On August 11, 2009, the Obama Administration released the “Over-the-Counter Derivatives Markets Act of 2009” (the “Proposed Bill”), sweeping legislation that for the first time would subject the over-the-counter (“OTC”) derivatives markets, OTC derivatives dealers, derivatives clearing organizations and agencies, swap repositories and major non-dealer participants to comprehensive regulation. The Proposed Bill is dense and complex and is rife with interpretive issues. It will have major consequences for the OTC derivatives markets, dealers and participants, as well as for the CFTC and SEC. It represents a significant policy reversal from the Commodities Futures Modernization Act of 2000, legislation that essentially shielded the OTC derivatives market from pervasive regulation.
Among other things, the Proposed Bill would:
- grant the CFTC increased jurisdiction over “swaps,” other than “security-based swaps” (while preserving the exemption for hybrid instruments), and grant the SEC jurisdiction over “security-based swaps”;
- bring under regulation new categories of market participants, including “swap dealers” and “security-based swap dealers” (which we sometimes refer to collectively as “derivatives dealers”) and “major swap participants” and “major security-based swap participants” (which we sometimes refer to collectively as “major derivatives participants”), with major derivatives participants being defined solely by the size of derivatives positions entered into or held;
- require standardized swaps to be centrally cleared by a derivatives clearing organization registered with the CFTC and require standardized security-based swaps to be centrally cleared by a clearing agency registered with the SEC, subject to certain exceptions;
- create a legal presumption that a swap or security-based swap is standardized if it is accepted for clearing by any clearing organization or agency;
- require all standardized swaps to be traded on a regulated exchange or alternative swap execution facility, unless no clearing organization or agency will accept the instrument for clearing or one of the counterparties is not a derivatives dealer or major derivatives participant and does not meet the eligibility requirements of any clearing organization or agency that clears the instrument;
- direct regulators to impose capital and margin requirements for OTC derivatives on all derivatives dealers and major derivatives participants, with higher capital requirements for derivatives that are not centrally cleared;
- require reporting of OTC derivatives not accepted for clearing to a registered swap repository or, if there is no repository that will accept the trade, directly to the CFTC or SEC or their designee; and require confidential sharing, upon request, of individual transaction and counterparty data with other regulators, including foreign financial supervisors;
- require the CFTC and SEC or their designees to make available to the public aggregate data on swap and security-based swap trading volumes and positions;
- create a system of mandatory federal registration, supervision and regulation of all derivatives dealers, major derivatives participants and swap repositories;
- require certain large swap traders and large security-based swap traders to report to the SEC and CFTC information pertaining to swaps and security-based swaps that have a significant price discovery function;
- give the CFTC and SEC rulemaking authority to prevent abuses in the OTC derivatives markets, including setting position limits and instituting reporting requirements for OTC derivatives that perform or affect a significant price discovery function;
- grant the SEC authority to limit, and to direct self-regulatory organizations (“SROs”) to limit, the positions in security-based swaps and securities on which such security-based swaps are based that may be held by any member of an SRO or any persons who effect transactions in security-based swaps or other securities with members;
- limit, thereby constraining, the trading of swaps or security-based swaps with counterparties that are not “eligible contract participants” solely to transactions effected on a designated contract market or national securities exchange, and tighten the definition of eligible contract participants for certain government entities;
- amend the Securities Exchange Act of 1934 (the “Exchange Act”) to extend the beneficial ownership reporting requirements of Section 13 (and thereby indirectly the short-swing profit rule of Section 16) to include equity securities underlying security-based swaps and other derivatives through rules that may be adopted by the SEC;
- apply to offshore OTC derivatives markets, derivatives dealers and major derivatives participants, as there are no explicit territorial limitations for most of the provisions;
- grant the CFTC authority to register and partially regulate foreign boards of trade that permit direct access to US participants;
- preserve most (but not all) legal certainty and federal preemption of gaming and bucket shop laws;
- amend the Securities Act of 1933 (the “Securities Act”) to include “security-based swap” in the definition of “security” and require registration under Section 5 of security-based swaps that are offered or sold to any person that is not an eligible contract participant, potentially leading to unintended consequences;
- require reporting within 180 days of the enactment of the Proposed Bill of all OTC derivatives entered into prior to the enactment of the Proposed Bill
- subject certain retail commodities transactions to the Commodity Exchange Act of 1936 (the “Commodity Exchange Act”); and
- require derivatives dealers and major derivatives participants to implement conflicts-of-interest systems and procedures establishing information walls between the research functions and any clearing and trading activities, and mandate that the CFTC require futures commission merchants and introducing brokers to do the same.
