By Paul M. Architzel and Bruce B. Fekrat, WilmerHale, Washington.

The U.S. Commodity Futures Trading Commission (“CFTC”) recently promulgated rules requiring the registration of foreign boards of trade (“FBOTs”) that provide U.S. members and participants with direct access to the FBOTs’ electronic trading and order matching systems (see WSLR, December 2011, page 8). The registration requirement will replace the current no-action process for permitting such direct market access.

The CFTC explained that the new registration rules will provide greater standardization of treatment and transparency than the current no-action process, and thereby will provide greater legal certainty and promote fair and consistent treatment to all FBOT applicants.

The rules will become effective on February 21, 2012.

Statutory Origins

In a last-minute addition, the final version of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) provides that the CFTC may adopt regulations requiring FBOTs that enable members located in the United States to directly access their electronic trading and order matching systems to register with the CFTC. The registration provision of the Dodd-Frank Act leaves the registration requirements to the discretion of the CFTC, requiring only that the CFTC take into consideration…

cforms contact form by delicious:days

By Richard Hill

Several financial industry experts said Sept. 22 that one of their key fears as regulators implement the Dodd-Frank Wall Street Reform and Consumer Protection Act is that bigger industry participants with the means to do so will decide to conduct business in jurisdictions outside the United States with friendlier regulatory environments.

“One of the impacts many of us fear will occur is that large institutions—which are well-capitalized and have flexibility—will in fact take a lot of their business” to jurisdictions that have less stringent oversight, Sharon Brown-Hruska, vice president of the securities and finance practice at National Economic Research Associates, said at a forum on U.S. and global financial reform sponsored by Georgetown University’s McDonough School of Business and PricewaterhouseCoopers.

Brown-Hruska, a former Commodity Futures Trading commissioner who also has served as the agency’s acting chairman, said that if that flight were to occur, “the impact could be significant and trickle down” to investors and commercial end-users of swaps.

Her comments came as U.S. and international regulators—most significantly in the European Union—strive to complete the first rules for swaps trading. Domestic regulators are working to implement the 2010 Dodd-Frank law by sometime in 2012. Group of 20 countries have stated a goal of completing rulemaking by the end of 2012.

Robert Colby, a partner at Davis Polk and Wardwell LLP and a former deputy director of the Securities and Exchange Commission’s Division of Trading and Markets, agreed with Brown-Hruska. He said that if the United States finalizes relatively stricter rules for over-the-counter derivatives, companies “are naturally going to try to deal outside this environment.”

Kathleen Cronin, managing director, general counsel, and corporate secretary for CME Group, observed that while many industry participants focus on the CFTC and SEC rulemaking process, there is a larger perspective to be observed. “It’s not just in the United States. … We also have concerns about how foreign coordination will work. All of the international interplays are very important,” she said…

cforms contact form by delicious:days

The Securities and Exchange Commission Aug. 31 voted unanimously to issue a concept release soliciting public comments on issues raised by mutual funds, exchange-traded funds, and other investment companies’ use of derivatives.

The comments received in response to the release will inform a study by staff in the SEC’s Division of Investment Management as to whether regulatory actions and guidance are warranted to update 1940 Investment Company Act provisions.

The SEC, at the same meeting, also unanimously agreed to issue an advance notice of proposed rulemaking to solicit comment on possible amendments to a rule that excludes certain asset-backed securities issuers from the definition of “investment company.” Moreover, it agreed to issue a concept release to seek comments on interpretive issues raised by a Company Act provision that excludes companies that acquire mortgages and mortgage-related instruments from the act’s requirements.

Staff Study

Significant losses in mutual funds during the financial crisis of 2008 and 2009 prompted a new focus by the SEC on derivatives and leverage. In March 2010, the SEC announced that staff would study the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds (42 SRLR 568, 3/29/10; 42 SRLR 621, 4/5/10).

