Cross-Border Margin Requirements for Uncleared Swaps CFTC Finalizes Rule Regarding the Cross-Border Application of its Margin Requirements for Uncleared Swaps INTRODUCTION On May 24, 2016, the Commodity Futures Trading Commission ( CFTC ) voted to adopt a final rule (the Final Rule ) to establish a framework for determining the cross-border application of the CFTC s final rule adopting margin requirements for uncleared swaps, which the CFTC had adopted on December 16, 2015 (the CFTC Margin Rules ). The Final Rule is closely aligned with the cross-border framework in the final rules promulgated on November 30, 2015 by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency (collectively, the Prudential Regulators and the Prudential Regulators Margin Rules ), and is generally consistent with the CFTC s proposed rule regarding the cross-border application of the margin rules (the Proposed Rule ), which was published on July 14, 2015. The Final Rule determines the applicability of the CFTC Margin Rules depending upon the location of the counterparties to an uncleared swap and the nexus of the counterparties to the United States, including, in the case of counterparties that are not U.S. persons, whether the obligations of the counterparties are consolidated for financial accounting purposes by a U.S. parent entity. BACKGROUND Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) provides that, subject to certain exemptions, standardized swaps and security-based swaps must generally be cleared through a derivatives clearing organization ( DCO ) that is registered with the CFTC New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
under the Commodity Exchange Act ( CEA ) or through a clearing agency registered with the Securities and Exchange Commission (the SEC ), respectively. For swaps that are not subject to a mandatory clearing requirement, Sections 731 and 764 of the Dodd-Frank Act created, respectively, a new Section 4s of the CEA and a new Section 15F of the Securities Exchange Act of 1934 (the Securities Exchange Act ) that require the CFTC, the SEC, and the Prudential Regulators to adopt rules establishing initial margin and variation margin requirements for swap dealers, major swap participants, security-based swap dealers and major security-based swap participants (collectively, Covered Swap Entities or CSEs ) with respect to uncleared swaps, i.e., swaps that are not cleared by a DCO or a clearing agency, or by a clearing house that has received an exemption from registration from the CFTC or the SEC ( Covered Swaps ). 1 Pursuant to these provisions, Covered Swap Entities that are subject to regulation by one of the Prudential Regulators must satisfy the margin and capital requirements of the Prudential Regulators, while Covered Swap Entities for which there is no Prudential Regulator must meet the margin requirements imposed by the CFTC (for swap dealers and major swap participants) or the SEC (for security-based swap dealers and major security-based swap participants). 2 The Prudential Regulators Margin Rules addressed the cross-border application of the margin requirements and in particular the availability of an exclusion from the margin requirements or substituted for certain Covered Swaps entered into by non-u.s. entities. The CFTC s new Final Rule establishes the standards for application of the margin requirements to cross-border uncleared swaps for those Covered Swap Entities that are subject to the CFTC Margin Rules. THE FINAL RULE The Final Rule provides some relief from the requirements of the CFTC Margin Rules with respect to certain Covered Swaps entered into by non-u.s. entities. As will be described in greater detail, below, with respect to Covered Swaps with certain counterparties, non-u.s. Covered Swap Entities that are not foreign consolidated subsidiaries ( FCSs ) or U.S. branches of non-u.s. Covered Swap Entities may be excluded from all of the requirements of the CFTC Margin Rules (the Foreign Person Exclusion ). Covered Swaps for which the Foreign Person Exclusion is not available, the Final Rule provides a framework in which Covered Swap Entities may comply with the requirements of a foreign jurisdiction in lieu of the CFTC Margin Rules (referred to as substituted ), if certain conditions are satisfied, particularly the approval of the foreign jurisdiction s rules by the CFTC for purposes of substituted. The Final Rule generally follows the cross-border approach adopted in the Prudential Regulators Margin Rules and as was set forth in the Proposed Rule, with certain differences noted below. The Final Rule generally provides a narrower scope for application of the margin requirements of a foreign jurisdiction than the international framework promulgated by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (the International -2- For