This newsflash briefly summarizes the main provisions of the Proposed Bill. Davis Polk will continue to monitor developments in this area and will provide additional analysis in subsequent memoranda to our clients.
Regulation of OTC Derivatives Generally
In a remarkable policy determination, given recent concerns over regulatory fragmentation, the Proposed Bill would divide primary regulatory and supervisory authority for derivatives among the CFTC, SEC and, in some instances, federal bank regulators. The Proposed Bill would grant the SEC jurisdiction over swaps based on a narrow-based security index, a single security or loan, or the occurrence or non-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, condition or obligations of the issuer, but not over swaps based on broad-based indices and government securities. The intent of the Proposed Bill appears to give the SEC sole authority over credit default swaps, but given the drafting, it remains an open question whether certain credit default swaps (such as, for example, “pay-as-you-go” credit default swaps) in fact will meet the narrow definition of a security-based swap. The CFTC would have jurisdiction over the vast majority of swaps, including non-security-based swaps based on broad indices, government securities and currency swaps, but not foreign exchange swaps and forwards. Interestingly, the CFTC would have primary regulatory authority over swaps based on broad-based indices of securities. Both the CFTC and SEC would have jurisdiction over so-called “mixed swaps” that contain both security-based swap and non-security based swap components. The CFTC’s and SEC’s jurisdiction would exclude "identified banking products," a term that would include deposits, acceptances, letters of credit, loans and certain loan participations, unless the federal bank regulators, in consultation with the CFTC and SEC, determined that the products in question would meet the definition of swap or security-based swap and had become known to the trade as such, or had been structured for purposes of avoiding Commodity Exchange Act, Securities Act or Exchange Act jurisdiction.
It is unclear whether certain types of common OTC derivatives would fall outside of the scope of the Proposed Bill. Physically-settled options and purchase contracts on securities would remain under SEC jurisdiction. In addition, the Proposed Bill contains specific language that could call into question the treatment of call spreads entered into by issuers in connection with issuances of convertible debt offerings. The Proposed Bill would seem to preserve the ability of issuers to issue structured notes, although questions remain about whether credit-linked notes would be treated as security-based swaps. The Proposed Bill’s restrictions, however, would apply to the swaps used by structured note issuers to hedge their obligations under such structured notes and therefore could have a significant impact on the structured notes markets.
As described below, the CFTC and SEC would need to jointly adopt most rules implementing the Proposed Bill, and in some cases, would be required to do so in consultation with federal bank regulators. The Proposed Bill would explicitly limit the exemptive authority of the CFTC and SEC over swaps and security-based swaps provisions to those areas in which the regulators are specifically authorized to grant exemptions.
The Proposed Bill includes “security-based swap” in the definition of “security” in the Securities Act. This may have significant unintended consequences for other laws and regulations that cross-reference to the Securities Act definition of security and for preexisting contractual arrangements.
Regulation of OTC Derivatives Markets
As expected, the Proposed Bill would require that “standardized” OTC derivatives be cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC. More surprisingly, the Proposed Bill would further require that all OTC derivatives that are centrally cleared be traded on a CFTC- or SEC-regulated exchange or a regulated alternative swap execution facility. These clearing and exchange trading requirements have certain exceptions as described below.
The Proposed Bill provides that any OTC derivatives cleared by a regulated derivatives clearing organization or agency would be presumed to be “standardized.” The CFTC and SEC would also have the ability to further define a “standardized” contract by applying factors that include volume, dissemination of terms to third parties, frequency of references in other transactions and similarity to other agreements, contracts or transactions. The CFTC and SEC would separately have the authority to designate a particular swap or class of swaps as standardized taking into account these same factors to jointly prescribe rules as necessary to prevent attempts by market participants to evade the designation of specific OTC derivatives as standardized. The Proposed Bill would also require advance certification of clearing of new instruments by CFTC-regulated entities, with exceptions.
