House Financial Services Draft OTC Derivatives Legislative Proposal

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1 House Financial Services Draft OTC Derivatives Legislative Proposal House Financial Services Chairman Barney Frank Releases Discussion Draft of the Over-the-Counter Derivatives Markets Act of 2009, on Which Committee Plans Hearing and Markup SUMMARY On October 2, U.S. House Financial Services Committee Chairman Barney Frank released a discussion draft of the Over-the-Counter Derivatives Markets Act of 2009 ( Committee Discussion Draft ) 1, the Committee s legislative proposal to regulate the over-the-counter ( OTC ) derivatives industry. The proposed legislation would comprehensively regulate the OTC derivatives market, products and participants, and would amend many provisions of the Commodity Futures Modernization Act ( CFMA ), which was adopted in Although the Committee s draft is similar to the Over-the-Counter Derivatives Markets Act of proposed legislation released by the Treasury Department in August ( Treasury legislative proposal ), there are several important differences. BACKGROUND The Committee Discussion Draft shares many of the themes set forth in the joint principles 3 offered by Chairman Frank and House Agriculture Committee Chairman Colin Peterson in July. The Financial Services Committee has jurisdiction over the federal banking regulators and the Securities and Exchange Commission ( SEC ), while the Agriculture Committee has jurisdiction over the Commodity Futures Trading Commission ( CFTC ). The Committee Discussion Draft also closely follows the proposals offered by Treasury Secretary Timothy Geithner 4 and CFTC Chairman Gary Gensler 5 earlier this year, including the Treasury Department s version of Over-the-Counter Derivatives Markets Act of 2009, released in August. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 Chairman Frank has indicated that the House Financial Services Committee will hold a number of hearings on financial regulatory reform issues this fall, including a hearing on OTC derivatives on October 7th and a mark-up of the Committee Discussion Draft on October 14th, before introducing a comprehensive regulatory reform legislative package. Although it was expected that Chairman Peterson would offer several amendments to the Committee Discussion Draft, he recently indicated his plan to release his own version of the legislation, having expressed concerns that the Committee Discussion Draft does not address excessive speculation in the oil and agricultural markets. FRAMEWORK OF LEGISLATION The Committee Discussion Draft effectively divides regulatory authority over OTC derivatives between the CFTC and the SEC. The proposed legislation would also create new categories of market participants under the Commodity Exchange Act and the Securities Act of 1933 and would direct the CFTC and the SEC to adopt joint interpretations of the defined terms, which includes swap, swap dealer, swap repository, and major swap participant, as well as security-based swap, and major security-based swap participant. Specifically, under the Committee Discussion Draft, security-based swaps are defined as those based on a single security or loan, a narrow-based security index, or the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event must directly affect the financial statements, financial condition, or financial obligations of the issuer, and will be regulated by the SEC. Swaps based on broad-based indices of securities as well as interest rates, currencies and commodities, will be regulated by the CFTC. Mixed Swaps are defined as security-based swaps that are also based on the value of a currency, interest rate, broad-based security index or commodity, and would come under the jurisdiction of the CFTC and the SEC. The CFTC and the SEC must jointly implement uniform rules to further define these terms within 180 days of enactment of the Committee Discussion Draft. If they cannot issue joint rules, the Treasury Department will promulgate these rules, which will be enforced by CFTC and SEC and will remain in effect until Treasury rescinds the rule or the CFTC and SEC implement joint regulations. The Committee Discussion Draft defines a swap dealer as any person engaged in the business of buying and selling swaps for such person s own account, through a broker or otherwise, but exempts from its definition of swap dealer any entity that buys or sells swaps for its own account, either individually or in a fiduciary capacity, but not as a part of a regular business. This contrasts with the broader Treasury legislative proposal definition of swap dealer, which captured market participants who used swaps for hedging, if their hedging activity did not qualify as hedging under Generally Accepted Accounting Principles ( GAAP ). The Committee Discussion Draft defines a major swap participant as an entity who is not a swap dealer and who maintains a substantial net position in outstanding swaps, excluding positions held primarily for -2-