Framework ). 3 The International Framework provides that the margin requirements of a jurisdiction may be applied to entities established in that jurisdiction (including to a subsidiary of a foreign entity) and that a branch of an entity may be subject to either the margin requirements of the jurisdiction where the branch s headquarters are located or the requirements of the host country. In contrast and as described more fully below, the Final Rule limits the application of substituted with respect to non-u.s. entities whose obligations are guaranteed by U.S. persons and with respect to FCSs and U.S. branches of non-u.s. Covered Swap Entities. In comparison to the International Framework, the Final Rule also provides a more prescriptive set of rules for determining whether the margin requirements of a non-u.s. jurisdiction are comparable to the CFTC Margin Rules. On the following page are two summary tables that set forth the cross-border application of the CFTC Margin Rules pursuant to the Final Rule: [Summary tables begin next page.] -3-
Cross-Border Applicability of the CFTC Margin Rules for Uncleared Swaps Summary Tables: 1. Covered Swap Entity ( CSE ) trading with another CSE: U.S. CSE Non-U.S. CSE guaranteed by a U.S. person (1) Nonguaranteed U.S. branch of non-u.s. CSE or (2) nonguaranteed FCS Non-guaranteed non-u.s. CSE (1) U.S. CSE or (2) Non- U.S. CSE guaranteed by U.S. person Margin Rules apply Margin Rules apply Margin Rules for posting IM Margin Rules for posting IM (1) Non-guaranteed FCS or (2) non-guaranteed U.S. branch of non-u.s. CSE Margin Rules for collecting IM Margin Rules for collecting IM Non-guaranteed non-u.s. CSE (does not include any (1) FCS or (2) U.S. branch of non-u.s. CSE) Margin Rules for collecting IM Margin Rules for collecting IM Exclusion (except for certain interaffiliate swaps) 2. CSE trading with a Non-CSE: (1) U.S. CSE or (2) Non- U.S. CSE guaranteed by U.S. person (1) Non-guaranteed FCS or (2) non-guaranteed U.S. branch of non-u.s. CSE U.S. person (does not include CSE) Non-U.S. person guaranteed by a U.S. person (does not include CSE) (1) Nonguaranteed non- U.S. person that is an FCS or (2) nonguaranteed U.S. branch of a non- U.S. CSE Margin Rules apply Margin Rules apply Margin Rules for posting IM Non-guaranteed non-u.s. person (does not include CSE) Margin Rules for posting IM Non-guaranteed non-u.s. CSE (does not include any (1) FCS or (2) U.S. branch of non-u.s. CSE) Exclusion (except for certain interaffiliate swaps) -4-
A. DEFINITIONS 1. U.S. Person The Final Rule determines the applicability of the CFTC Margin Rules based on whether each of the counterparties to a Covered Swap is a U.S. person or whether the Covered Swap is guaranteed by a U.S. Person. Under the Final Rule, a U.S. person is defined as, among other things: A natural person who is a resident of the United States; A legal entity that is organized or incorporated under the laws of the United States, including any branch of such legal entity; A legal entity that has its principal place of business in the United States; and A legal entity that is owned by one or more person(s) falling within the definition of U.S. person and for which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity. Unlike the CFTC s final cross-border guidance, which was released on July 15, 2013 (the Cross-Border Guidance ), 4 the Final Rule does not include in the definition of U.S. person a commodity pool, investment fund or other collective investment vehicle that is majority-owned by U.S. persons. Instead, the prong of the U.S. person definition relating to an entity owned by U.S. persons that have unlimited responsibility for the obligations of the entity applies only in situations in which the owners of the entity (which are U.S. persons) serve as guarantors for all of the legal entity s obligations and liabilities. In addition, unlike the Guidance, the U.S. person definition in the Final Rule does not include a catchall provision and therefore limits the scope of the definition to persons enumerated in the rule. For purposes of the Final Rule, the CFTC interprets principal place of business as the location from which the officers, partners, or managers of the legal person primarily direct, control, and coordinate the activities of the legal person. As an example, the release provides that the principal place of business of an investment fund would be the location where either (1) the formation and promotion of the fund occurred or (2) the implementation of the fund s investment strategy is located, depending on the relevant facts and circumstances. The scope of U.S. persons under the Final Rule is generally similar to the Prudential Regulators Margin Rules, except that the Final Rule adds to the concept of a U.S. person (i) an entity with its principal place of business in the United States and (ii) an entity for which a U.S. person bears unlimited responsibility for the entity. 2. Guarantee A non-u.s. Covered Swap Entity whose obligations under the Covered Swap are guaranteed by a U.S. person ( U.S. Guaranteed Covered Swap Entity ) is subject to the CFTC Margin Rules to the same extent as a Covered Swap Entity that is a U.S. Person (a U.S. Covered Swap Entity ). The Final Rule defines guarantee as an arrangement pursuant to which one party to a Covered Swap has rights of recourse -5-
