On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the JOBS Act).  The new legislation enlarges the menu of choices that private companies will have to raise capital while also reducing the burdens on “emerging growth companies” that ultimately resort to the public markets.  It also offers benefits for private investment funds. Many aspects of the JOBS Act are effective immediately; others require rulemaking by the SEC, generally on an expedited basis.

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By Heath Tarbert, Sylvia Mayer and Derrick Cephas

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Click here for a PDF of the related article A SIFI in Three Easy Steps?  FSOC Approves Final Rule for Nonbank SIFI Designations appearing in The Banking Law Journal, May 2012

On April 3, 2012, the Financial Stability Oversight Council (“FSOC”) voted to approve its long-awaited Final Rule implementing Section 113 of the Dodd-Frank Act, the controversial provision that directs the federal government to identify systemically important financial institutions (“SIFIs”) outside the traditional banking sector that could pose a threat to the U.S. financial system.[1] Once designated by a two-thirds majority of the FSOC (including an affirmative vote of the Treasury Secretary), each “nonbank financial company,” often referred to in short-hand as a “nonbank SIFI,” would be placed under Federal Reserve Board (“Fed”) supervision, as well as become subject to a host of enhanced prudential measures—including capital, liquidity, leverage, stress testing, resolution planning, and risk management requirements. The FSOC’s recent approval of the Final Rule—as well as its accompanying interpretive Guidance[2]—marks the start of an important first step in the application of enhanced SIFI regulation beyond large bank holding companies with assets of $50 billion or greater.[3]

The FSOC issued its Final Rule following consideration of over forty public comments to its Notice of Proposed Rulemaking (the “Proposed Rule”), released in October, 2011.[4]

Overview

The Final Rule establishes a three-step process comprising three individual “stages” by which the FSOC will apply two “Determination Standards” (one based on actual or potential material financial distress and the other based on the nature, scope, size, scale, concentration, interconnectedness or mix of activities) to analyze whether a company may pose a threat to the financial stability of the U.S., along with a six-category analytic framework to determine whether a company should be deemed a nonbank SIFI. In an effort to increase the transparency of the process, the FSOC issued accompanying Guidance providing additional details and insights into the nonbank SIFI determination process.

Nonbank Financial Companies

Only a “nonbank financial company” may be designated as systemically important by the FSOC under Section 113 of the Dodd-Frank Act and the Final Rule. It should be no surprise that the FSOC has interpreted “company” broadly to include any corporation, limited liability company, partnership, business trust, association, or similar organization.[5] That said, Congress specifically narrowed the class of potential nonbank SIFIs to companies that are not banks or bank holding companies that are nonetheless “predominantly engaged in financial activities” with certain exceptions—essentially meaning that 85% of a company’s consolidated annual revenues or assets are derived from activities that are financial in nature. While the FSOC is charged with establishing criteria to distinguish between nonbank SIFIs and other nonbank financial companies, the Fed is charged with defining what constitutes a financial activity and it has issued a proposed rule under that authority, the comment period for which was recently extended until May 25, 2012.[6] The Fed is expected to issue a final interpretation before the end of the summer, allowing for nonbank SIFI designations to commence in the late summer or early autumn.

Determination Standards and Statutory Considerations

Under the Final Rule, a particular nonbank financial company will be subject to Fed supervision and prudential standards if the FSOC determines: (i) material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States (the “First Determination Standard”); or (ii) the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability of the United States (the “Second Determination Standard”).

In deciding whether a particular nonbank financial company meets either of the Determination Standards, the FSOC must consider the ten statutory considerations required by Section 113, which the FSOC has consolidated into a six-category analytical framework: size, interconnectedness, lack of substitutes, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny. The FSOC has created a table (produced below) mapping the six categories to each of the ten statutorily mandated considerations.

During the comment period on the Proposed Rule, several commentators had questioned whether the six-category analytic framework would be effective if applied across or within industries. In response to such comments, the FSOC clarified in the Final Rule that evaluation of any nonbank financial company under the framework will be company-specific.

The Determination Process

The FSOC intends to follow a three-stage process involving an analysis based on an increasing amount of information to identify nonbank financial companies for determinations in non-emergency situations (“the Determination  Process”). Determinations will be made based on company-specific evaluations and quantitative and qualitative information that the FSOC deems relevant to a particular company.