An exception for mandatory clearing and exchange trading would be provided for OTC derivatives that are not accepted by any clearing agency for clearing, and OTC derivatives transactions in which one of the counterparties to the transaction is not a derivatives dealer or major derivatives participant and does not meet the eligibility requirements of any clearing agency that clears the swap. It is unclear what, if any, burden of proof would fall on a derivatives dealer or major derivatives participant seeking to trade a particular contract to demonstrate that no clearing agency would accept that contract for clearing. The exceptions to the mandatory clearing and exchange trading requirements are so narrow as to preclude transactions between affiliates and transactions with customers that are back-to-back with centrally cleared transactions entered into on an exchange or an alternative swap execution facility. Indeed, in such instances, regulators would not have general authority to grant exemptions and the Proposed Bill contains no specific authority to do so.
The viability of establishing and trading on alternative swap execution facilities, as an alternative to trading on a regulated exchange, is unclear from the text of the Proposed Bill. An alternative swap execution facility would be required to register with the CFTC or SEC and comply with core regulatory principles relating to enforcement, anti-manipulation, monitoring, information collection and disclosure, recordkeeping and reporting, antitrust considerations and conflicts of interest, and it would only be permitted to trade in swaps that “are not readily susceptible to manipulation.” The latter criterion could be evaluated with factors such as the capitalization, diversification, number of securities in an index or group and the ability to conduct surveillance of the contract and underlying securities. In addition, the facility would be required to establish participation and trading rules, and have the capacity to detect, investigate and enforce those rules.
Counterparties to a swap or security-based swap that is not accepted for clearing would also be required to report such swap to a registered repository. The repository would also be required to make available, on a confidential basis, all data obtained by it, including individual counterparty trade and position data, to the CFTC, SEC, appropriate federal bank regulators, Financial Services Oversight Council, Department of Justice and any other person the CFTC or SEC deems appropriate, including foreign regulators. If there is no repository that would accept the swap data in accordance with the rules (including timeframes) adopted by the CFTC or SEC, then the counterparties to such swap would be required to report directly to the CFTC or SEC.
The CFTC and SEC would also be charged with prescribing rules for recordkeeping and reporting by clearing houses and alternative swap execution facilities. Aggregate data on swap and security-based swap trading volumes and positions would be made available to the public by the CFTC and SEC or their designees.
The Proposed Bill potentially would have vast international implications – and would likely create significant uncertainties for market participants – because there are no explicit territorial limitations for most of the provisions. For example, the Proposed Bill would subject “any person,” with certain exceptions, to its requirements for registration, regulation, clearing, trading and information sharing. Unlike cash market securities transactions by foreign broker-dealers, which benefit from the so-called “chaperoning” exemption in Rule 15a-6, the Proposed Bill contains no exemptions for foreign derivatives dealers or foreign major derivatives participants trading with US counterparties. Nor does it grant authority to the CFTC or SEC to grant such exemptions.
Regulation of Derivatives Dealers, Major Derivatives Participants, Derivatives Clearing Organizations and Agencies and Swap Repositories
The Proposed Bill would establish regimes for the registration and regulation by the CFTC and the SEC of a wide array of new entities, including derivatives dealers and major derivatives participants, swap repositories, security-based swap repositories, clearing organizations and agencies and alternative swap execution facilities (both under the Commodity Exchange Act and the Exchange Act), and would also expand considerably the requirements applicable to CFTC-regulated derivatives clearing organizations. In general, there are very few exemptions from the registration requirements. Therefore, if enacted, the Proposed Bill would require many organizations to register and develop comprehensive compliance infrastructures for their OTC derivatives activities (possibly in multiple categories) and imply very considerable growth in the registration, rulemaking, interpretation, examination and enforcement functions of the two agencies.
The Proposed Bill would subject all derivatives dealers and major derivatives participants to federal regulation and supervision, including capital and margin requirements and registration with the CFTC, SEC or both agencies. Such dealers and participants entering into standardized derivative contracts would need to further adapt to the Proposed Bill’s clearing requirements by joining a derivatives clearing organization or agency, or making other arrangements to have access to clearing.
The terms “major swap participant” and “major security-based swap participant” would include any firm or person that takes large positions in OTC derivatives, other than as a hedge. Since there does not appear to be a "grandfathering" provision and because the mere holding of a large position could cause an entity to be a "major swap participant" or "major security-based swap participant,” it is likely that entities could become subject to regulation irrespective of their derivative market activities following enactment. Formerly unregulated frequent users of OTC derivatives, such as hedge funds, would be swept into the regulatory regime by these provisions.