When enacted in 1940, the Company Act—which imposes leverage, valuation, diversification, and industry concentration requirements for funds—did not contemplate the use of derivatives. The staff study, which is ongoing, potentially could result in regulatory changes or additional guidance to enhance the current framework. As part of the study, staff has suspended consideration of exemptive relief for exchange-traded funds that propose to invest significantly in derivatives.

At the meeting, SEC Chairman Mary Schapiro said that the commission’s approach to regulating fund use of derivatives has “developed on an ad hoc basis as new derivative instruments were introduced and new derivative hedging strategies gained popularity.”

“The current derivatives review gives us the opportunity to re-think our approach to regulating funds’ use of derivatives,” she continued. The input from commenters—especially those who use derivatives—would help the SEC to “get it right.”…

cforms contact form by delicious:days

NEW YORK—Non-U.S. financial institutions are concerned that pending derivatives regulation may chill their interest in market participation, at least until the way the law is going to be enforced is clarified, industry lawyers have told BNA.

The lawyers are focused on how the pending comprehensive U.S. derivatives regulation may extend to non-U.S. financial institutions already regulated in their home jurisdictions.

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203) for the first time regulates swaps and securities-based swaps as well as swap dealers and major swap participants.

The definition of swap dealer included in the law may capture non-U.S. entities, including overseas banks, that engage in swaps with U.S. persons, exposing the entities to margin, clearing, capital, and reporting requirements imposed under Dodd-Frank by the Commodity Futures Trading Commission on top of being regulated in their home jurisdiction.

While a large financial institution’s exposure to more than one jurisdiction is not unusual, the added layer of requirements imposed by a U.S. swaps regulator could compel non-U.S. banks to contemplate restructuring the way they conduct swap transactions, including moving activity out of the United States to avoid CFTC scrutiny, lawyers told BNA.

“Title VII was never really written with the global swaps business in mind. It was written with a … parochial view, as if swaps existed solely within the borders of the United States,” Cadwalader Wickersham & Taft LLP special counsel Scott Cammarn told BNA June 30.

‘Swap Dealer’ Definition

Section 721(49) of Dodd-Frank defines “swap dealer” as any entity holding itself out as a swap dealer, making a market in swaps, regularly entering into swaps with counterparties as part of its ordinary course of business for its own account, or engaging in any activity causing the entity to be commonly known in the trade as a dealer or market maker in swaps.

That disjunctive definition could apply to many of the largest non-U.S. banks, even those without a material U.S. presence such as a branch, the lawyers said. Non-U.S. banks swept into the Title VII regulatory regime could be subject to margin requirements, capital requirements, transaction and pricing reporting requirements, and the imposition of mandatory clearing requirements for standard swaps.

“The accepted understanding of Title VII is that if a party to the swap is a U.S. person, the swap itself is subject to Title VII, and therefore if you are an offshore entity—you’ve never been to the United States, you’ve never seen the United States—but you regularly engage in swaps with a U.S. person and you otherwise meet the definition of ‘swap dealer,’ you have to comply with Title VII,” Cammarn said…

cforms contact form by delicious:days

Marking the first time it has finalized rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commodity Futures Trading Commission July 7 adopted antifraud/anti-manipulation rules for swaps transactions, along with four other regulations.

Those rules addressed the definition of “agricultural commodity,” large trader reporting for physical commodity swaps, and consumer privacy and information protection.

According to the statute, almost all of the rules implementing the swaps and derivatives portion of the sweeping 2010 financial reform law were to be finalized by July 16. The five adopted July 7, however, were the first to be voted on—relatively uncontroversial items that all cleared unanimously. While the rules have been finalized, implementation is another matter, and there is no deadline for that action. The commission likely will take much of the rest of the year to vote on the roughly four dozen rule proposals remaining.

Security-Based Rule

CFTC staff has said the new antifraud/anti-manipulation rules, proposed in October and voted on as a package, are patterned after Section 10(b) of the 1934 Securities Exchange Act (42 SRLR 2075, 11/1/10). According to the commission, Final Rule 180.1 will “broadly prohibit” manipulative and deceptive devices and contrivances, employed intentionally or recklessly, “regardless of whether the conduct in question was intended to create or did create an artificial price.” Final Rule 180.2, meanwhile, codifies the CFTC’s long-standing authority to prohibit price manipulation, making it unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap or future, or any commodity involved in interstate commerce.

