Joint Industry Letters Regarding Self-Operative Derivatives Provisions of the Dodd-Frank Act (pdf)

Futures Industry Association Institute of International Bankers International Swaps and Derivatives Association Investment Company Institute Securities Industry and Financial Markets Association U.S. Chamber of Commerce Commodity Exchange Act Sections 1a(11), 1a(12), 1a(22), 1a(23), 1a(28), 1a(31), 1a(33), 1a(47), 1a(49), 2(e), 4d(a), 4d(f), 4d(g), 4m, 4s(a), 4s(h)(4), 4s(k), 4s(l), 5h, 12(h), 21 and 22(a) June 10, 2011 Chairman Gary Gensler Commissioner Michael Dunn Commissioner Jill E. Sommers Commissioner Bart Chilton Commissioner Scott D. O’Malia Commodity Futures Trading Commission Three Lafayette Centre 1155 21st Street N.W. Washington, DC 20581 Re: Request for Clarification and Relief Under Sections 754 and 739 of the Dodd-Frank Wall Street Reform and Consumer Protection Act; Petition for Exemption Pursuant to Section 4(c) of the Commodity Exchange Act Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia: The undersigned trade associations, on behalf of their members and similarly situated participants in the swap markets, urgently request that the Commodity Futures Trading Commission (the “CFTC” or “Commission”) take steps to ensure an orderly implementation of amendments made to the Commodity Exchange Act (the “CEA”) by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and minimize the potential for market disruption, uncertainty and undesirable litigation. Preliminarily, the undersigned wish to acknowledge and express their appreciation to the Commission and its staff for the extraordinary efforts that have been undertaken to date in order to achieve an orderly implementation of Dodd- Frank. The undersigned specifically request that the Commission give effect to Congress’ intent, as manifested in Sections 712(e) and 754 of Dodd-Frank, and utilize the full Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 2 extent of Commission exemptive authority, to ensure a coordinated implementation of both those provisions that are implemented directly through Commission rulemaking and those statutory provisions that depend upon (or “require”) related Commission rulemaking. We further request clarification of, and exemptive relief regarding, the treatment of swap transactions under the provisions of the CEA applicable to futures contracts. We urge the Commission to take prompt action in order to avoid unprecedented confusion, potential market disruption and an environment that would not be conducive to the respect for the rule of law that underpins the strength and competitive position of U.S. markets. I. Background A. Effective Dates of Swap Provisions As the Commission is aware, Section 754 of Dodd-Frank provides that amendments made by Title VII, Subtitle A shall, unless otherwise specified, take effect on the later of July 16, 2011 or, to the extent a provision requires a rulemaking, not earlier than 60 days after publication of the final rule or regulation implementing such provision. There are several respects in which a statutory provision may “require a rulemaking.” These include not only situations in which the provision is expressly directed to be implemented through a Commission rulemaking, but also situations in which a rulemaking is either required to give content to a substantive standard or requirement or defined term used in the statutory provision, or necessary to avoid compelling an impossible requirement or manifestly inappropriate result. Clarity with respect to the application of Section 754, together with a prudent approach to the effective dates of Dodd-Frank’s various requirements, is critical because, despite the extraordinary efforts of the Commission and its staff to undertake the rulemakings necessary to implement Dodd-Frank, including more than 50 proposed rules, notices, or other requests seeking public comment, it has become clear that the final rulemakings necessary to implement Title VII will not be completed or effective until after, and in some case considerably later than, July 16, 2011. As the Commission has acknowledged, compliance with Dodd-Frank does not only require the promulgation of final rules. In many cases considerable effort and time is necessary in order for firms to adopt the compliance systems and other infrastructure necessary to adhere to prospective regulatory requirements. We understand that the Commission anticipates completing its adoption of final rules over the second half of 2011 and that the Commission is considering how to phase in the effective dates of final rules. Both legislators and market participants, including members of the undersigned trade associations, are widely supportive of such a phased-in implementation process. A coordinated, phased-in approach is clearly necessary, as a practical matter, to prevent undue disruption of the swap markets.1 It is also clearly necessary to give effect to 1 See Letters from the Financial Services Forum, Futures Industry Association, International Swaps and Derivatives Association and Securities Industry and Financial Markets Association to David A. Stawick, Secretary, the CFTC, (continued on next page) Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 3 Section 754, which is an unequivocal manifestation of Congress’ intent to ensure a coordinated implementation of Commission rulemaking and otherwise applicable statutory provisions. Neither Dodd-Frank nor Congress provides any indication that Congress intended the self- executing provisions2 of Dodd-Frank to become effective