Stage 1: Initial Identification of Nonbank Financial Companies for Evaluation

In Stage 1 of the process, the FSOC will narrow the field of potential nonbank SIFIs by applying uniform quantitative thresholds, applicable across the financial sector. The quantitative thresholds employed at Stage 1 relate to the following more readily quantifiable analytical categories: size, interconnectedness, leverage, and liquidity risk and maturity mismatch. The objective of Stage 1 is merely to identify nonbank financial companies that should be subject to further evaluation in subsequent stages of review—Stage 1 is by no means a final determination of SIFI status. The FSOC believes that Stage 1 will be a useful tool that will allow nonbank financial companies and the public to assess whether a company will be subject to further evaluation.

A nonbank financial company will move to Stage 2 for further evaluation if it meets both the total consolidated assets threshold ($50 billion in global total consolidated assets for U.S. nonbank financial companies or $50 billion in U.S. total consolidated assets for foreign nonbank financial companies) and any one of the other thresholds listed below:

• Credit Default Swaps Outstanding: $30 billion in gross notional credit default swaps outstanding for which the nonbank financial company is the reference entity, where gross notional value equals the sum of credit default swap contracts bought (or equivalently sold).

• Derivative Liabilities: $3.5 billion of derivative liabilities, where derivative liabilities equals the fair value of any derivatives contracts in a negative position after taking into account the effects of master netting agreements and cash collateral held with the same counterparty on a net basis.[7]

• Total Debt Outstanding: $20 billion of total debt outstanding. The definition of total debt outstanding will include, regardless of maturity, outstanding loans, bonds, repurchase agreements, commercial paper, securities lending arrangements, surplus notes (for insurance companies) and other indebtedness.

• Leverage Ratio: A minimum leverage ratio of total consolidated assets (excluding separate accounts) to total equity of 15 to 1. Separate accounts are excluded from the ratio calculation because such accounts are not available to satisfy claims of general creditors of the nonbank financial company.

• Short-Term Debt Ratio: Ratio of total debt outstanding (as defined above) with a maturity of less than 12 months to total consolidated assets (excluding separate accounts) of 10 percent.

When applying the Stage 1 thresholds, the FSOC intends to use U.S. GAAP when available, and look to statutory accounting principles, international financial reporting standards, or other such data in the absence of GAAP-based financials.

As reporting requirements evolve, the FSOC may also review quantitative thresholds as appropriate. For example, it may consider credit exposure data proposed to be collected under Section 165(d) of the Dodd-Frank Act or swap information to be reported to swap data repositories under Section 728 of the statute.

Additionally, the FSOC stresses that because the uniform quantitative thresholds may not identify all of the means by which a nonbank financial company could pose a threat to financial stability of the United States, it reserves the right to evaluate certain nonbank financial companies in this initial stage using other firm-specific qualitative or quantitative factors.  Companies identified during Stage 1 will be subjected to the Stage 2 evaluation (the “Stage 2 Pool”).

Stage 2: Review and Prioritization of Stage 2 Pool

At this stage of the process, the FSOC will conduct an in-depth analysis of each nonbank financial company to determine the potential threat that each could pose to U.S. financial stability. As in Stage 1, the FSOC will utilize publicly available information, including information possessed by the company’s primary financial regulatory agency or home country supervisor. Based on this information, the FSOC will embark on a more focused evaluation of the “risk profile and characteristics of each individual nonbank financial company,” using the six-category analytical framework discussed above. The FSOC will also evaluate the nonbank financial company using qualitative factors, such as whether the resolution of the specific nonbank financial company could pose a threat to U.S. financial stability, and the degree to which such nonbank financial company is already subject to regulatory scrutiny. As appropriate, in this stage the FSOC will begin consulting with the primary financial regulatory agency of each nonbank financial company and, to the extent it deems appropriate, the primary financial regulatory agency of each of its subsidiaries. After the completion of the Stage 2 analysis, the FSOC will notify the nonbank financial companies identified as requiring further review (the “Stage 3 Pool”).

