Saturday, June 18, 2011

With Effective Date of Dodd-Frank Derivatives Provisions Looming, SEC Gives Guidance on Title VII

Title VII of the Dodd-Frank Act establishes a regulatory regime for the OTC derivatives markets by providing the SEC and the CFTC with the tools to oversee these markets. Dodd-Frank provides for CFTC regulation of swaps, SEC regulation of security-based swaps, and joint CFTC-SEC regulation of mixed swaps. The provisions of Title VII generally are effective on July 16, 2011, unless a provision requires a rulemaking. Specifically, if a Title VII provision requires a rulemaking, such provision will not necessarily go into effect on the Effective Date, but instead will go into effect not less than 60 days after publication of the related final rule or on July16, 2011, whichever is later.

The SEC expects that it will not have completed regulations implementing Title VII by July 16, 2011. As a result, the Commission believes it would not be reasonable to require market participants to put systems in place or hire personnel based on a regulatory scheme that is not fully in place. To require otherwise, depending on the content of the final rules, might require these entities to incur costs to change their systems again in a relatively short period of time.

To address the concerns of market participants and industry associations, The SEC has issued guidance, Release No. 34-64678, stating that a substantial number of Title VII provisions require a rulemaking and thus will not go into effect on the Effective Date. A number of Title VII provisions also expressly or implicitly apply only to “registered” persons. Until the related registration processes for such persons have been established by final Commission rules, and such persons have become registered pursuant to such rules, they will not be required to comply with these Title VII provisions.

One comment letter to the SEC was from a consortium of securities, futures and banking trade associations, including the FIA, SIFMA, ISDA and the American Bankers Association. In their letter, the trade associations expressed significant concerns that the new antifraud liability for security-based swaps would be interpreted broadly on July 16 in light of the expanded scope of antifraud liability proposed by the SEC under Rule 9j-1. In the view of the associations, the antifraud proposal is overly broad and would expose security-based swap market participants to inappropriate enforcement liability because it creates uncertainty as to what is required to comply with the new antifraud provisions. For example, said the trade groups, the antifraud proposal does not provide safe harbors analogous to Exchange Act Rule 10b5-1. They sought clarity that the antifraud proposal will not be applied on July 16 before a final rule is effective.

In Release No. 34-64678, the SEC said that, once the relevant provisions of the Dodd-Frank Act take effect, persons effecting transactions in security-based swaps, or engaged in acts, practices, and courses of business involving such swaps, will be subject to the general antifraud and anti-manipulation provisions of the federal securities laws that were in place before the enactment of Dodd-Frank, including Sections 9(a) and 10(b) of the Exchange Act. The SEC further emphasized that persons would retain all available rights as a result of any violation of these general antifraud and anti-manipulation provisions.

The SEC also granted temporary relief allowing an entity that trades security-based swaps and is not currently registered as a national securities exchange, or that cannot yet register as a security-based swap execution facility because final rules for such registration have not yet been adopted, to continue trading security-based swaps during this temporary period without registering as a national securities exchange or as a swap execution facility.

This relief is necessary to facilitate the operation of entities that trade security-based swaps so that these instruments can continue to be traded without the need for entities that trade such instruments to register as national securities exchanges before the Commission has put in place a registration regime for security-based swap execution facilities, at which time the entities that operate these facilities would be able to choose between registration as a national securities exchange and a swap execution facility.

The temporary exemption would also avoid legal uncertainty regarding whether a national securities exchange is operating as a swap execution facility until further guidance is available.

Dodd-Frank regulates the collection and handling of collateral that counterparties to security-based swaps deliver to secure their obligations arising from such swaps and sets out certain rights of the counterparties who deliver such collateral. Some of these provisions require SEC rulemaking and thus will not require compliance on the Effective Date because the Commission will not have adopted a segregation rule by that date.

Section 10B of the Exchange Act, added by section 763(h) of the Dodd-Frank Act, provides that the SEC must adopt regulations establishing limits on the size of positions in any security-based swap that may be held by any person. These provisions will become effective on the Effective Date, but, by their plain language, pertain to Commission action. Thus, these provisions do not require compliance by market participants on the Effective Date.

Dodd-Frank also provides for the registration, operation, and governance of swap data repositories, with some provisions either requiring a rulemaking or other Commission action or applying only to registered swap data repositories. Compliance with those provisions will not be required on the Effective Date because the Commission will not have adopted final rules by that date.

Similarly, the SEC granted a temporary exemption from compliance with the requirement for a swap data repository to provide direct electronic access to the Commission since this will require investment of significant time and resources by a data repository to implement the technology to be used to enable this direct electronic access and to coordinate with the Commission to establish its direct electronic access to data maintained by the repository.

The form and manner in which a swap data repository will provide direct electronic access may vary, depending in part on the amount of data stored at the repository and how it maintains that data. In addition, this requirement would obligate a swap data repository to make changes to existing systems and practices, or develop entirely new systems and practices, all of which would require significant investment of time and resources. It would be inefficient for a swap data repository to expend time and resources to develop the technological systems necessary to provide the direct electronic access required prior to knowing the capabilities the Commission rules will require these systems to have

Similarly, Dodd-Frank requires a swap data repository to maintain the privacy of any
and all swap transaction information that it receives from swap dealers and counterparties. Temporary relief from this mandate will provide swap data repositories additional time to implement robust policies and procedures to protect the privacy of data reported to them.

Temporary relief will also allow swap data repositories to establish transparent governance arrangements. Delaying compliance with this requirement until
the Commission’s final rules setting forth the full panoply of duties applicable to swap data repositories will avoid possible complications and unnecessary expenditures of time and resources and unnecessary disruption of a swap data repository’s governance structure, which could adversely impact its operations.

The trade association letter noted that market participants have little confidence that they will be able to assure compliance with the self-operative provisions. This is particularly problematic, said the industry groups, because of Section 29(b) of the Exchange Act, which may render void any contract made in violation of the Exchange Act. The associations asked the SEC to expressly provide that no security-based swap agreement can be void under Section 29(b) as a result of the self-operative provisions, except by reason of the existing securities antifraud and anti-manipulation laws.

While the SEC does not believe that Section 29(b) would apply, in order to have no doubt and to avoid legal uncertainty or market disruption, the Commission granted temporary exemptive relief from Section 29(b). Thus, under its authority under Section 36 of the Exchange Act, the SEC temporarily exempts any security-based swap contract entered into on or after the Effective Date from being void or considered voidable by reason of Section 29 because any person that is a party to the swap contract violated a provision of the Exchange Act that was amended or added by subtitle B of Title VII of the Dodd Frank Act and for which the Commission has taken the view that compliance will be triggered by registration of a person or by adoption of final rules by the Commission, or for which the Commission has provided an exception or exemptive relief, until such date as the Commission specifies.

The SEC explained that the exemption is necessary because the legal uncertainty that could result if contracts entered into after the Effective Date were void or voidable under Section 29(b) could be disruptive to the financial markets, create confusion for both financial institutions and their customers, or result in unnecessary and wasteful litigation.