The Long Arm of US OTC Derivatives Reform and Non-US Fund Managers
Dodd-Frank upended the status quo of the global OTC derivatives markets, imposing a host of clearing, margin and other requirements on market participants. But as these reforms began to take effect in the United States in the second quarter of 2013, managers of non-U.S. funds were still waiting for the answer to a key question: how would these requirements apply outside of the United States?
Because funds that are “U.S. persons” will be subject to nearly the full weight of Dodd-Frank’s OTC reforms, the answer turns on how both the U.S. Commodities and Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) define “U.S. person.” But the two regulators took very different approaches to this task: the CFTC proposed, then withdrew, an expansive definition of U.S. person after feedback from the industry, leaving a temporary definition in its place. Just before the temporary definition expired in July 2013, the CFTC issued a new, final definition of U.S. person.1 In contrast, to date, the SEC has only issued a single proposal for the U.S. person definition, and it is still not clear when the SEC’s final rules will take effect.2 Crucially for non-U.S. managers, though, these definitions are not the same. A fund may be a U.S. person for the CFTC’s purposes but not under the SEC’s proposed definition. Thus, whether U.S. swaps rules apply may be determined by whether the CFTC or the SEC asserts jurisdiction over a particular type of swap.
The Jurisdictional Divide
The SEC and CFTC share jurisdiction over swaps. Many non-U.S. managers are already familiar with this divide – it is the same division that determines which derivatives should be “counted” for the CFTC’s de minimus exemption from commodity pool operator registration. In short, the SEC claims jurisdiction over swaps on individual securities and “narrow-based” securities indices, while the CFTC broadly claims jurisdiction over “commodity” swaps encompassing nearly all other swaps. Importantly, the CFTC’s jurisdiction includes “mixed swaps” – swaps that contain elements of being both a security and a commodity. This is crucial for managers that use total return swaps to gain access to markets subject to currency controls – a total return swap on an equity security that is not denominated in U.S. dollars is subject to the CFTC’s jurisdiction because it exposes a fund to both equity risk and, in the CFTC’s view, currency risk. Thus, a total return swap is a mixed swap subject to the CFTC’s jurisdiction.
The Definition(s) of U.S. Person
After a manager determines whether a non-U.S. fund’s trading activity is subject to both or either SEC and CFTC jurisdiction, the manager can analyze whether the fund may be considered a U.S. person for Dodd-Frank swaps regulation.
As noted above, the CFTC’s definition has been finalized and will take effect on October 9, 2013, triggering many of the CFTC’s swaps-related rules.3 In contrast, the SEC’s definition, proposed on May 1, 2013, is still subject to revision. A manager using only instruments covered by the SEC may not be subject to most U.S. regulation until the SEC definition is finalized.
Of the two definitions, the CFTC’s is by far the more problematic for non-U.S. fund managers.4 Under the CFTC’s guidance, a U.S. person includes not only funds that are domiciled in the United States, but also funds that are majority-owned by certain types of U.S. persons (as defined in the guidance). This “look-through” may initially be difficult for non-U.S. managers to put into practice – the definition of U.S. person is different than the existing SEC and CFTC definitions used for other purposes, so existing fund subscription agreements do not capture it. Now, managers of non-U.S. funds must survey existing investors using this distinct definition and monitor whether U.S. persons hold more than half of such funds. In master-feeder structures, a fund must look through to the feeders’ underlying investors. But funds need not look through to other beneficial owners who invest through entities unaffiliated with such funds.
The CFTC’s U.S. person definition also includes funds with a principal place of business in the United States. While this should present little difficulty for managers with no operations in the United States, the presence of a key portfolio manager or senior principal in the United States could lead to a fund becoming a U.S. person.5
While the SEC’s delay in issuing final guidance on its own U.S. person definition may be frustrating to some market participants, the SEC proposal represents far less of a departure from existing rules than the CFTC’s guidance. Under the SEC’s proposed definition, a fund may be a U.S. person if it is organized or incorporated under the laws of the United States, or if (similar to the CFTC guidance) it has a principal place of business in the United States. Thus, the SEC’s definition is primarily territorial – the extent to which U.S. investors hold interests in the fund would be irrelevant.
What to Do Next
These dueling definitions can only cause confusion. They differ not only from each other, but from the existing definitions used to screen investors.6 Even where these definitions use similar terms, such as “principal place of business,” the SEC and CFTC have long and separate histories of interpreting such terms.
Under both the CFTC and SEC guidance, brokers and other counterparties are allowed to reasonably rely on a counterparty’s representation that it is not a U.S. person. But they are likely to take a conservative default position regarding whether any particular fund is covered by these rules. Thus, non-U.S. managers should review their trading activity and determine for themselves whether a fund should, in fact, be covered. If a fund uses CFTC-covered swaps and will be considered a U.S. person, the October 9 deadline is looming.
1) Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45292 (July 26, 2013).
2) Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Release No. 34-69490 (May 1, 2013).
3) Funds that are non-U.S. persons may experience certain changes in their counterparty transactions as well. Counterparties established in the European Union, Hong Kong, Japan, Australia, Switzerland and Canada may have until December 21, 2013 to begin compliance (or the CFTC may allow them to comply with local regulation under a “substituted compliance” process).
4) For more information regarding other aspects of the CFTC’s cross-border release, please refer to DechertOnPoint, CFTC Issues Cross-Border Swaps Regulation Guidance and Exemptive Order.
5) The CFTC will look to whether the senior principal personnel overseeing either (a) the “formation and promotion” of the fund or (b) the “implementation of the [fund’s] investment strategy” are in the United States.
6) Most subscription agreements already use both the SEC’s Regulation S, Rule 902 definition of U.S. person and the CFTC’s Rule 4.7 definition of Non-U.S. Person.