Stage 3: Review of Stage 3 Pool

At the final stage of review, the FSOC will use nonpublic information obtained directly from the nonbank financial company and likely consider qualitative factors such as a company’s resolvability, the opacity of its operations, its complexity and the extent and nature of its regulatory scrutiny to analyze its potential to pose a threat to financial stability. The analysis will depend on the particular circumstance of each company under consideration. The FSOC will formally notify the nonbank financial company that it is under consideration for a Proposed Determination through a Notice of Consideration that will likely contain a request that the nonbank financial company provide certain additional financial information relevant to the FSOC’s analysis. The FSOC will be seeking both qualitative and quantitative data, which may involve “confidential business information,” including:

• internal assessments;
• internal risk management procedures;
• funding details;
• counterparty exposure or position data;
• strategic plans;
• resolvability;
• potential acquisitions or dispositions; and
• other anticipated changes to the nonbank financial company’s business or structure that could affect the threat to U.S. financial stability posed by the nonbank financial company.

Whenever possible, however, the FSOC will rely on information available from the nonbank financial company’s primary financial regulatory agency. As part of its submission to the FSOC, the nonbank financial company will be allowed to submit written materials contesting the FSOC’s consideration of the nonbank financial company for a proposed determination.

With respect to its consideration of resolvability, the FSOC will assess the complexity of the nonbank financial company’s legal, funding and operational structure, as well as any impediments to its orderly and timely resolution. Additionally, the FSOC will focus on legal entity and cross-border operations issues in evaluating resolvability, including:

• the ability to separate functions and spin off services or business lines;
• the likelihood of preserving franchise value in a recovery or resolution scenario;
• maintaining continuity of critical services within the existing or in a new legal entity or structure;
• the degree of the nonbank financial company’s intra-group dependency for liquidity and funding;
• payment operation and risk management needs; and
• the size and nature of the nonbank financial company’s intra-group transactions.

Notification and Procedural Rights 

After completing the Determination Process, the FSOC will confer and vote on whether to make a Proposed Determination with respect to a certain nonbank financial company. If the FSOC decides to issue a Proposed Determination, then the FSOC will issue a written notice to the respective nonbank financial company, outlining the basis of the Proposed Determination. At this point, the nonbank financial company will be permitted to request an evidentiary hearing before the FSOC to contest the Proposed Determination. After such hearing, (if one is requested), the FSOC will determine by a vote of two-thirds of the voting members of the FSOC (including the affirmative vote of the Treasury Secretary) whether to subject a particular nonbank financial company to supervision by the Fed and to the enhanced prudential standards established under Section 165 of the Dodd-Frank Act and beyond (a “Final Determination”). Once again, the FSOC will provide the affected nonbank financial company with written notice of the FSOC’s Final Determination, which will explain the rationale underlying the FSOC’s decision. After the Final Determination is issued by the FSOC, the affected nonbank financial company may seek judicial review by bringing an action in federal district court seeking an order requiring the determination to be rescinded.

Anti-Evasion Provision

The Final Rule includes an “escape valve” provision, which authorizes the FSOC to require that financial activities of a company that do not meet the statutory definition of a nonbank financial company be subject to Fed oversight and prudential standards, if the FSOC determines that (i) “material financial distress related to, or the nature, scope, size, scale, concentration, interconnectedness, or mix of, the financial activities conducted directly or indirectly by a company . . . would pose a threat to the financial stability of the United States, based on consideration” of the ten statutory considerations described above, and (ii) “[t]he company is organized or operates in such a manner as to evade the application of Title I of the Dodd-Frank Act” or the Final Rule. This provision, as its name suggests, aims to prevent attempts to evade regulation through creative structuring.

Confidentiality 

Addressing a concern raised by many companies, the Final Rule requires that any “data, information, and reports,” submitted in connection with the Determination Process, remain confidential. In addition, the submission of any non-publicly available data or information in connection with the Determination Process will not constitute a waiver of any privilege arising under federal or state law. However, the Final Rule goes on to provide that any information submitted remains subject to the provisions of the Freedom of Information Act (“FOIA”), including any exceptions thereunder. What is more, the FSOC released its FOIA Rule concurrent with the Final Rule to ensure data or information received pursuant to the nonbank SIFI process will benefit from such protections. Whether information will remain confidential, however, remains to be seen. The FSOC’s determinations as to the application of FOIA in particularly instances could be overturned by the federal courts, which retain the authority to construe the statute.

Emergency Exception

Notwithstanding the procedural requirements outlined above, the FSOC may waive or modify any of the notice and procedural requirements with respect to a nonbank financial company if the FSOC determines that such waiver or modification is necessary or appropriate to prevent or mitigate threats posed by the nonbank financial company to the financial stability of the United States. The FSOC will provide written notice of the waiver or modification no later than 24 hours after the waiver or modification is granted. If a waiver or modification of the procedural requirements of the Final Rule is granted with respect to a nonbank financial company, such company will be afforded the right to an evidentiary hearing contesting the waiver or modification.