prior to provisions that are not otherwise self-executing. To the contrary, Section 754 indicates that Congress intended statutory and regulatory provisions to come into effect in a coordinated manner and, indeed, intended for statutory provisions that would otherwise be effective by their terms to be delayed pending related Commission rulemaking. Congressional intent to accomplish a coordinated implementation of statutory and regulatory provisions is also evidenced by the 360-day rulemaking timeframe in Section 712(e), which is designed to synchronize the rulemaking process with the effective date provisions of Section 754. Reasonable minds may differ as to how effectively the wording of Section 754 expresses congressional intent. There can be no question, however, about Congress’ intent. Dodd-Frank thus provides no basis for the Commission to proceed based on any assumption that Congress desired the self-executing provisions of Dodd-Frank which depend on related Commission rulemaking to become effective, as a timing matter, before other provisions of Dodd-Frank. Rather, given Congress’ careful statutory implementation design, the construction of Section 754 proposed herein is in fact necessary to effectuate congressional intent. While the Commission has completed an extraordinary volume of proposed rulemaking since the enactment of Dodd-Frank, these rulemakings present novel and complex issues and have attracted a broad range of extensive and substantive comments. Moreover, many of these rulemakings present significant interdependencies. As a result, considerable uncertainty remains with respect to certain key elements of the Commission’s emerging regulatory framework for swaps. Also relevant, in light of its potential impact on the structuring of swaps activity, even greater uncertainty exists with respect to the emerging regulatory framework of the SEC with respect to security-based swaps and security-based swap registrants. In the case of at least some significant elements of the swap activities of most firms, the structuring of these swap activities is dependent both upon CFTC and SEC registration, capital, margin and related requirements. Further complicating matters, until the finalization of a number of critical rulemakings (including, in particular, those applicable to capital, margin, treatment of inter- affiliate transactions, registration requirements and extraterritorial application of Dodd-Frank, among others), financial institutions, particularly internationally-active financial institutions, are (continued from previous page) and Elizabeth M. Murphy, Secretary, the Securities and Exchange Commission (“SEC,” and, together with the CFTC, the “Commissions”), dated May 4, 2011, and from Richard M. Whiting, Executive Director and General Counsel, Financial Services Roundtable, to David A. Stawick, Secretary, the CFTC, dated April 6, 2011. 2 In this letter we refer to those provisions of Dodd-Frank that would come into effect on July 16, 2011, subject to the provisions of Section 754, as “self-executing provisions.” Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 4 unable to complete the analysis that is needed to determine how to structure their derivatives activities. Specifically, many firms do not yet have the guidance necessary to determine through which entities that activity should continue to be conducted under the new regime. This further complicates the ability of firms to anticipate and plan necessary implementation measures. It also raises problems for any implementation approach that depends on a provisional registration requirement if any compliance obligations attach to that status or if any demonstration of compliance with substantive requirements is required for provisional registration. Market participants should not be forced to bear the significant and unnecessary costs of building two compliance and systems infrastructures: the first to comply with what Dodd-Frank may require pending final rules, and the second to comply with what Dodd-Frank does require once final rules are adopted. A construction of Section 754 that would require guesses, judgments or assumptions to be made regarding these uncertainties would be fundamentally inconsistent with sound policy and prudent stewardship of U.S. markets and, in certain cases, could conflict with the long-standing doctrine that statutes must be sufficiently explicit to determine what persons are covered and what conduct is prohibited. In the absence of such clarity, affected provisions could be void for vagueness. Principles of statutory construction resist interpretations that might raise doubts as to a statute’s constitutional validity.3 These issues affect not only Commission rulemakings but also those provisions of Dodd-Frank that, while arguably self-executing, depend meaningfully, in one way or another, on related Commission rulemakings. These considerations make it critical for the Commission, in order to avert severe market disruption, widespread, inadvertent non-compliance with the CEA, and litigation, to take urgent measures to ensure an orderly implementation of Dodd-Frank requirements. We believe that Dodd-Frank – and Section 754 in particular – together with the Commission’s statutory exemptive authority under Section 4(c) of the CEA, provide the Commission the necessary authority and tools to accomplish this result. B. Distinction between Swaps and Futures and Other Instruments Dodd-Frank excludes futures contracts (and options on futures contracts) from the definition of “swap” and repeals those provisions of the CEA that had provided an effective exemptive framework for certain swaps from regulation (or invalidation) as futures contracts. However, Dodd-Frank’s definitional exclusion does not establish a functional distinction between these two different categories of instrument. As the Commission is well aware, regulators, practitioners and others have struggled over the years to articulate a clear distinction between the two categories. 