The CFTC and SEC would share certain aspects of regulatory authority with the federal bank regulators who would have prudential oversight over derivatives dealers and major derivatives participants that are banks, and branches or agencies of foreign banks, and, for purposes of setting capital requirements, bank holding companies. In most cases, rulemaking and interpretations would be jointly promulgated by both the CFTC and SEC, and the federal bank regulators would have rulemaking authority with respect to margin, capital and prudential rules with respect to the entities they regulate. There is no “bank exemption” from registration as a swap dealer, security-based swap dealer, major swap market participant or major security-based swap participant. The CFTC and SEC would have authority to provide conditional or unconditional exemptions from rules for such dealers and participants that are subject to substantially similar requirements as brokers or dealers.
Importantly, regulators would be required to impose and enforce higher capital requirements for OTC derivatives that are not centrally cleared. The Proposed Bill would permit, but not require, federal bank regulators to prescribe margin requirements for certain hedging counterparties that are not predominantly engaged in financial activities and are not derivatives dealers or major derivatives participants. The capital and margin requirements set by the federal bank regulators would serve as a floor for capital and margin requirements set by the CFTC and SEC and for capital requirements set by the Federal Reserve for bank holding companies and Tier 1 financial holding companies, as defined in recently proposed systemic-risk legislation. The CFTC and SEC would be required to set capital and margin requirements for non-bank derivatives dealers and non-bank major derivatives participants that are “as strict or stricter” than those set by federal bank regulators for derivatives dealers and major derivatives participants that are banks. Harmonization of CFTC and SEC regulations is sought by requiring the two agencies to prescribe requirements that treat “functionally or economically similar products” similarly.
The Proposed Bill would impose new requirements, as may be prescribed by the CFTC or SEC, for recordkeeping and reporting on a timely basis and business conduct, back-office standards, conflicts of interest systems and antitrust considerations for derivatives dealers and major derivatives participants. The business conduct requirements contain prescriptions for establishing standards of care for verifying that any counterparty is an eligible contract participant and for making disclosures to counterparties. The CFTC and SEC would be empowered to limit the activities of derivatives dealers and major derivatives participants that are not banks, while the federal bank regulators would have such authority over applicable banking entities, in addition to their authority to set prudential regulations for such entities. The Proposed Bill would also extend the cease-and-desist authority of the federal bank regulators to cover derivatives dealers and major derivatives participants, derivatives clearing organizations, swap repositories and alternative swap execution facilities over which the federal bank regulators would be granted jurisdiction.
Unless exempted, derivatives clearing organizations and agencies would be required to be registered with the CFTC and SEC, respectively. The Proposed Bill would require dual registration of a person that meets the requirements for derivatives clearing organizations and agencies, regardless of whether it is already registered as an organization or agency or is also a bank, unless the person is subject to comparable comprehensive supervision and regulation on a consolidated basis by the SEC, CFTC, a federal bank regulator or the appropriate foreign governmental authorities. The CFTC and SEC would be given authority to jointly adopt uniform rules governing such entities. Along the lines of Section 17A of the Exchange Act, the provisions of the Proposed Bill specify certain core principles applicable to derivatives clearing organizations to be registered with the CFTC. The core principles cover, amongst other things, settlement procedures, minimum financial resources, reporting, recordkeeping, establishment of governance fitness standards (which would require the organization’s or agency’s board to include market participants) and the avoidance of rules that result in any unreasonable restraint of trade or material anticompetitive burden.
Overall, the Proposed Bill would require extensive joint rulemaking and interpretation by the CFTC and SEC, which history suggests would prove a difficult task. If the CFTC and SEC cannot agree within 180 days, the Treasury Department would become the default rulemaker.
Preventing Market Manipulation, Fraud, Insider Trading and Other Abuse
According to a Treasury press release, the Proposed Bill would give the CFTC and SEC “clear, unimpeded authority” to deter market manipulation, fraud, insider trading and other abuses in the OTC derivatives markets. As one means to prevent fraud and manipulation, the CFTC and SEC would be able to set position limits and major market reporting requirements for OTC derivatives transactions under their respective jurisdictions that perform or affect a significant price discovery function with respect to regulated markets. The SEC would have antifraud and anti-manipulative rulemaking power over swaps on broad-based indices and government securities under Section 10 of the Exchange Act.