According to David Meister, director of the Division of Enforcement, the rule makes it unlawful to “intentionally or recklessly” use or attempt to use any manipulative device, scheme, or artifice to defraud; to make or attempt to make materially false statements or omissions; to engage or attempt to engage in any act, practice, or course of business that operates as a fraud or deceit; or to deliver or attempt to deliver any false report that affects the price of any commodity in interstate commerce.

Staff noted that the rule does not impose any new affirmative duties of inquiry, diligence, or disclosure. “The failure to disclose information prior to entering into a transaction, either in an anonymous market setting or in bilateral negotiations, will not, by itself, constitute a violation,” it said in a fact sheet. At the same time, it asserted that “trading on the basis of material non-public information in breach of a pre-existing duty … or by trading on the basis of material non-public information that was obtained through fraud or deception,” could violate the rule, as could “fraud-by-partial-omission or half-truths.”

Staff also related that the scienter requirements in the rules—“intentional or reckless” in 180.1, and “specific intent” in 180.2—“function to ensure that good-faith mistakes or negligence will not constitute a violation.”

The language in Dodd-Frank that sparked the rule was inserted by Sen. Maria Cantwell (D-Wash.), whom CFTC Chairman Gary Gensler recognized after the rule became final. Separately, Cantwell said in a statement that the new rule “creates a bright line which will deter bad actors from trying to get away with” manipulative actions that go back to Enron. She noted that variations of the rule have been used successfully by other federal regulators, and she said she hoped the CFTC could apply it “particularly in the oil futures market.”

Industry, Commissioners ‘Concerned.’

At the same time, however, the Futures Industry Association said it was “concerned” that the final rules did not provide more guidance on how the CFTC intends to apply its new authority. “The lack of clarity on how the broad new standards in the final rules will be applied has the potential to chill legitimate trading and reduce market liquidity,” the trade group said. Although she voted in favor of the final rule, Commissioner Jill Sommers also expressed “lingering concerns and questions” about the final rule. Specifically, she wondered “what set of circumstances will give rise to a charge under” existing CFTC anti-manipulation authority as opposed to the new manipulation prohibition, which has a lower scienter standard.

Sommers asserted that as the CFTC begins to exercise its new authority, it should do so in a way that “seeks to address activity that affects or threatens the integrity of our markets and does not result in unfair surprise[s] to market participants.” Commissioner Scott O’Malia, like Sommers, a Republican, voted to adopt the rule but nonetheless expressed concerns. He said the new rule did not provide “adequate clarity” and that “such vagueness … will add confusion to the markets.”

He said that adopting securities-based rules “runs the risk of disregarding the unique qualities of the futures and derivatives markets,” and also called for more clarity about how the CFTC would apply its authority…

cforms contact form by delicious:days

The Securities and Exchange Commission June 29 unanimously agreed to propose new rules to establish business conduct standards for security-based swap dealers and major SBS participants that enter into swap transactions with counterparties.

The proposal also would impose additional requirements for dealing with counterparties that are “special entities,” which include employee benefit plans under the 1974 Employee Retirement Income Security Act, endowments, and state and federal agencies.

Under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC and the Commodity Futures Trading Commission are required to create a framework for regulating over-the-counter derivatives. Very broadly, the SEC has jurisdiction over SBSs, while the CFTC has jurisdiction over other kinds of swaps.

More specifically, the reform statute’s Section 764 authorizes the SEC to promulgate business conduct rules for SBS entities. SEC staff previously estimated that SBSs constitute 5 percent to 10 percent of the overall $600 trillion swaps market.

