Sunday 19 February 2012

Extra-Territorial Implications of Dodd-Frank - Part 2

Another excellent podcast on the extra-territoriality of Dodd-Frank as it applies jurisdiction and scope, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and David Lucking of Allen & Overy.

The discussion of cross-border perfection of interests in securities has a particular resonance for me.  I was on the International Bar Association Ad Hoc Working Group on Modernising Ownership, Transfer and Pledging Laws which developed the modern legal standards for transfer and perfection of interests in securities.  After almost 20 years, it still isn't clear that US regulators and US judges would recognise international principles.
  • Section 772 provides territorial scope of Dodd-Frank jurisdiction for CFTC and SEC, and they are different.  CFTC jurisdiction will not apply unless there is a “direct and significant connection” or attempted evasion of US law.  SEC jurisdiction shall not apply to business outside the USA unless there is evasion.  Both have evasion, but CFTC has “direct and significant connection” test.  Little guidance has been provided from either on how they will interpret these provisions, although CFTC has indicated it will address jurisdiction in Spring 2012.
  •  “US Person” definition has not been provided for Title VII of Dodd-Frank.  Scope focuses on types of activities and where they take place and the connection with the US, rather than limiting scope by the nationality of entities entering into transactions.  There is no definition of “US Person” in the Commodities Exchange Act although CFTC rule says a “non-US person” is one organised under the laws of a foreign jurisdiction or that has a principal place of business in a foreign jurisdiction.  For the SEC, Regulation S has a whole body of law as to who is a US person for Regulation S.  Dodd-Frank seems to focus on impact of a transaction on the US for a connection to the US.
  • If two persons are clearly outside the US, but the underlying basis of a transaction is in the US, then the status is unclear.
  •  There are now final rules on registration provisions and registration can be found on the National Futures Association website.  Market participants are still confused on whether their activities and products bring them within the registration provisions.  Some will have to make a judgement call to start the registration process without being certain which entities or activities may be subject to registration on extra-territorial activity.
  •  Likely there will be some structuring and activity which increases the cost of doing business as a consequence of uncertainty as to the application of registration requirements.  This may be particularly a constraint on a large international bank which is uncertain of whether the whole entity must register or just a US branch of the bank.  Requirements for registration include the principles of the organisation and the fingerprints of senior executives.  This will be difficult for some entities where management is likely to resent such intrusive US demands.
  •   Both CFTC and SEC have made initial proposals on the definition of a “Swap Execution Facility”.  This is a new concept, though derives from exchanges or contract markets.  The regulators need to explain how SEFs will work.  The SEC and CFTC proposals are very different from each other – so equity derivatives and credit derivatives may be treated differently.  Similar products will have divergent regulation and execution requirements.  This may encourage some geographic migration as platforms are set up near underlying markets.
  • Platforms in Europe may be considered to be SEFs by SEC or CFTC, but the authorisation principles and coordination on mutual recognition and supervision are unclear. 
  • There was no international consensus that SEFs are “a good idea”.  The G20 did not embrace this idea, although Europe may be moving toward the concept.
  • There is broad global consensus that mandatory, central clearing of some derivatives should be required.  The issue for market participants will work in practice.  Section 725(h) provides for exemption of a clearing entity if the CFTC determines it is subject to comparable regulation elsewhere.  The CFTC has not devoted resources to comparability analysis for foreign clearing organisations, so as a practical matter you have different CCPs in different geographies complying with different legal  regimes.
  • The US Uniform Commercial Code creates a “security interest” in margin and collateral, but in Europe there are security interests using title transfer.  The two different legal models may create a conflict for anyone taking margin or collateral from a US entity because of the different implications for customer protection in a default.
  • Some clearing houses might have gone for mutual recognition – choosing not to register in the US as a Designated Clearing Organisation (DCO).  If this is so, any US customer would have to use a US Futures Commission Merchant.  LCH-Clearnet and ICE, which are already registered as DCOs, have changed their rules to allow FCMs access to clearing members on behalf of their customers to meet US requirements.
  • The CFTC has finalised rules on reporting (1) reporting of information to swap data repositiories, (2) public dissemination of information for post-trade price transparency.  Reporting is also a feature under EMIR.  There needs to be further clarity on mutual recognition of reporting or dual reporting requirements.  Confidentiality of information also raises issues in some jurisdictions and with some counterparties, which will have to be reflected in documentation so that reporting can comply with regulatory requirements.  It still isn’t clear that the US will recognise the sufficiency of overseas data repositories, or whether some form of global data repository would be preferable.
  • The US political context will be influenced by US political priorities in an election year, including unemployment.  US extra-territoriality may be extended more strictly in order to preserve business in the US, and prevent firms from moving jobs, operations or transactions to overseas markets.  While it would be optimal to address these issues globally through Financial Stability Board or G20, the reality is that this remains impractical given competing domestic priorities.
  • Dodd-Frank was enacted in 2010 but implementation is still lagging.  Actual requirements are now rolling out, and 2012 will be a big year to monitor developments and ensure businesses are compliant as rules become effective.  The rules will be evolving over several years as international understandings and clarifications address gaps and inconsistencies, so the compliance challenge will be ongoing.

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