Annual Reevaluation and Rescission of Determinations

“Not less frequently than annually,” the FSOC is required under Section 113(d)(1) to reevaluate each currently effective determination and rescind any such determination if the FSOC determines that the particular nonbank SIFI no longer meets the requirements outlined in the Final Rule. Prior to its annual reevaluation, the FSOC will notify each nonbank financial company that is subject to a currently effective determination and the company will have the opportunity to submit written materials contesting its determination. Reevaluations will focus on material changes to the nonbank financial company or the markets in which it operates since its previous review. Rescinding a determination requires an affirmative vote of two-thirds of the FSOC, including the Treasury Secretary. Upon rescission of a determination, the FSOC will notify the company and publicly announce the rescission.

Important Changes

Although the Final Rule is substantially similar to the Proposed Rule, several differences, as well as responses to comments are worth highlighting:

• Within the six category framework, “outstanding loans borrowed and bonds issued” was changed to “total debt outstanding.” That threshold is defined broadly to include loans, bonds, repurchase agreements, commercial paper, securities lending arrangement, surplus notes, and other forms of indebtedness. The definition will also be used in calculating the short-term debt ratio threshold.
• The FSOC clarified that it intends to use U.S. GAAP when available, and look to statutory accounting principles, international financial reporting standards, or other such data in the absence of GAAP-based financials.
• Prior to conducting its reevaluation and rescission process, the FSOC will notify companies subject to currently effective determinations and allow them to contest the determinations in writing.
• The Final Rule clarified that there will be no broad, industry-wide “exemptions from potential determinations under section 113 of the Dodd-Frank Act,” meaning that hedge funds, private equity firms, asset managers, and insurance companies could be designated.
• Furthermore, while hedge fund commentators had requested clarification as to whether separate funds would be considered separately for purposes of total consolidated assets, the Final Rule remains unclear—the Guidance states that the FSOC “may consider the aggregate risks posed by separate funds that are managed by the same adviser, particularly if the funds’ investments are identical or highly similar.” Similarly, where asset managers asked for clarification as to how assets under management would be considered, the Final Rule merely states that the FSOC’s “ analysis will appropriately reflect the distinct nature of assets under management compared to the asset manager’s own assets.”
• The Final Rule noted that there is little data available for financial guarantors, asset management companies, private equity firms, and hedge funds. As a result, and in light of the new Form PF filing requiring financial disclosures, the FSOC will later “consider whether to establish an additional set of metrics or thresholds tailored to evaluate hedge funds and private equity firms and their advisers.” Likewise, the FSOC “may develop additional guidance regarding possible metrics and thresholds relevant to determinations regarding asset managers[.]”
• For purposes of evaluating Stage 1 thresholds, the FSOC will consider global assets, liabilities, and operations for U.S. nonbank financial companies, but only U.S. assets, liabilities, and operations for foreign nonbank financial companies.
• The FSOC rejected the requests of several commentators to provide notice to a company if it progresses to Stage 2 or does not progress to Stage 3. Similarly, the FSOC rejected the suggestion that it explain the reasons why a company will be subjected to Stage 3 review.
• The FSOC declined to publish or otherwise publicly identify those nonbank financial companies under evaluation.

Conclusion

The FSOC’s recent issuance of the Final Rule interpreting Section 113 represents a critical milestone in the implementation of the Dodd-Frank Act.  As some commentators have noted, the Final Rule’s increased emphasis on risk-related metrics is an indicator that regulators understand the dangers of labeling some institutions as nonbank SIFIs while other companies with similar risk profiles remain unregulated and unsupervised.  Nevertheless, with the recent issuance of the Final Rule, U.S. regulators can now do something they never have had the luxury of doing:  determining which large financial institutions they will regulate and supervise.

]]> http://financial-reform.weil.com/uncategorized/systemically-important-easy-steps-fsoc-approves-final-rule-nonbank-sifi-designations/feed/ 0 http://financial-reform.weil.com/uncategorized/agencies-clarify-effective-date-doddfrank-pushout-rule/ http://financial-reform.weil.com/uncategorized/agencies-clarify-effective-date-doddfrank-pushout-rule/#comments Mon, 02 Apr 2012 18:41:20 +0000 thinson http://financial-reform.weil.com/?p=1675

By Heath Tarbert  and Dimia Fogam

The Board of Governors of the Federal Reserve System (FRB), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) issued guidance to clarify the effective date of  Section 716 of Dodd-Frank, commonly referred to as the Push-Out Rule. The Agencies stated that Section 716 will become effective on July 16, 2013.