3 See United States v. Jin Fuey Moy, 241 U.S. 394, 401 (1916) (“[a] statute must be construed, if fairly possible, so as to avoid not only the conclusion that it is unconstitutional, but also grave doubts upon that score.”); Almendarez- Torres v. United States, 523 U.S. 224, 237-38 (1998); Jones v. United States, 529 U.S. 848, 857 (2000). Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 5 The adoption of the context-based exemptive and exclusionary approach to the treatment of swaps under the Commodity Futures Modernization Act of 2000 (the “CFMA”), as opposed to a definitional approach, reflected precisely the challenges presented by this distinction. Although the Commissions have undertaken an extensive proposed joint rulemaking on, and exclusions from, the definitions of the terms “swap” and “security-based swap,” the Commissions have not taken steps to-date to address this issue. Left unresolved, the ambiguity created by the definitional exclusion, however, runs the risk of creating uncertainty, and potentially, consequential disputes, about what is and what is not a swap or a futures contract. This, in turn, raises the prospect that certain types of over-the-counter (“OTC”) transactions commonly regarded as swaps might be per se illegal if they are conducted in accordance with the framework for swaps but are subsequently held by the Commission or a court also to be futures contracts. We do not think this is Congress’ intended outcome. Nevertheless, as a result of this uncertainty, prior to the effective date of repeal of the provisions in the CEA that had provided legal certainty to swap market participants, it is critical that the Commission take timely steps to provide clarity and legal certainty to those who rely on compliance with the swap provisions of Dodd-Frank. Swap market participants complying in good faith with the swap provisions of the CEA and Commission rules should not be subject to rescission, private rights of action or CFTC enforcement risk in the event of an after-the-fact determination by the CFTC or a court that the relevant swap transaction is more properly characterized as a futures contract. In addition, until the effective date of the Commissions’ swap and security-based swap definition rules, the Commission should provide interim relief to market participants who engage in transactions that the Commissions have proposed to exclude from the definition of swap. Otherwise, those transactions would become subject to Dodd-Frank, with potentially significant unintended consequences, such as the possible prohibition under Section 2(e) of the CEA of a wide range of mortgage interest rate protection products and forward contracts, and other instruments that the Commissions have acknowledged were never intended to be regulated as swaps, as well as the possible preemption under Section 12(h) of the CEA of state insurance regulation. II. Discussion A. Section 754 of Dodd-Frank Section 754 of Dodd-Frank specifies the basis for determining the effective date of Title VII’s amendments to the CEA. Specifically, Section 754 provides that: Unless otherwise provided in this title, the provisions of this subtitle shall take effect on the later of 360 days after the date of the enactment of this subtitle or, to the extent a provision of this subtitle requires a rulemaking, not less than 60 days after Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 6 publication of the final rule or regulation implementing such provision of this subtitle. [Emphasis added.] A number of provisions in Dodd-Frank by their terms become effective on July 16, 2011, subject to the provision of Section 754. It is therefore necessary to determine whether these provisions “require a rulemaking,” in which case such provisions would become effective at the time that any such related rulemaking becomes effective. As noted above, there are several respects in which a statutory provision may “require a rulemaking.” The most obvious example is one in which the statutory provision is expressly directed to be implemented through a Commission rulemaking. Other clear examples include circumstances in which compliance with a statutory provision requires registration and the registration regime has not become effective, or in which a registrant is required to comply with statutory standards (for example, capital or margin requirements, or the obligation to adopt policies and procedures) that cannot be complied with absent final rules giving content to these standards and requirements. Still others include provisions that rely for their application on a defined term that is required to be implemented through Commission rules that have not been finalized and become effective. While defined terms that are subject to further definitional rulemaking are subject to different levels of uncertainty, it is essential that any provision using a defined term provide clarity as to the persons, products and activities to which it applies.4 The plain meaning reading of Section 754 encompasses each of these situations5 and, even if the provision were susceptible to