3 hedging (including balance sheet hedging) or risk management purposes. However, an entity may be categorized as a major swap major swap participant for 1 or more individual types of swaps, such that substantial net position would be calculated not only on an entity s aggregate outstanding swap contracts, but on its outstanding positions for a particular swap. The CFTC and SEC must define substantial net position through joint rulemaking, but the Treasury Department will do so if they are unable to promulgate such rules. Again, major swap participants are defined more narrowly in the Committee Discussion Draft than in the Treasury legislative proposal, as the Treasury definition of major swap participants included end-users whose hedging activities did not qualify as hedging under GAAP. While excluding a broader range of end-users from regulation than the Treasury legislative proposal, by excluding end-users that use swaps for hedging purposes, whether or not the hedging qualifies under GAAP, the Committee Discussion Draft definition of major swap participant is likely to capture hedge funds and investments advisors, as did the Treasury legislative proposal. While the CFTC and SEC are given authority to regulate the OTC derivatives market, under the Committee Discussion Draft they share regulatory authority with federal bank regulatory authorities, referred to as Prudential Regulators. For state-chartered banks that are members of the Federal Reserve system or the state-chartered branch of foreign banks, the Federal Reserve will be the Prudential Regulator; for a national bank or federally chartered branch or agency of a foreign bank, the Office of Comptroller of the Currency will be the Prudential Regulator; and for a state-chartered bank that is not part of the Federal Reserve, the Federal Deposit Insurance Corporation will be the Prudential Regulator. However, federal banking regulators will maintain their jurisdiction over identified banking products, unless the appropriate federal banking agency, in consultation with the CFTC and/or SEC, determines that the banking product meets the definition of swap or security-based swap and has become known to the market as a swap or security-based swap. If the regulators make that determination, the banking product will be regulated by the CFTC or the SEC. The bill sets an aggressive timeline six months to one year for the agencies to implement the various required rule-makings. Swap transactions entered into before the enactment of the Committee Discussion Draft must be reported to a regulated repository within six months of the effective date of the regulation and those entered into on or after the date of enactment must be reported within 90 days or such time as required by the CFTC or SEC. Finally, the Discussion Draft provides the CFTC and the SEC with explicit but limited exemptive authority over the regulation of swaps, likely to raise serious concerns with the CFTC and the SEC. -3-

4 Required Clearing of OTC Contracts Unlike the Treasury legislative proposal, the Committee Discussion Draft does not define swaps as being standardized or customized. Instead, the CFTC and SEC will jointly implement uniform rules to determine which contracts must be cleared, taking into account the public interest, in addition to other criteria, such as trading liquidity and adequate pricing data, the ability of one or more swap clearing houses to clear the contract, and the impact on competition and mitigation of system risk. However, there is no clearing requirement if one of the counterparties is not a swap dealer or major swap participant ( MSP ) or if a Designated Clearing Organization ( DCO ) will not accept the swap. Swaps that are not cleared must be reported to a regulated trade repository or to the CFTC or SEC and if one counterparty is a swap dealer, the swap dealer must report the transaction. Otherwise, parties can agree which party will report the transaction to the trade repository or the CFTC or SEC. For swaps that must be cleared and where both counterparties are swap dealers or MSPs, the swaps must also be executed on a Designated Contract Market, an alternative swap execution facility ( ASEF ) in the case of security-based swaps, or a Swap Execution Facility ( SEF ) in the case of other swaps, or comply with CFTC-mandated recordkeeping and reporting requirements. Both the clearing and execution requirements in the Committee Discussion Draft are significantly different from the comparable provisions in the Treasury legislative proposal. Specifically, the Treasury proposal required all standardized swaps to be executed on an exchange or ASEF and to be cleared. The Discussion Draft, in contrast, provides that cleared contracts between two eligible contract participants ( ECPs ) can be reported to the CFTC or SEC without being executed on an exchange or ASEF. The Discussion Draft has also broadened the exceptions to the clearing requirements, by exempting any transaction in which one of the counterparties is not a swap dealer or MSP. Both SEFs and ASEFs must register with the CFTC and/or SEC, although the regulators can exempt entities from dual registration. The SEFs and ASEFs are required to abide by specified Core Principles, be able to prevent market abuses and investigate market disruptions, to monitor trading to prevent manipulation and price distortion, to obtain relevant information from traders as requested by the CFTC and the SEC, to provide timely information to the public, and to comply with recordkeeping and reporting requirements. Through the DCOs and trade repositories, both of which must register with the CFTC and the SEC (unless the DCO clears swaps that are not required to be cleared), regulators will have access to information about OTC derivative transactions and related open positions of individual market participants on a daily basis; the public will have access to aggregated data on open positions and trading volumes. The DCOs must implement risk management tools and systems to safeguard and minimize operations risks, maintain adequate financial resources to prevent any risk to its members and participants, and develop appropriate, objective and equitable membership criteria, so that all clearable swaps are accepted by the DCO. This provision was inserted to ensure fungibility and competition between clearing and trading platforms, a concern raised by panelists at the joint hearing held by the CFTC and the SEC -4-

