Application of Dodd-Frank Requirements to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties

On November 14, the Division of Swap Dealer and Intermediary Oversight (the "DSIO") of the Commodity Futures Trading Commission (the "CFTC") created confusion and consternation in the derivatives world by issuing an advisory[1] indicating that certain requirements will apply to swaps entered into between a registered non-U.S. swap dealer and a non-U.S. person if the swap is handled by personnel or agents of the non-U.S. swap dealer located in the United States. These requirements (the "Transaction-Level Requirements") include: (i) mandatory clearing and swap processing; (ii) margining (and segregation) for uncleared swaps; (iii) mandatory trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct standards.[2]

The DSIO advisory purports to be an interpretation of the cross-border guidance issued by the CFTC on July 26, 2013, in which the CFTC interprets Section 722 of Dodd-Frank[3] (the "Cross-Border Guidance").[4] In particular, Section 722(d) of Dodd-Frank states that the Commodity Exchange Act ("CEA") swaps provisions that were added by Dodd-Frank do not apply to activities outside the United States unless those activities (i) have a direct and significant connection with activities in, or effect on, commerce of the United States; or (ii) contravene rules or regulations that the CFTC may prescribe or promulgate as are necessary and appropriate to prevent the evasion of any provision of the CEA.

The Cross-Border Guidance had been widely read to provide that swaps between non-U.S. swap dealers and non-U.S. persons would either not be subject to the Transaction-Level Requirements, or would in certain circumstances be subject to the analogous requirements of a foreign jurisdiction determined by the CFTC to be comparable to the corresponding Dodd-Frank requirements ("substituted compliance").

In the advisory, the DSIO states that the CFTC meant for this exclusion from compliance (or substituted compliance) with the Transaction-Level Requirements for swaps between non-U.S. swap dealers and non-U.S. counterparties to apply only where the activities of the non-U.S. swap dealer take place outside the United States, and accordingly a non-U.S. swap dealer (whether or not an affiliate of a U.S. person) "regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute a swap with a non-U.S. person generally would be required to comply with the Transaction-Level Requirements," even if the swap is booked in a non-U.S. branch of the non-U.S. swap dealer.

The DSIO's position caught many by surprise. In its Cross-Border Guidance, the CFTC stated that where a swap is between a non-U.S. swap dealer on the one hand, and a non-U.S. person that is not a guaranteed or conduit affiliate on the other, the CFTC would not expect the parties to the swap to comply with certain Transaction-Level Requirements.[5] The CFTC stated that "generally there may be a relatively greater supervisory interest on the part of foreign regulators with respect to transactions between two counterparties that are non-U.S. persons so that application of the … Transaction-Level Requirements may not be warranted."[6]

Additionally, in a footnote contained in the Cross-Border Guidance, in discussing that the Transaction-Level Requirements would apply to U.S. branches of non-U.S. swap dealers even though the CFTC considers such branches to be non-U.S. persons, the CFTC noted its "strong supervisory interest in regulating the dealing activities that occur within the United States, irrespective of the counterparty."[7] Many interpreted the Cross-Border Guidance, particularly in light of this footnote, as allowing trades to be "handled" in the United States as long as the activity did not constitute dealing and as long as the non-U.S. swap dealer was not using its U.S. branch.

This unexpected interpretation by the DSIO may pose problems for both swap dealers and their counterparties. Swap dealers may have to reevaluate their business models, as many dealers have chosen to centralize particular functions in certain offices or jurisdictions for efficiency and consistency purposes. If any such functions relate to arranging, negotiating, or executing swaps, such dealers may be inadvertently subjecting their swaps to the requirements of Dodd-Frank. Unfortunately, the vagueness of the criteria set forth by the DSIO will not make it easy to determine what activities can and cannot be conducted in the United States—it is unclear how the words "regularly" and "generally" will be interpreted, and it is also unclear exactly what activities the DSIO might believe are included in arranging, negotiating, or executing a swap.

Involvement of internal or external legal counsel located in the United States in swap negotiation, for example, could be interpreted as subjecting the swaps involved to Dodd-Frank regulation. Since a great number of swaps executed worldwide are documented using New York governing law, U.S. counsel are frequently involved in the negotiation of swaps even though such swaps have no other relationship to the United States. Requiring New York credentialed attorneys to relocate outside of the United States in order to provide the necessary advice, or making other similar changes to ensure that all arranging, negotiating, and execution activity takes place outside of the United States, would involve a significant restructuring of many dealers' current operations. In addition, from a practical perspective, even if a dealer wishes to restructure its operations to avoid any potential concerns, such a restructuring will take time, which the dealers do not have—the DSIO's interpretive position appears to be effective immediately, with no phase-in period provided.

