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 U.S.
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 U.S.
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
such determinations.
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.
regulation.
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 Hong Kong .
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.