SEC Issues Proposed Rules Regarding Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants and our memorandum to clients, dated January 19, 2011, entitled Security-Based Swaps: SEC Proposes to Require Security-Based Swap Dealers and Major Security-Based Swap Participants to Provide and Verify Trade Acknowledgments in Security-Based Swap Transactions Each proposed form is available at For these purposes, an associated person means any partner, officer, director or branch manager of the SBS Entity (or any person occupying a similar status or performing similar -8-

9 6 7 ENDNOTES (CONTINUED) functions); any person directly or indirectly controlling, controlled by, or under common control with, the SBS Entity; or any employee of the SBS Entity, provided that the term does not include any person whose functions are solely clerical or ministerial. For these purposes, generally, a person is subject to statutory disqualification if such person: has been expelled, suspended or barred from membership or participation in, or from being associated with a member of, any self-regulatory organization, foreign or international securities exchange, contract market or futures association (or foreign equivalents); is subject to an order of the SEC, other appropriate regulatory agency, or foreign financial regulatory authority denying, suspending or revoking such person s registration as (or barring such person s being associated with) an SBS Entity and certain other regulated entities for a period not exceeding 12 months; is subject to an order of the CFTC denying, suspending or revoking such person s registration under the Commodity Exchange Act; is subject to an order of a foreign financial regulatory authority denying, suspending or revoking such person s authority to engage in transactions in contracts of sale of a commodity for future delivery or other instruments traded on or subject to the rules of a contract market or board of trade (or foreign equivalent); has been found to be a cause by such person s conduct of any such suspension, expulsion or order by the SEC, an appropriate regulatory agency, a self-regulatory agency, foreign or international securities exchange or foreign financial regulatory authority while associated with an SBS entity and certain other regulated entities; has associated with any person who is known, or in the exercise of reasonable care should be known, to be such a person; or has committed or omitted certain acts or is subject to certain final orders enumerated in Section 15(b) of the Exchange Act, has been convicted of certain felonies within ten years of the date of the filing of an application for membership or participation in certain self-regulatory organizations, or made in any application for membership or participation in, or to become associated with a member of, a self-regulatory organization, report required to be filed with a self-regulatory organization, or proceeding before a self-regulatory organization any statement which was at the time, and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, or has omitted to state in any such application, report or proceeding any material fact which is required to be stated therein. Conditional registration would be available to Major SBS Participants, but not SBS Dealers, after the Last Compliance Date, because a Major SBS Participant is likely to need additional time to implement the compliance requirements applicable to Major SBS Participants. -9-

10 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; or Alison Alifano ( ; in our New York office. CONTACTS New York Robert E. Buckholz, Jr Whitney A. Chatterjee Jay Clayton Andrew G. Dietderich Robert W. Downes David J. Gilberg David B. Harms Kenneth M. Raisler Robert W. Reeder III Alan J. Sinsheimer Rebecca J. Simmons Frederick Wertheim Washington, D.C. Eric J. Kadel, Jr Robert S. Risoleo Dennis C. Sullivan Los Angeles Patrick S. Brown Alison S. Ressler SC1:

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