Another novel and noteworthy aspect of the Proposed Bill is that it would grant the SEC the authority to establish aggregate position limits for securities listed on a national securities exchange and to require SROs to adopt rules for position limits in any security-based swap and, most significantly, any security on which such security-based swap is based. Limitations on ownership of listed securities imposed by the SEC and SROs would be unprecedented and have alarming significance for the markets.
Both the Commodity Exchange Act and the Exchange Act regimes would impose “statutory disqualification” limitations on persons associated with newly regulated entities. “Statutory disqualifications” include certain administrative, civil or criminal penalties. These limitations may cause unexpected difficulties for firms that have not been subject to similar limitations in the past, and may require changes in personnel practices and expanded due diligence in connection with mergers and other corporate transactions.
Limiting the Investors that are Eligible to Engage in OTC Derivatives Transactions
The Proposed Bill would make it more difficult for small municipalities and certain other governmental entities to engage in OTC derivatives transactions. It would tighten the definition of “eligible contract participant” that can engage in OTC derivatives transactions, requiring, with exceptions, that government entities own or manage on a discretionary basis at least $50 million in investments, rather than the $25 million currently required. This means that such entities not meeting this threshold would only be able to enter into transactions where the contract is traded on a regulated exchange or board of trade designated as a contract market. Limitations on the eligibility of individuals to enter into derivatives would also be tightened under the Proposed Bill. The definition of eligible contract participant would be amended to require that the amounts individuals have invested on a discretionary basis be in excess of a set threshold, as opposed to the current requirement that they merely have total assets exceeding such threshold.
These changes apparently reflect the Administration’s concern, as discussed in its White Paper released in June, that current limits on the types of counterparties that can participate in OTC derivatives markets are not sufficiently stringent to protect unsophisticated parties from entering into inappropriate derivatives transactions. To this end, the Proposed Bill would require the CFTC and SEC to jointly adopt a rule that further defines the term “eligible contract participant” within 180 days after the effective date of the Proposed Bill.
Entities and persons not meeting the definition of an eligible contract participant would only be permitted to enter into swaps that are on or are subject to the rules of a board of trade designated as a contract market and would only be permitted to enter into security-based swaps if the transaction is effected on a registered national securities exchange. The Proposed Bill would also require registration under Section 5 of the Securities Act of security-based swaps that are offered or sold to any person that is not an eligible contract participant, thereby further complicating participation in such transactions.
Moreover, security-based swap dealers would be required to register with the SEC as broker-dealers (if they are not so registered already), and thus would be subject to the full regulatory scheme applicable to registered broker-dealers.
Extending Section 13 and Section 16 Requirements
The Proposed Bill would amend the Securities Exchange Act of 1934 (the “Exchange Act”) to extend the beneficial ownership reporting requirements of Section 13 (and thereby indirectly the short-swing profit rule of Section 16) to include equity securities underlying security-based swaps and other derivatives through rules that may be adopted by the SEC. An open issue is whether Section 13 requirements would apply regardless of whether the purchaser has voting rights.
Preemption of State Law
The Proposed Bill would amend the Exchange Act with respect to the preemption of state law, including gaming and bucket shop laws. Under the Proposed Bill, security-based swaps between eligible contract participants or effected on a national securities exchange would benefit from a preemption of state wagering, gaming, bucket shop and similar laws. On the other hand, unlisted retail structured notes would still seem to benefit from the preemption of state gaming laws provided by Section 12(e)(2) of the Commodity Exchange Act which preempts transactions excluded from the Commodity Exchange Act by the hybrid exemption.
In addition, the Proposed Bill provides a preemption of most state securities laws: “No provision of state law regarding the offer, sale, or distribution of securities shall apply to any transaction in a security-based swap or a security futures product, except that this sentence shall not be construed as limiting any state antifraud law of general applicability.” There remains, however, a significant ambiguity, whether this provision would effectively preempt state insurance laws such as the model statute being drafted by the National Conference of Insurance Legislators relating to credit default insurance. Even assuming this were intended to cover such statutes, there could be arguments made by state regulators under the McCarran-Ferguson Act of 1945, which generally requires that if the federal government wishes to regulate insurance, it must do so explicitly.