multiple interpretations, we are not aware of any legislative history suggesting that Congress intended an interpretation of this provision that would result in a more limited scope. Indeed, we believe Section 754 should be interpreted to evidence a rational implementation design; one in which Congress did not intend to compel untenable results or the imposition of inappropriate requirements and attendant legal uncertainty. Common sense also dictates that the words of Section 754 be given their most natural reading. Congress also drew a distinction between the finalization of rules and the date as of which they become effective. Indeed, Section 754 imposes a minimum period of 60 days following publication in the Federal Register before a final rule may become effective. This is an important implementation tool for the Commission because it permits the Commission to ensure an orderly implementation of Dodd-Frank by establishing effective dates for its rules that 4 See note 3, supra, and accompanying text. 5 The definition of “require” is to “call for as suitable or appropriate” or to “demand as necessary or essential.” See Webster’s Third New International Dictionary (16th ed., 1971). The word “require” in Section 754 should also be interpreted in connection with the word “implement,” which means to “give practical effect to and ensure of actual fulfillment by concrete measures.” Id. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 7 are appropriate both for the rulemakings themselves as well as for dependent statutory provisions. We urge the Commission to take these considerations into account in construing Section 754 and otherwise preparing for an orderly implementation of the Dodd-Frank swap regime. This is necessary to prevent the occurrence on July 16, 2011 of a broad range of unintended and highly disruptive consequences, including those summarized briefly below:6  Swap Dealers and Major Swap Participant Registration. The provisions of Section 4s(a) of the CEA requiring swap dealers and major swap participants to be registered are dependent on a number of required rulemakings and raise a number of issues. Most obvious, the definitions of these terms, as required under Section 712(d) of Dodd-Frank, have not been finalized, nor has the application of these substantive definitions extraterritorially or to inter-affiliate transactions. Additionally, rules establishing a registration regime for these entities, as required by CEA Section 4s(b)(5), have not been finalized and become effective. Although the Commission could hastily adopt a provisional registration framework, other required rulemakings that have not been finalized would make that approach imprudent and inconsistent with Section 754’s plain meaning and intent. In order to register a swap dealer, firms must be in a position to determine which entity (or entities) within their holding company group is (are) the most suitable one (ones) in which to conduct the activity requiring registration. Firms cannot complete the regulatory, financial, operational and related analyses necessary to reach that conclusion without understanding applicable capital and margin regulations, how inter-affiliate transactions will be treated for purposes of various requirements, and whether, and if so how, registration and substantive regulatory requirements will be applied extraterritorially. In this regard we note that all of the 15 largest swap dealers are internationally active and 8 of the 15 largest swap dealers are part of consolidated financial holding company groups that are organized and headquartered outside the United States. A very significant portion, and in some cases a majority, of the global swap activity of these 15 swap dealers is conducted with counterparties located outside the United States. These related rulemakings are expressly required under Dodd-Frank. More importantly, they are required as a practical matter in order for firms to complete the structuring of their swap activities that is a pre-condition to their implementation of the infrastructure necessary to adhere to Dodd-Frank’s regulatory requirements. 6 We have summarized here some of the key issues that illustrate the serious consequences arising from premature effectiveness of Dodd-Frank, although we note that this summary is not necessarily an exhaustive list of all such issues. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 8 In the absence of the approach recommended above (or equivalent Commission relief), market participants would be required to make a judgment regarding whether they qualify as a “swap dealer” or “major swap participant.” Many substantive definitional questions for which the CFTC has solicited comment in its mandatory rulemaking under Section 712(d) remain unresolved and firms would have to guess or otherwise make judgments or assumptions as to how these provisions will be finalized. For example, when is a person regarded as “regularly enter[ing] into swaps with counterparties as an ordinary course of business”? Or when do outstanding swaps “create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”? Is dealing in foreign exchange swaps and forwards relevant prior to finalization of any exemptive relief by the U.S. Department of the Treasury? Are inter-affiliate or extraterritorial transactions excluded or included? Who is a “U.S. person” for purposes of all these rules? What is the relevance, if any, of inter-affiliate guarantees? As a result of these considerations, provisions applicable to swap dealers and major swap participants should not take effect until final rules defining those terms are effective. In particular, registration should not be required absent an effective registration regime and finalization of rules governing the regulatory requirements that are manifestly material to the structuring of swap activities by prospective registrants.  