against a guarantor with respect to its counterparty s obligations. A party to a swap has rights of recourse against the guarantor under the Final Rule if that party has a conditional or unconditional legally enforceable right to receive or collect payments from the guarantor, based upon the obligations of the counterparty to the swap. The terms of the guarantee do not need to be included in the swap or otherwise reduced to writing, so long as the swap participant has legally enforceable rights of recourse in the relevant jurisdiction. The definition of guarantee in the Final Rule aligns closely with the Prudential Regulators Margin Rules and is generally consistent with the Proposed Rule, except that, unlike the Proposed Rule, the Final Rule provides that a guarantee encompasses any arrangement in which the guarantor itself has a legally enforceable right, conditional or otherwise, to receive or otherwise collect payments from any other guarantor. 3. Foreign Consolidated Subsidiary Under the Final Rule, an FCS is defined as a non-u.s. Covered Swap Entity in which a U.S. ultimate parent entity has a controlling financial interest, such that the ultimate parent entity includes the non-u.s. Covered Swap Entity s operating results, financial position, and statement of cash flows in its own consolidated financial statements, in accordance with U.S. Generally Accepted Accounting Principles ( GAAP ). An entity constitutes a U.S. ultimate parent entity if no other entities within that entity s consolidated group have a controlling influence over the entity under GAAP. An entity that is an FCS is unable to rely on the Foreign Person Exclusion, although substituted is available to an FCS to the same extent as a non-u.s. Covered Swap Entity. 4. Representations Regarding Counterparty Status The Final Rule permits market participants to reasonably rely on written counterparty representations with respect to the status of its counterparties. Specifically, a market participant may reasonably rely on a counterparty representation as to its status as a U.S. person, FCS, or a non-u.s. person whose obligations are guaranteed by a U.S. person, unless the market participant has information that would cause a reasonable person to question the accuracy of the representation. Whereas the Proposed Rule would have permitted reliance on counterparty representations solely with respect to their status as a U.S. person, the Final Rule permits reasonable reliance on written counterparty representations as to whether the counterparty is a U.S. person, an FCS, or a non-u.s. person whose obligations under the swap are guaranteed by a U.S. person. B. U.S. COVERED SWAP ENTITIES AND NON-U.S. COVERED SWAP ENTITIES WHOSE OBLIGATIONS ARE GUARANTEED BY A U.S. PERSON The requirements of the CFTC Margin Rules generally apply to a U.S. Covered Swap Entity and to a non- U.S. Covered Swap Entity whose obligations under the swap are guaranteed by a U.S. person. -6-
may be available for these entities, but only with respect to requirements relating to the posting of initial margin to any non-u.s. counterparty. With respect to U.S. Covered Swap Entities and U.S. Guaranteed Covered Swap Entities, the identity of the counterparty determines the availability of partial substituted regarding the requirement to post initial margin. In particular, the CFTC Margin Rules apply to all Covered Swaps entered into by a U.S. Covered Swap Entity or U.S. Guaranteed Covered Swap Entity where the counterparty is a U.S. Covered Swap Entity or U.S. Guaranteed Covered Swap Entity. When the counterparty is a non-u.s. person whose obligations under the relevant swap are not guaranteed by a U.S. Person, then the U.S. Covered Swap Entity (or U.S. Guaranteed Covered Swap Entity) may rely on substituted solely with respect to the requirement to post initial margin (referred to as partial substituted ), which permits the entity to post initial margin in accordance with the margin requirements of the foreign jurisdiction in lieu of the requirements of the CFTC Margin Rules. To rely on this partial substituted, the counterparty must be subject to a foreign jurisdiction s margin requirements and the CFTC must have issued a Comparability Determination (as defined below) with respect to such jurisdiction s requirements relating to the posting of initial margin. C. NON-U.S. COVERED SWAP ENTITIES WHOSE OBLIGATIONS ARE NOT GUARANTEED BY A U.S. PERSON 1. Exclusion from the Margin Requirements With respect to a non-u.s. Covered Swap Entity whose obligations under the Covered Swap are not guaranteed by a U.S. Person, the availability of the Foreign Person Exclusion from the CFTC Margin Rules depends upon the nature of the relationship to U.S. persons of the non-u.s. Covered Swap Entity and the counterparty. In particular, under the Final Rule a Covered Swap entered into by an FCS or by a U.S. branch of a non-u.s. Covered Swap Entity is not eligible for the Foreign Person Exclusion. The Foreign Person Exclusion is available with respect to a Covered Swap entered into by a non-u.s. Covered Swap Entity with a non-u.s. counterparty, provided that neither counterparty s obligations under the relevant swap are guaranteed by a U.S. Person and neither counterparty is an FCS or a U.S. branch of a non-u.s. Covered Swap Entity. In comparison to the Proposed Rule, the Final Rule includes a