Section 716 prohibits federal assistance, including access to the Federal Reserve discount window and FDIC deposit insurance, to any swaps entity with respect to any swap, security-based swap, or other activity of the swaps entity. The term “swap entity” refers to any swap dealer, security-based swap dealer, major swap participant, or major security-based swap participant that is registered under the Commodity Exchange Act or Securities Exchange Act of 1934.  However, the rule allows certain entities to remain eligible for federal assistance if they “push out” certain derivatives activities from their insured depository institutions and limit their swap and security-based swap activities to bona fide hedging and similar risk related activities or to acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank.

The recent clarification of the Push-Out Rule’s effective date will be helpful to financial institutions that must migrate existing derivatives holdings from their insured depository institution subsidiaries to separately capitalized affiliates or subsidiaries registered with the Securities and Exchange Commission or the Commodity Futures Trading Commission. Those swaps most likely to be “pushed out” by July 13, 2013 include: equity swaps; energy swaps; metal swaps (excluding gold and silver); agricultural swaps; and non-cleared credit default swaps.

______________________________________________________________________

The Working Group will continue to monitor any developments and provide timely coverage at Weil’s Financial Regulatory Reform Center.  If you are interested in discussing this or other regulatory developments, please contact Working Group member Heath P. Tarbert (202-682-7177 or heath.tarbert@weil.com).

For more information, visit the conference website.

Weil partner Walter Zalenski will speak on the new Consumer Financial Protection Bureau (CFPB), established by the Dodd-Frank Reform Act, at the Risk Management Association’s 6th Annual Governance, Compliance, and Operational Risk Conference (GCOR VI), to be held in Cambridge, Massachusetts on April 25-26, 2012.

more Weil Events click here

Weil Corporate Governance partner Holly Gregory will be among a panel of experts sharing their experiences and views on board service in an informal, off-the-record discussion at the upcoming 2012 Financial Women’s Association Directors’ Dinner, which will take place at Weil’s New York office on Tuesday, April 17, 2012 at 5:45pm. Other panel members include Elisabeth DeMarse, CEO of Newser.com and founder of DeMarseCo, Inc.; Barbara J. Krumsiek, Chair, CEO and President of Calvert Investments, Inc. and a Director and Chair of Acacia Life Insurance Company; and Pamela J. Packard, a corporate director and a retired vice chairman of a public accounting and consulting firm. Merrie S. Frankel, a Senior Credit Officer and Vice President in the Commercial Real Estate Finance Group at Moody’s Investors Service, will serve as moderator.

For more information visit the event website.

more Weil Events click here

By Heath Tarbert and Dimia Fogam

The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) released for public comment their proposed joint guidance on leveraged lending activities.

The proposed guidance is a revision to the interagency leveraged finance guidance issued in 2001 and would apply to all OCC-, FRB- and FDIC-supervised financial institutions that are substantively engaged in leveraged lending activities—such as those common to the private equity and hedge fund lending market. 

Given the immense growth in the volume of leveraged credit as well as the increased participation of non-regulated investors over the last decade, the Agencies have expressed concerns that prudent underwriting practices are deteriorating. Specifically, bank regulators have noted that debt agreements have increasingly included features that provide limited lender protection, that capital structures and repayment prospects for some transactions have at times been overly aggressive, and that management information systems at some institutions have fallen short of accurately aggregating exposures on a timely basis. 

In light of those concerns, the Agencies propose replacing their existing guidance with revised leveraged lending guidance that will form the basis of their supervisory focus and review of regulated financial institutions on a going forward basis. 

The Agencies have emphasized the importance of a supervised financial institution having the capacity to evaluate and monitor underwritten credit risk properly, ensure that each borrower has a sustainable capital structure, demonstrate an understanding of the potential impact of various forms of distress on a borrower’s financial condition, and incorporate stress testing into its risk management of both leveraged portfolios and its distribution pipeline. The proposed guidance is intended to build upon the recently proposed guidance on stress testing.