CFTC Proposal

The CFTC proposed its corresponding business conduct standards for swap dealers and major swap participants in December (42 SRLR 2368, 12/13/10). The rulemaking has been controversial, with pension plan participants in particular voicing fears that the CFTC’s proposed broad definition of “advisor,” together with a proposal by the Department of Labor to expand the definition of “fiduciary” under ERISA, could threaten their ability to enter into swap transactions (43 SRLR 717, 4/4/11)…

cforms contact form by delicious:days

By Thomas P. Vartanian
and Lawrence K. Nesbitt

The number of formal enforcement actions issued by the federal banking agencies exploded again in 2010, following a record setting year in 2009 in which the federal banking agencies issued more than 1000 formal enforcement actions for the first time. In 2010, the federal banking agencies issued approximately 1500 formal enforcement actions, which was a significant increase over the approximately 1100 formal enforcement actions issued in 2009.

This historic high level of enforcement activity by the federal banking agencies reflects the continuation of a very challenging business environment for the banking industry as a whole, despite the fact that many depository institutions appear to have made significant strides since the depths of the financial crisis to shore up capital, bulk up reserves, and improve liquidity. It may also reflect an increased willingness on the part of the federal banking agencies to issue formal enforcement actions against institutions prior to their failure, following congressional pressure and numerous reports stating that banking regulators were too slow to take such actions against failing institutions in the recent past.

During the past three years, over 3000 formal enforcement actions, including almost 700 assessments of civil money penalties (“CMPs”), have been issued by the federal banking agencies. In addition, more than 2500 informal memoranda of understanding have reportedly been issued by the federal banking agencies during that period of time. While these statistics do not exactly translate into the number of U.S. depository institutions that have recently been subject to an enforcement order, because of repetitive actions at the same institution and orders directed at individuals, they do suggest that a very significant percentage of U.S. depository institutions have been the subject of some form of formal or informal bank regulatory enforcement action during the past three years. As expected, the overwhelming focus of bank enforcement activity since the beginning of the recent financial crisis has been on the fundamental building blocks of safety and soundness, including capital, asset quality, management, earnings and liquidity. With regard to liquidity, we have seen a distinct regulatory shift over the past couple of years that has thrown the internet and wholesale funding model into disrepute with the banking agencies, leading to significant pressure on banking institutions using such funding that are unable to transform overnight into retail banks.

The historic high level of bank enforcement activity is not the only bad news for the banking industry. The federal banking agencies, the Special Inspector General for TARP (“SIGTARP”), the U.S. Department of Justice (“DOJ”), the Federal Housing Finance Agency (“FHFA”), and other state and federal agencies are actively engaged in investigations regarding the mortgage finance industry and are seeking to identify institutions and individuals who played a role in the functional collapse of private financial markets. The principal focus of these inquiries is mortgage fraud, whether it be by the lender, the borrower, or the middleman, and servicing defects, whether they relate to filings, servicing, or foreclosure. In that regard, the “robo-signing” problems in the industry have been well chronicled, as have the attempts by the 50 state attorneys general to investigate and assert claims against the largest mortgage servicers in the country.

At the same time, the increasing number of lawsuits being brought by investors and others asserting fraud in the issuance and sale of mortgage-backed securities and related synthetic derivative instruments is further complicating an already treacherous landscape. In combination with criminal prosecutions that are beginning to appear and more than 140 outstanding investigations by SIGTARP, a perfect storm for bank enforcement has clearly emerged.

Formal Enforcement Actions: 2005 – 2010

Civil Money Penalties: 2005 – 2010

The Securities and Exchange Commission unanimously voted jointly to propose with the Commodity Futures Trading Commission a series of rules and interpretive guidance to define the terms “swaps,” “security-based swaps,” and “security-based swap agreements.”

The joint proposal also would clarify the scope of the mixed swaps category—which is regulated by both agencies—and would require regulated entities to maintain the same books and records for security-based swaps as they would for swaps.

The CFTC, on the same day, voted 4-1 to issue the joint proposal.

Moreover, the SEC unanimously agreed to propose amendments to remove credit rating references in six rules—including a rule requiring the calculation of net capital—and one form pertaining to broker-dealers under the 1934 Securities Exchange Act.