restriction relating to the ability of a non- U.S. Covered Swap Entity to rely on the Foreign Person Exclusion with respect to certain inter-affiliate transactions. Under the CFTC Margin Rules (and unlike the Prudential Regulators Margin Rules), a Covered Swap Entity is generally not required to collect initial margin from an affiliate, provided that the affiliate collects initial margin on its market-facing swaps or is subject to comparable initial margin collection requirements in the relevant jurisdiction. The Final Rule provides that the Foreign Person Exclusion is unavailable if the market-facing swap of the non-u.s. Covered Swap Entity is not subject to comparable initial margin collection requirements in its home jurisdiction and any of the risk associated with the uncleared swap is transferred to a U.S. Covered Swap Entity (through affiliate transactions) or to -7-
a U.S. Guaranteed Covered Swap Entity by virtue of its guarantee of the swap to a non-u.s. Covered Swap Entity. The Final Rule generally aligns with the Prudential Regulators Margin Rules regarding the exclusion from the margin requirements. However, since the Final Rule includes more categories of entities in the definition of U.S. person than the Prudential Regulators Margin Rules, the Prudential Regulators Margin Rules may provide a broader exclusion from the margin requirements with respect to entities located outside of the United States but with their principal place of business in the U.S. and those entities for which a U.S. person bears unlimited responsibility and serves as a financial backstop. 2. Availability of Compliance The Final Rule permits a non-u.s. Covered Swap Entity to avail itself of substituted by complying with the margin requirements of the relevant foreign jurisdiction in lieu of with the CFTC Margin Rules, if the CFTC has determined that the margin requirements of that foreign jurisdiction are comparable to the CFTC Margin Rules (a Comparability Determination ). is available under the Final Rule for any non-u.s. Covered Swap Entity whose obligations under the Covered Swap are not guaranteed by a U.S. person and in which the counterparty is not a U.S. Covered Swap Entity or a U.S. Guaranteed Covered Swap Entity. An FCS or a U.S. branch of a non-u.s. Covered Swap Entity, although not eligible for the Foreign Person Exclusion, can rely on substituted with respect to a Covered Swap entered into with a counterparty that is not a U.S. Covered Swap Entity or a U.S. Guaranteed Covered Swap Entity. When a swap counterparty is a U.S. Covered Swap Entity or a Guaranteed U.S. Covered Swap Entity, the Final Rule allows for substituted only with respect to the initial margin collection requirements of the CFTC Margin Rules. In this scenario, the non-u.s. Covered Swap Entity must still comply with all other requirements of the CFTC Margin Rules relating to, among other things, the posting of initial margin. The Final Rule generally aligns with the Prudential Regulators Margin Rules with respect to the availability of substituted, except that the Prudential Regulators Margin Rules may provide more expansive availability of substituted in light of the broader definition of U.S. person in the Final Rule. D. COMPARABILITY DETERMINATIONS Pursuant to the Final Rule, in order for a Covered Swap Entity to rely on substituted, the CFTC must make a Comparability Determination with respect to the margin requirements of the relevant foreign jurisdiction. The CFTC may condition or limit the availability of substituted in its discretion. The Final Rule provides that either a Covered Swap Entity that is eligible for substituted or a foreign regulatory authority with supervisory authority over a Covered Swap Entity may -8-
request a Comparability Determination, and such request may cover some or all aspects of the CFTC Margin Rules. A person requesting a Comparability Determination must provide certain items to the CFTC including, among other things, a description of the foreign jurisdiction s margin requirements and a description of how the margin requirements address the relevant elements of the CFTC Margin Rules, as well as a description of the supervision of the relevant foreign regulatory authority over its margin requirements. In making a Comparability Determination, the CFTC will consider all relevant factors, and will specifically examine, among other things: The scope and objectives of the relevant jurisdiction s margin requirements; Whether the relevant foreign jurisdiction s margin requirements achieve comparable outcomes to the Commission s corresponding margin requirements; and The ability of the relevant regulatory authority or authorities to supervise and enforce with the relevant foreign jurisdiction s margin requirements. The CFTC will also consider the consistency of the margin requirements of the foreign jurisdiction with the International Framework, although the CFTC indicated that a finding of consistency with the International Framework is a necessary but not sufficient condition for receiving a Comparability Determination. The Final Rule also provides that if a Covered Swap Entity relies on a Comparability Determination and does