Institutions engaged in leveraged financing should adopt a risk management framework that has as its foundation written risk objectives, risk acceptance, and risk controls. The framework should have an intensive and frequent review-and-monitoring process. Among other things, the proposed guidance covers: 

• Definition of Leveraged Finance: Institutions should define leveraged finance within their policies with sufficient detail to ensure consistent application across business lines. The definition should include the institution’s exposure to financial vehicles, whether or not leveraged, that engage in leveraged lending activities.

• Policy Expectations: The leveraged finance policy should, at a minimum, identify: an institution’s risk appetite (including pipeline limits and transaction and aggregate hold levels); credit and underwriting approval authorities; expected risk-adjusted returns for leveraged transactions; and a method of ensuring that the risks of leveraged lending activities are appropriately reflected in the institution’s Allowance for Loan and Lease Losses as well as in its capital adequacy analyses.

• Underwriting Standards: These should address the Agencies’ expectations for cash flow capacity, amortization, covenant protection, and collateral controls. Institutions should also devise standards for evaluating various types of collateral and expected risk-adjusted returns.  Additionally, such standards should take into account whether the business premise for a given transaction is sound and whether the borrower’s capital structure is sustainable irrespective of whether the loan is underwritten with the intent to hold or to distribute.

• Valuation Standards: Given the importance of enterprise valuation in the underwriting process and the specialized knowledge needed for the development of credible enterprise valuation, it should be independently performed or validated. An institution should focus on sound methodologies in its determination of enterprise value. Furthermore, the stress testing of enterprise values and their underlying assumptions should be conducted and documented periodically

• Pipeline Management:  Institutions must be able to accurately measure exposure on a timely basis and to establish policies and procedures that address failed transactions as well as general market disruptions. Each financial institution should also establish guidelines for conducting periodic stress tests on its pipeline exposures.

• Reporting and Analytics:  Institutions should have information systems that accurately capture key obligor characteristics in order to aggregate them across business lines and legal entities on a timely basis. Comprehensive reports should be provided to management at least quarterly and summaries should be provided to the board of directors.

Implementation of the proposed guidance should be consistent with the size and risk profile of an institution’s leveraged portfolio relative to its assets, earning, liquidity, and capital. Although some sections of the guidance will apply to all leveraged transactions (e.g., underwriting), the vast majority of community banks should not be affected, as they have little or no exposure to leveraged loans.

Nevertheless, larger financial institutions that specialize in lending to private equity and hedge funds should expect increased supervisory scrutiny in the coming months as the proposed guidance is finalized. The deadline for submitting comments on the proposed guidance is June 8, 2012.

______________________________________________________________________

The Working Group will continue to monitor any developments and provide timely coverage at Weil’s Financial Regulatory Reform Center.  If you are interested in discussing this or other regulatory developments, please contact Working Group member Heath P. Tarbert (202-682-7177 or heath.tarbert@weil.com).

By Sylvia Mayer, Kathlene Burke, and Brian M. Wells

Absent this statutory provision, counterparties to contracts of subsidiaries and affiliates could exercise contractual rights to terminate their agreements based upon the insolvency of the covered financial company.  As a result, otherwise viable affiliates of the covered financial company could become insolvent, thereby inciting the collapse of interrelated companies and potentially amplifying ripple effects throughout the economy.  Preamble to the Notice of Proposed Rulemaking implementing section 210(c)(16) of the Dodd-Frank Act

By Jakub Biernacki

            The Commodity Futures Trading Commission (the “CFTC”) adopted final rules under the Commodity Exchange Act (the “CEA”) that established the process for the registration of swap dealers (“SDs”) and major swap participants (“MSPs”, and collectively with SDs, “Swaps Entities”) and the timing of the Swaps Entity registration requirements.  The CFTC adopted these regulations in accordance with section 4s of the CEA, which was recently added to the CEA by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  These final rules are based in large part on the CFTC’s registration regulations proposed on November 23, 2010, and have become effective as of March 19, 2012.  Please note that the full scope of the regulatory requirements for Swaps Entities is not yet settled as we are still awaiting final rules that provide definitions of SDs and MSPs and key regulatory requirements applicable to Swaps Entities under Section 4s of the CEA, which will include, among other matters, capital and margin requirements (collectively, the “Section 4s Requirements”).