From the counterparty perspective, it will be very difficult to determine whether dealers' actions are subjecting a counterparty's otherwise offshore swaps to the requirements of Title VII of Dodd-Frank. As a result, counterparties may need to rely on representations and covenants from their swap dealers, which may be difficult to obtain.

The DSIO's position is also likely to reintroduce conflicts the market hoped had been resolved regarding the applicability of different regulatory regimes. A swap between a non-U.S. swap dealer and a non-U.S. counterparty that is subject to Dodd-Frank requirements solely as a result of the involvement of U.S. personnel in arranging, negotiating, or executing the swap will likely have its predominant, if not exclusive, economic effect in a non-U.S. jurisdiction, and that other jurisdiction will be very likely to insist that its own laws and regulations govern that swap. Parties to such a swap could easily face conflicting requirements in the two jurisdictions, and even if technically the parties are able to comply with both sets of rules, the costs involved in doing so are likely to be very high.

The DSIO position also appears to be inconsistent with the intent of both Congress and the CFTC. In the Cross-Border Guidance, the CFTC, after a lengthy analysis of the language of its mandate, explicitly stated that it construes section 2(i) of the CEA "to apply the swaps provisions of the CEA to activities outside the United States that have either (1) A direct and significant effect on U.S. commerce; or, in the alternative, (2) a direct and significant connection with activities in U.S. commerce, and through such connection present the type of risks to the U.S. financial system and markets that [the Dodd-Frank provisions relating to swaps] directed the Commission to address."[8] Equally, the CFTC noted that the "United States thus has a strong interest in applying the Dodd-Frank Act requirements, rather than substitute requirements adopted by non-U.S. authorities, to swaps with U.S. persons. Exercise of U.S. jurisdiction with respect to the Category A Transaction Level Requirements over swaps between U.S. persons and non-U.S. persons is a reasonable exercise of jurisdiction because of the strong U.S. interest in minimizing the potential risks that may flow to the U.S. economy as a result of such swaps."[9]

A swap executed by a non-U.S. swap dealer with a non-U.S. counterparty that has its sole economic effect in a non-U.S. jurisdiction, but happens to be negotiated by a person based in the United States, would not seem to be brought back within the tentacles of Dodd-Frank based on the statements made by the CFTC in its Cross-Border Guidance. In addition, the DSIO position, which would appear to require an analysis of the role of U.S.-based personnel in individual non-U.S. swap transactions, also creates tension with the CFTC's view that "it is the connection of swap activities, viewed as a class or in the aggregate, to activities in commerce of the United States that must be assessed to determine whether application of the CEA swaps provisions is warranted."[10]

While it is understandable that the DSIO may fear end-runs around Dodd-Frank rules, the present advisory addresses no articulated evasion risk and in fact potentially reaches companies' good faith efforts to comply with those rules. Problems associated with this approach include the troubling vagueness of the proposed criteria, the practical issues associated with attempting to comply with the terms of the advisory, the potential for concurrent application of multiple regulatory regimes, and the apparent conflict with previously promulgated official CFTC positions. Further, at the policy level, the rules put forth in this advisory risk contributing to the balkanization of the swaps market, which to some degree has already begun as a result of the imposition of varying regional regulations. If an uncertain degree of contact with the U.S. might subject an otherwise offshore swap to U.S. regulation, counterparties may well create walls that prevent their U.S. and foreign staff from coordinating with or even speaking to each other about such matters. Such a walling-off of people and businesses is likely to increase, rather than decrease, overall risk, since the sharing of information and best practices is vital to proper risk management.

Lawyer Contacts

For further information, please contact your principal Firm representative or one of the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com.

Tracy L. Oley
Washington
+1.202.879.5416
tloley@jonesday.com

Joel S. Telpner
New York
+1.212.326.3663
jstelpner@jonesday.com

Alice Yurke
New York
+1.212.326.3623
ayurke@jonesday.com

M. Joel Laub
New York
+1.212.326.3403
jlaub@jonesday.com

Dickson C. Chin
New York
+1.212.326.7893
dchin@jonesday.com

Jonathan J. Ching
New York
+1.212.326.7829
jching@jonesday.com

Ilene K. Froom
New York
+1.212.326.3821
ifroom@jonesday.com

James E. Gauch
Washington
+1.202.879.3880
jegauch@jonesday.com

Jayant W. Tambe
New York
+1.212.326.3604
jtambe@jonesday.com

Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our "Contact Us" form, which can be found on our web site at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.