not comply with the foreign jurisdiction s margin requirements, the CFTC would be permitted to initiate an action for a violation of the CFTC Margin Rules against such entity. The Prudential Regulators Margin Rules did not list specific factors to be considered in making a determination with respect to the comparability of the margin requirements of a foreign jurisdiction. Under the Prudential Regulators Margin Rules, the Prudential Regulators consider whether the requirements of the foreign regulatory framework for Covered Swaps entered into by the relevant Covered Swap Entity are appropriate for the safe and sound operation of the Covered Swap Entity, taking into account the risks associated with the swaps. E. SPECIAL PROVISIONS 1. Non-Segregation Jurisdiction Relief from Margin Requirements The Final Rule provides relief from certain margin requirements with respect to Covered Swap Entities that enter into swaps in foreign jurisdictions that lack the legal and operational infrastructure for practical with the CFTC Margin Rules. In particular, an FCS or a foreign branch of a U.S. Covered Swap Entity may be eligible to engage in Covered Swaps in such a jurisdiction without complying with the requirements of the CFTC Margin Rules to post initial margin or to hold initial margin collected by the Covered Swap Entity at a custodian that is not the Covered Swap Entity, counterparty, or an affiliate. Reliance on this relief requires that the inherently insufficient legal or operational structures of the foreign jurisdiction preclude with the posting requirements for eligible initial margin collateral of the -9-
CFTC Margin Rules, and that the foreign regulatory authorities require the Covered Swap Entity to transact in swaps with the counterparty through an establishment within the foreign jurisdiction and do not permit posting of collateral in the U.S. or another jurisdiction pursuant to which the CFTC has made a Comparability Determination. To rely on this relief, the counterparty of the Covered Swap Entity must be a non-u.s. person that is not a Covered Swap Entity and the counterparty s obligations under the Covered Swap cannot be guaranteed by a U.S. person. In addition, the Covered Swap Entity must collect initial margin in cash on a gross basis and must post and collect variation margin in cash for the Covered Swap. The Final Rule also imposes a limit on the value of swaps that the eligible Covered Swap Entity may conduct in such a jurisdiction. Specifically, the Final Rule provides that the total outstanding notional value of all uncleared swaps in the broad risk categories provided in the CFTC Margin Rules as to which the Covered Swap Entity is relying on this relief may not exceed five percent of the Covered Swap Entity s total outstanding notional value of all uncleared swaps in that same risk category. 5 The Covered Swap Entity must also have policies and procedures to ensure it is in with this provision and maintain records documenting that the requirements of this provision are satisfied. 2. Non-Netting Jurisdictions The Final Rule addresses the application of the CFTC Margin Rules with respect to jurisdictions in which netting, collateral, or third party custodial arrangements may not be legally effective, in particular in the event of the insolvency of a counterparty. This provision addresses issues that arise when a Covered Swap Entity cannot conclude that a netting agreement with a counterparty in a foreign jurisdiction meets the definition of eligible master netting agreement under the CFTC Margin Rules. In order to calculate initial margin and variation margin requirements with respect to multiple Covered Swaps with a single counterparty on a net basis under the CFTC Margin Rules, the Covered Swap Entity must determine that such swaps are executed pursuant to an eligible master netting agreement. The Final Rule permits a Covered Swap Entity to calculate initial margin and variation margin requirements on a net basis in determining the amount of margin that it posts with respect to swaps entered into with a counterparty in such a jurisdiction. The Covered Swap Entity must treat such Covered Swaps under the agreement on a gross basis for purposes of calculating and complying with the requirements relating to the collection of initial margin and variation margin. * * * Copyright Sullivan & Cromwell LLP 2016-10-
ENDNOTES 1 2 3 4 5 The margin requirements do not apply to physically settled foreign exchange swaps and foreign exchange forwards pursuant to a determination by the Secretary of the Treasury. See Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (Nov. 20, 2012). The Prudential Regulators Margin Rules apply generally to Covered Swap Entities that are banks and bank holding companies and the CFTC Margin Rules apply to non-bank entities that are Covered Swap Entities. See Margin requirements for non-centrally cleared derivatives, BCBS-IOSCO (Mar. 2015). Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292 (July 26, 2013). The broad risk categories are: (i) commodity; (ii) credit; (iii) equity; and (iv) foreign exchange or interest rate. -11-
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