5 on regulatory harmonization in the beginning of September. Finally, DCOs must impose proper margin requirements to facilitate risk management. The Committee Discussion Draft provides legal certainty for any hybrid instrument sold to any investor or any swap agreement, contract, or transaction between eligible contract participants or persons reasonably believed to be eligible contract participants despite the failure of either transaction to meet the definition of a swap or to be cleared pursuant to the Committee Discussion Draft. However, as in the Treasury legislative proposal, this safe harbor does not extend to security-based swaps. Regulation of OTC Dealers The Committee Discussion Draft requires Prudential Regulators, the CFTC, and the SEC to impose strict capital requirements on all dealers and MSPs through joint rulemaking within 180 days of enactment of the legislation. Prudential Regulators will have authority over banks that act as swap dealers and the CFTC and the SEC will have jurisdiction over non-bank swap dealers and MSPs. The regulators must set higher capital requirements for non-cleared swaps, for bank holding companies and Tier 1 financial holding companies. Swap dealers and MSPs will be required to maintain prescribed levels of capital, daily trading records and records of their communications with counterparties, and will be required to comply with business conduct standards set by the CFTC and the SEC, to disclose material risks of swap transactions, the source and amount of fees or remuneration that swap dealers and/or MSPs would receive, and other material incentives and/or conflicts. In addition, swap dealers and MSPs must monitor trades to prevent violations of position limits and provide data to the CFTC and SEC on a timely basis, as well as have the ability to obtain information from their counterparties as requested by the CFTC and/or SEC. Finally, swap dealers and MSPs must implement informational barriers to prevent conflicts of interest between research units and trading units under common control. The CFTC and SEC will be required to harmonize their regulatory regimes for swap dealers and MSPs. The CFTC and the SEC must impose both initial and variation margin for swap dealers and major swap participants on all swaps that are not cleared, and also have the discretion to impose such requirements in connection with swaps in which one of the counterparties is not a swap dealer or MSP. Any margin requirements set by the CFTC and the SEC must be as least as strict as those requirements imposed by the Prudential Regulators, but the CFTC and the SEC must allow end-users to use non-cash collateral to satisfy margin requirements, a significant difference from the Treasury legislative proposal. In addition, the swap dealer, futures commission merchant ( FCM ), if it clears transactions for clients, or DCO must segregate, maintain and use funds or property for the end-user for cleared swap agreements in accordance with rules set by the CFTC, SEC or Prudential Regulator. For swaps that are not cleared, at the request of the counterparty, the swap dealer, FCM or DCO must segregate the counterparty s margin account and maintain the funds and/or other property in account under control of third-party, which will be designated as a segregated account for the counterparty. To implement the segregation provisions, -5-

6 Congress will most likely need to amend and refine existing provisions in the Bankruptcy Code, which was not included in the Committee Discussion Draft. Position Limits The proposed legislation gives the CFTC authority to set aggregate position limits across futures markets, OTC derivatives that perform a significant price discovery function and foreign boards of trade, as well as require large trader reporting requirements for OTC derivatives that perform a significant price discovery function. The CFTC will have the authority to grant hedge exemptions from the aggregate position limits. The SEC and self-regulatory organizations ( SRO ) will also have the authority to set aggregate position limits and position accountability limits for security-based swaps, although not the underlying securities as required by the Treasury Legislative Proposal, as well as to provide hedge exemptions from aggregate position limits. Regulation of Securities-Based Swaps The Committee Discussion Draft repeals several of the provisions of the Gramm-Leach-Bliley Act and amends the CFMA, by defining security-based swaps as securities under the Securities Act of 1933, so that if an issuer offers a swap, for the purposes of the Securities Act the issuer is deemed to have offered the underlying security. There is also a registration requirement for a security-based swap, if offered to a non-eligible contract participant, as the proposed legislation broadens the definition of Section 13(d) and Section 13(g) to include security-based swaps for the purposes of determining beneficial ownership. However, security-based swap agreements may continue to be entered into as private placements, without registration under the Securities Act or the Exchange Act of While the Discussion Draft does not include any definitional changes to securities under the Exchange Act, expanding the definition of securities to include security-based swaps under the Securities Act will have the effect of expanding the registration and other requirements under the Exchange Act to include entities that utilize security-based swaps. The expansion of Rule 13d beneficial ownership to security-based swaps creates serious implications under the Section 16(a) reporting requirements and the Section 16(b) short-swing profit rule, and the inclusion of security-based swaps under the Securities Act will also have implications for other statutes and regulations that reference the Securities Act. Additional Provisions The Committee Discussion Draft gives the CFTC authority to prohibit access to foreign boards of trade ( FBOT ) that provide direct access to contracts linked to U.S.-listed contracts, unless the FBOT implements certain regulatory standards that are comparable to the requirements applied by the U.S. exchange. The Committee Discussion Draft imposes regulations for Retail Commodity Transactions, between non- Eligible Contract Participants, unless the contract is for physical delivery, is executed on a national -6-

7 security exchange or involves indentified banking products. The CFTC and SEC are given authority to ban abusive swaps if they are detrimental to the stability of the financial market. Finally, the proposed legislation states that the CFTC and the SEC shall consult and coordinate with foreign regulators on the establishment of international standards. * * * ENDNOTES The Committee Discussion Draft is available at: For additional information on the Treasury Department s legislation, see our Memorandum, Treasury OTC Derivatives Legislative Proposal, dated August 17, The Treasury Department s legislative proposal is available at: The Frank-Peterson Principles are available at: The Treasury Proposal is available at: The CFTC s Proposal is available at: er-3.pdf. Copyright Sullivan & Cromwell LLP

8 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., 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 David J. Gilberg Kenneth M. Raisler Washington, D.C. Dennis C. Sullivan NY12525:

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