US and global hedge fund associations are concerned that the proposed CFTC Guidance on the cross-border application of the Dodd-Frank Act derivatives regulations would create uncertainty and subject non-U.S. market participants and transactions to US regulation, particularly commodity pools, pooled accounts, and hedge funds and other collective vehicles organized outside the U.S. In a letter to the CFTC, the Managed Funds Association and the Alternative Investment Management Association expressed particular concern with the definition of ``U.S. person’’ in the proposed Guidance and questioned the global comparability of the substituted compliance doctrine enunciated in the Guidance.
They noted that a prong of the definition of
person looking to the direct or indirect ownership percentage of U.S. persons
may be inconsistent with the stated aims of the Dodd-Frank Act. In the view of
the hedge fund groups, an ownership test alone is not indicative of whether the
activities of a non-U.S. fund would have a direct and significant effect on the
U.S financial system. In addition, they are concerned about the look-through
created by basing the U.S.
person status of funds on indirect as well as direct ownership. As a practical
matter, it is often difficult, if not impossible, to establish indirect
ownership status with certainty, such as the status of members of
fund-of-funds, pension plans or shareholders in a listed entity.
In addition, with respect to requiring funds to ascertain the
person status of their direct investors, the hedge fund associations urged the
Commission to clarify that funds may rely on representations from investors as
to their U.S.
person status. The Commission should not require funds to verify independently
such status, reasoned the associations, since the investors themselves, not the
funds, have the necessary information and are thus in the best position to make
More broadly, the hedge fund groups urged the Commission to modify the proposed Guidance to instead adopt the definition of “U.S. person” in Regulation S under the Securities Act, which would eliminates the problems or inconsistencies in the Guidance because it does not include a majority ownership or CPO registration test; but looks to a composite of factors that together determine the level of activity within, or nexus to, the U.S.
Also, market participants have long recognized the Regulation S definition as one that provides a simple and rational way to determine
U.S. person status. Moreover, the
Regulation S definition is one for which market participants already have
well-established policies, procedures and operational systems relating to the
status of investors and counterparties.
The groups clarified that their intention is not to have all non-U.S. hedge funds avoid regulation but rather to avoid unnecessarily duplicative regulation. Therefore, where non-U.S. funds are outside of the
U.S. person definition
under Regulation S such that the Title VII requirements would not apply, those funds
should be subject to comparable foreign regulation, given the nature and the
domicile of the counterparties with which they are likely to trade. Where no
comparable foreign regulation exists for a non-U.S. hedge or collective fund,
and no substituted compliance is available based on the status of the fund’s
counterparty, then the Commission should consider whether it is appropriate to
apply the transaction-level requirements where the activities of the non-U.S. funds
would have a direct and significant effect on the U.S financial system.
The MFA and AIMA believe that such an approach would ensure that all those covered by the
U.S. person definition have significant and
clearly definable ties to the U.S.
and that all parties and swaps are subject to suitable regulation. It would
also achieve consistency with the stated objectives of the Dodd-Frank Act to
provide oversight of U.S.
and non-U.S. market participants with a direct and significant effect on the
U.S financial system, as well as minimize overlap with EU and other non-U.S.
The Guidance introduces the concept of substituted compliance under which, as recently explained by Chairman Gensler at Senate Ag Committee hearings, the CFTC would defer to comparable and comprehensive foreign regulations. The CFTC proposes to permit a non-U.S. swap dealer or non-U.S. major swap participant, once registered with the Commission, to comply with a substituted compliance regime under certain circumstances. Substituted compliance means that a non-U.S. swap dealer or non-U.S. major swap participant is permitted to conduct business by complying with its home regulations, without additional requirements under the Commodity Exchange Act.
While strongly reaffirming their support for a coordinated cross-border approach to derivatives regulation that reflects the global nature of the derivatives markets, the hedge fund associations are concerned that the proposed Guidance does not envision the doctrine of substituted compliance being applied to a situation in which a U.S. swap dealer desires to enter into a swap with a non-U.S. person, or a non-U.S. swap dealer desires to enter into a swap with a U.S. person. The Guidance would require the swap dealers to comply with the relevant entity-level and transaction-level requirements.
However, the non-U.S. person and non-U.S. swap dealer would likely also be subject to regulation in their home jurisdiction. Given that the MFA and AIMA expect EU and other international derivatives regulations to be of similar scope to Title VII of Dodd-Frank, if the regulations that apply in the foregoing example are not substantially identical, the result would be duplicative regulation of the parties and the trade. Thus, they urged the Commission to modify the proposed Guidance to permit all parties to seek substituted compliance, with the understanding that, if the parties or trade are not subject to comparable regulation in another jurisdiction, the Commission will require the Title VII requirements to apply.
The hedge fund associations also asked the CFTC and other international regulators to focus on addressing the details of how substituted compliance will work in practice. The Guidance provides some information about the Commission’s comparability determinations and the ongoing coordination between the Commission and non-U.S. regulators. But a number of questions remain. For example, in the case of trade execution requirements, non-U.S. regulators have chosen to implement such a requirement with a different scope than that of the Commission, such as the MiFID II proposal in the EU, or they have elected not to propose a trade execution requirement, such as in
Market participants need greater clarity when foreign regulators have intentionally chosen to vary their derivatives regulations from that required by Title VII of the Dodd-Frank Act. Although the Commission and other regulators will make independent comparability determinations, noted the hedge fund groups, these processes and the results of these determinations are interconnected.
Noting the importance of a global understanding among regulators and greater transparency to market participants, the associations encouraged an open dialogue among the CFTC, the SEC and their global counterparts as all regulators of derivatives work to develop harmonized regulations with comparable and coordinated substituted compliance processes.