Registration of Swap Dealers and Major Swap Participants

            Section 4(s) of the CEA provides that neither an SD nor an MSP may act as such unless it is registered as an SD or an MSP, respectively, with the CFTC.[1]  Registration will be required by the day the final rules defining Swaps Entities become effective.  In the meantime, the CFTC permits applicants to begin the registration process provisionally to avoid scrambling to meet the approaching registration deadlines. Those market participants that expect to qualify as Swaps Entities will be able to provisionally register with the National Futures Association (“NFA”) and demonstrate compliance with a number of the new requirements applicable to Swaps Entities on a rolling basis as they become effective.  The provisional registration will be granted upon filing of the application and documentation demonstrating compliance or the ability to comply with the Section 4s Requirements in effect on such date – and not upon NFA’s review and approval of the documentation. On and after the date on which NFA confirms that the applicant for registration as a Swaps Entity has demonstrated its initial compliance with the applicable requirements the provisional registration of the applicant shall cease and the applicant shall be registered as an SD or an MSP, as the case may be. If the application is determined by NFA to be deficient, NFA will notify the applicant that its application is deficient, whereupon the applicant must withdraw its registration application, it must not engage in any new activity as an SD or an MSP, and the applicant shall cease to be provisionally registered if it does not cure such deficiencies within 90 days after notice.

            To apply for registration as a Swaps Entity, and to apply for membership in NFA, an SD or an MSP will need to file Form 7-R electronically with NFA.  As of today, Form 7-R requires a Swaps Entity applicant to disclose the following information with respect to the applicant:

• name, address and entity type;
• intent to engage in the CFTC-regulated swap transactions;
• membership in any U.S. exchanges;
• location of business records (and, with respect to foreign applicants, a U.S. location where records will be available for the CFTC and NFA inspection);
• any non-U.S. financial regulators and self-regulatory organizations that have regulated the applicant in the previous five years;
• criminal, regulatory and disciplinary histories;
• any previous bankruptcy proceedings; and
• contact information.

            Filing a Form 7-R authorizes the CFTC to conduct on-site inspections of the applicant.  The applicant would also be required to file a Form 8-R on behalf of each of its principals and associated persons along with a fingerprint card, which NFA uses to conduct background checks and determine whether principals and associated persons are subject to a statutory disqualification. As of today, Form 8-R requires each Swaps Entity applicant to disclose the following information with respect to each of its principals and associated persons:

• name and address;
• criminal, regulatory and disciplinary histories; and
• past residential, employment and education history.

            Swaps Entities would be required to review and update their NFA registration forms and any information provided to the CFTC annually.  Swaps Entities will be required to correct any deficiencies or inaccuracies in their registration materials and update their filed registration materials on an annual basis as determined by NFA.  Swaps Entities may seek confidential treatment of documentation submitted to demonstrate compliance with the Section 4s Requirements.

Regulations regarding an “associated person” of Swap Dealers and Major Swap Participants

            An associated person of an SD or an MSP is any employee of a Swaps Entity engaged in the solicitation or acceptance of swaps or the supervision of any person or persons so engaged. Such term has typically referred to a salesperson of an applicant.  Although an associated person is required to file a Form 8-R, there is no requirement for associated persons of Swaps Entities to register with the CFTC.  Nevertheless, a Swaps Entity may not permit any individual associated person who is a natural person “to effect or be involved in effecting swaps” on behalf of the Swaps Entity if he is subject to a statutory disqualification under the CEA.  Persons are subject to a statutory disqualification if they (i) have been refused registration within five years preceding the filing of the provisional application, or had their registration suspended (and the period of such suspension has not expired), or revoked; (ii) are permanently or temporarily enjoined by a court or regulatory order from acting in any registered capacity under the CEA or securities regulation; (iii) have been convicted of any felony that involves embezzlement, fraud, theft, bribery or misappropriation of funds in connection with any commodities or securities transactions within ten years preceding the filing of the provisional application or at any time thereafter; or (iv) have violated (or aided and abetted in violation of) any provision of the CEA or certain other U.S. federal statutes, where such violation involves embezzlement, fraud, theft, bribery or misappropriation of funds.

            Each Swaps Entity will be responsible for ensuring that none of its associated persons is subject to a statutory disqualification and will be required to certify to this effect in the Form 7-R. Similarly, NFA may deny registration to a Swaps Entity if any of its principals is subject to a statutory disqualification.

            The CFTC addressed in the rule only the process for registration and did not expressly address the extraterritorial scope of the SD and MSP registration requirements.