Senate Hearings Reveal Concern with Differing SEC and CFTC Approaches to Cross-Border Application of Dodd-Frank Derivatives Regulations; CFTC Guidance Questioned

Senate Agricultural Committee hearings on the implementation of the derivative regulation provisions of Title VII of the Dodd-Frank Act exposed senatorial concerns over the different approaches to the cross-border application of Title VII undertaken by the SEC and CFTC. The SEC expects to propose holistic regulations on cross-border application of the Dodd-Frank Act derivatives provisions later this year, while the CFTC has already issued proposed interpretative guidance on cross-border application of Title VII.

Committee Chair Debbie Stabenow (D-MI) emphasized the importance of coordinating the regulations between the SEC and CFTC and harmonizing the regulations internationally. Senator Pat Roberts (R-KN) is concerned that the CFTC avoided doing a cost-benefit analysis by issuing guidance. He is also concerned that, given the different approaches taken by the CFTC and SEC to cross-border application of Title VII, the US could end up with two separate and distinct cross-border regulatory regimes.

Robert Cook, Director of the SEC Trading and Markets Division, noted that the SEC intends to take a single holistic approach to regulations addressing the cross-border application of Title VII. He assured the Committee that the development of the cross-border regulations are being informed by discussions with the CFTC and regulators in other jurisdictions

According to the SEC official, the issuance of a single proposal addressing the global implications of Title VII is intended to give foreign regulators, investors and market participants a chance to consider as an integrated whole the regulation of foreign entities engaged in cross-border transactions involving US parties. This holistic cross-border regulatory approach will be published before finalization of the regulations discussed therein, he said, so that the comments received can inform the drafting of the final rules.

Noting that it was a judgment call to do cross-border application by regulation or by guidance, Mr. Cook pledged that extraterritorial application of Title VII will be done by SEC rulemaking with full economic and cost-benefit analysis. He said that the SEC staff is actively working on the cross-border regulations and a release is expected by the end of the year.

Senator Roberts noted that the substituted compliance concept in the CFTC guidance has no force of law. He questioned what happens when foreign derivatives regulations are different from US regulations. CFTC Chair Gary Gensler replied that the CFTC would defer to comparable and comprehensive foreign regulations under the substituted compliance doctrine. The CFTC Chair also noted that the proposed guidance, which was issued pursuant to Section 722(d) of Dodd-Frank, is open for public comment before the CFTC finalizes it.

Chairman Gensler noted that Section 722(d) states that swaps reforms must not apply to activities outside the US unless those activities have a direct and significant connection with activities in, of effect on, commerce of the United States. He noted that, in Dodd-Frank, Congress included Section 722(d) for swaps regulated by the CFTC, but included a different provision with regard to the SEC’s oversight of the security-based swap market.

In earlier testimony before the House Capital Markets Subcommittee, the securities industry viewed the substituted compliance approach as highly prescriptive, requiring the CFTC to individually review the regulations of foreign jurisdictions and render cross-border equivalence determinations that are not outcomes-based but instead could be used as a tool to export regulations from one jurisdiction to another.

In his prepared testimony, Director Cook noted that the application of Title VII to cross-border transactions raises a substantial number of complex issues. Among other things, it requires consideration and appreciation of foreign regulatory frameworks and of competition concerns. While noting that this is not an easy task, he believes that the publication of a fully developed, comprehensive SEC proposal to address these issues, and the concomitant opportunity for all interested parties to comment, will significantly advance the level of understanding, and greatly facilitate public dialogue, on these issues.

Such a proposal will also give interested parties an opportunity to compare the SEC’s approach to addressing the cross-border application of Title VII to the security-based swap market to the CFTC’s proposed guidance regarding the cross-border application of Title VII to the swap market. In its proposal, the CFTC proposed approaches to a number of very difficult issues, such as the appropriate definition of U.S. person and the treatment of guarantees in the cross-border context. The SEC is considering the CFTC’s proposed approaches to these issues in addition to alternative approaches for the security-based swap market.

For instance, the SEC understands the concerns the CFTC has raised regarding the ability of market participants to enter into swap transactions offshore but bring the risk of those transactions directly back into the United States. The CFTC has proposed one approach to this issue by requiring foreign swap dealers receiving U.S. guarantees to register even if they are engaged exclusively in non-U.S. business. In addition to considering this approach, the SEC staff is evaluating alternative ways of addressing any risks posed to the U.S. financial system by such overseas transactions.

Similarly, the CFTC has proposed to interpret the term “U.S. person” broadly to include certain foreign entities whose swap activities have a direct and significant connection with activities in, or effect on, U.S. commerce. For example, the CFTC would include in the definition of “U.S. person” foreign entities in which U.S. persons have a majority ownership interest, as well as foreign entities in which U.S. persons are responsible for their liabilities. In addition to considering this approach, the SEC staff is evaluating alternative ways to address potential risk to the U.S. financial system from business conducted outside the United States.

In his testimony, ISDA CEO Robert Pickel expressed significant concerns with the CFTC guidance, including inadequate coordination with the SEC on its companion cross-border release and with non-US regulators, and an overly expansive interpretation of the extraterritorial application of Title VII. The guidance also denotes a vague approach to comparability determinations for non-US regulatory systems and a lack of fair treatment of US market participants.

 Ultimately, feared ISDA, these issues combine to threaten a level playing field by imposing on US market participants a substantially earlier rollout of regulatory requirements which may drive customers to foreign competitors not yet so burdened and by moving in advance of SEC clarification of its own extraterritorial jurisdiction, thereby creating the potential for inconsistency between the swap and security-based swap markets.

Responding to an invitation from Senator Roberts to expand on his concerns with the two distinct regulatory approaches to cross-border application of Title VII, the ISDA CEO urged Congress to look at the implications of distinct SEC-CFTC frameworks and how cross-border regulation will impact the availability of derivatives products to US investors and users of derivatives. Also, he cautioned that a there is a risk of retaliation from non-US regulators that could harm US companies, as well as global markets.