Swaps Regime

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC and the CFTC to create a regulatory framework for over-the-counter derivatives. The reform statute charges the SEC with jurisdiction over security-based swaps, and the CFTC with jurisdiction over other kinds of swaps.

In her opening remarks, SEC Chairman Mary Schapiro said that the proposal would provide guidance to market participants and clarify, through “clear and objective criteria,” whether a product was a swap under the CFTC’s purview, a security-based swap under the SEC’s purview, or a mixed swap under the jurisdiction of both agencies. “The proposed definitions balance several policy and legal issues in a way I believe is practical, takes into account the specific nature of derivatives contracts, and is consistent with existing securities regulations,” she said.

Robert Cook, director of the SEC’s Division of Trading and Markets, told the commissioners that the proposed definitions are “vital” because they would set out the scope of the products subject to regulation and to the antifraud provisions of the federal securities laws. He added that staff views the proposed rules and interpretations “as an opportunity for further dialogue with the public.”

The SEC and CFTC’s joint proposal, very broadly, would clarify that certain instruments are not swaps or security-based swaps and thus not under the purview of the agencies. Products that are not considered swaps include traditional insurance products, and certain consumer and commercial transactions entered into by individuals and families, such as employment contracts, mortgage agreements, and fixed rate natural gas contracts for home heating.

Many market participants had voiced concern during the comment process and in meetings with SEC staff that the derivatives rulemaking inadvertently would draw in insurance products (43 SRLR 719, 4/4/11).

Title VII Instruments

Secondly, the proposal would draw the lines between swaps products—collectively known as “Title VII instruments”—to clarify whether they should be regulated by the SEC, CFTC, or both. Products such as foreign exchange forwards, foreign exchange swaps, foreign currency options (except those traded on a national securities exchange), and forward rate agreements would be considered Title VII instruments. The agencies, through proposed guidance, would clarify whether the particular agreements, contracts, and transactions are swaps, security-based swaps, or mixed swaps. Once a determination is made, the proposed guidance would provide that the characterization remains throughout the life of the product unless the product is amended or modified.

Under the proposal, mixed swaps—a very narrow category—would be subject to both the SEC and CFTC’s regulations. However, certain requirements would apply to bilateral uncleared mixed swaps entered into by at least one dually regulated swap and security-based swap dealer or major swap and security-based swap participant. The agencies also proposed a process by which market participants may approach the agencies for a joint determination of whether a particular product or class of products is a swap, security-based swap, or mixed swap.

Although the SEC and CFTC were in agreement with respect to the vast majority of products, there are differences in approaches in a few areas, including insurance for swap products. The SEC believes that insurance for swap products should be treated and regulated as insurance while the CFTC believes that such insurance should be treated and regulated as swaps. Where there are differences, the agencies ask for comments and input on which approach would be more appropriate. Such differences ultimately have to be reconciled at the adoption stage.

Anti-Evasion

The agencies also differed in the anti-evasion area. Dodd-Frank authorizes the agencies to enact anti-evasion rules to bar transactions or activities designed to avoid Title VII responsibilities. While the CFTC has proposed anti-evasion rules for the swap products under its regulation, the SEC has not proposed any rules but instead has asked for comment on whether it should propose such rules. Unlike the other differences in the joint proposal, which must be bridged at the finalization stage, the reform statute allows the agencies to differ in their anti-evasion rules.

Meanwhile, the commissioners said the overriding goal for the proposal should be to provide certainty and clarity to the marketplace. They called for comments on whether the lines between the products can be drawn more clearly.

In particular, Commissioner Elisse Walter urged the public to weigh in with “pragmatic and precise” comments that would help the two agencies better define the scope of the regulations. Commissioner Luis Aguilar also warned that the agencies must draw clear jurisdictional lines that are “not susceptible to regulatory arbitrage.”

The proposal is open for comment for 60 days after publication in the Federal Register…

cforms contact form by delicious:days

The Commodity Futures Trading Commission proposed two rules Jan. 20—one that generally would permit the transaction of agricultural swaps under the same terms as any other swap, and another addressing the required documentation between counterparties regarding the…

cforms contact form by delicious:days