In a letter to the SEC and CFTC, eight U.S. Senators urged the Commissions not to allow a U.S.-based financial firm to escape U.S.-mandated swaps oversight simply because its swaps trading is conducted through an offshore affiliate or branch. If the current SEC and CFTC proposals are adopted, warned the senators, U.S. financial firms could easily arrange their affairs to produce that outcome. The letter, which was addressed to CFTC Chair Gary Gensler and SEC Chair Mary Jo White, was signed by Senators Jeff Merkley (D-OR), Carl Levin (D-MI), Tom Harkin (D-IA), Elizabeth Warren (D-MA), Jeanne Shaheen (D-NH), Barbara Boxer (D-CA), Richard Blumenthal (D-CT), and Dianne Feinstein (D-CA).
If the current proposals are adopted, they noted, foreign firms doing business with the foreign affiliate of a U.S.-based derivatives dealer would likely opt to forego an express guarantee from the U.S.-based entity in return for more favorable pricing and the ability to avoid U.S. trading regulations and any attendant costs. If those arrangements were to become widespread, feared the senators, Title VII of Dodd-Frank would be rendered inapplicable to that derivatives trading activity, at the same time placing U.S,. businesses at a competitive disadvantage to their foreign counterparts. Some proposals also appear to allow swaps between U.S. guaranteed foreign affiliates and some non-U.S. persons to be outside U.S.-mandated oversight, including the doctrine of substituted compliance. The senators emphasized that this would be unacceptable for the same reasons. Regulating conduits to capture these risks is important, said the senators, but is ultimately insufficient.
The CFTC proposed guidance on cross-border derivatives regulation introduced the concept of substituted compliance under which 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.
The senators reminded the SEC and CFTC that they have a statutory obligation to ensure that the liabilities of unregulated, risky foreign swaps trading truly cannot flow back to the U.S. To achieve that goal, it is important to understand the contexts in which these issues of liability would likely arise. For example, the liabilities of an offshore affiliate may come back to the U.S.-based entity if a foreign court, following foreign law, were to determine that the U.S.-based entity is liable. It could also happen under U.S. law, if a U.S. court were to elect to pierce the corporate veil, and find that the U.S.-based entity is liable for the actions of its affiliate.
The senators explained that another way the liabilities may come back to the U.S.-based entity is if the U.S.-based entity is placed under market pressure into effectively guaranteeing the liabilities of an offshore affiliate. Protecting the firm’s reputation and customer base has proven to be a powerful motivator when a U.S. parent has been asked to stand behind its affiliates.
This pressure to absorb liabilities of an offshore affiliate may be particularly acute if the U.S.-based entity and the foreign entity share a common name or valued customers or counterparties; if the entities have a business reliance on one another for an essential business or service; if the entities share employees or executives; or if the counterparties to the foreign entity believe that the U.S.-based entity is likely to bail out the liabilities of the foreign entity or press it to do so
The senators urged the SEC and CFTC to revise their proposals to apply U.S. oversight and regulation to offshore affiliates and branches of U.S.-based firms whose liabilities could flow back to the United States. They allowed that in appropriate limited circumstances the doctrine of substituted compliance may stand in for direct U.S. supervision.