Advisors to Special Entities and Other Business Conduct Standards. CEA section 4s(h) both imposes, and requires that the Commission adopt certain rules establishing, business conduct standards for swap dealers and major swap participants. Section 4s(h)(4) imposes special requirements on swap dealers who act as advisors to Special Entities. At this point, it is not clear to whom the rules apply or what the rules, in fact, require to be done. They should not take effect until those uncertainties are resolved by Commission rulemaking, as discussed below. First, as a result of uncertainties in the definitions of the terms “swap” and “swap dealer,” many market participants are not in a position to make a clear judgment regarding whether these requirements apply to them. These uncertainties are compounded by the fact that, read literally, Section 4s(h)(4) does not refer to registered swap dealers. We note, however, that Section 4s(h) makes inconsistent references to “swap dealers and major swap participants,” on the one hand, and “registered swap dealers and major swap participants,” on the other hand. (Compare the reference in Section 4s(h)(1) to “registered swap dealers and major swap participants,” to “swap dealers and major swap participants” in Section 4s(h)(3), which specifies the business conduct rules to be adopted by the Commission and to be adhered to by registered swap dealers and major swap Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 9 participants.) Accordingly, it is not at all clear that the references in Section 4s(h)(4) are intended to apply to swap dealers that are not registered under the CEA. This lack of attention to the distinction between registered and unregistered status was likely not considered consequential by Congress precisely because Dodd- Frank includes no statutory exemptions from registration as a swap dealer. Congress also clearly could not have intended for the Commission to be responsible for enforcing compliance with substantive (as opposed to anti-fraud) regulatory requirements by persons not subject to Commission oversight as registrants. Accordingly, the distinction is consequential only in the implementation phase and, as a result, the Commission should utilize its further definitional authority under Section 721(b) of Dodd-Frank to clarify that all of the external business conduct standards apply only to registered swap dealers and major swap participants. Pending such rules, the Commission should not apply Section 4s(h)(4) or other external business conduct standards until its registration and definitional rules for swap dealers are effective. In addition, as indicated in the Commission’s proposed rulemaking for external business conduct standards, the statute does not specify the meaning of, and the Commission has requested comment as to the appropriate scope of, a number of critical terms, including the terms “acts as an advisor,” “best interests” and “Special Entity.” These terms must be clarified prior to the effectiveness of Section 4s(h)(4). Moreover, as a practical matter, it makes no sense to implement the provisions of Section 4s(h)(4), as well as the other business conduct standards required under Section 4s(h), until the business conduct rules required by Section 4s(h)(6) and related definitions are finalized and take effect, and firms understand what is required of them and have the opportunity to implement the compliance and systems infrastructure required to adhere to these requirements. If these rules become effective before their scope and content is clarified, given the extremely negative consequences that could result if a swap dealer were to be deemed, inadvertently and in hindsight, to be an advisor, pension plans and other Special Entities could face the prospect of a period of significantly reduced access to the swap markets or, at a minimum, a curtailment in access to important information and communications from swap dealers. Special Entities whose access to the swap market for risk management purposes becomes restricted would be exposed to greater levels of credit, interest rate and other risk, and overall market liquidity could be diminished.  Duties of Swap Dealers and Major Swap Participants. We understand that the Commission is considering a provisional registration requirement for swap dealers and major swap participants. Under Section 4s(j), certain duties, Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 10 including those involving the implementation of risk management programs and diligent supervision, arguably would technically apply to such a provisionally registered swap dealer or major swap participant. For the reasons discussed above, we believe such an approach would be imprudent and inconsistent with Section 754. In addition, we note that the content of the proposed duties is the subject of pending Commission proposed rules. Accordingly, the duties applicable to registered swap dealers and major swap participants under Section 4s(j) should not take effect until the rules governing those duties required under Section 4s(j)(7) are finalized and take effect, and firms have the opportunity to implement the compliance and systems infrastructure required to adhere to these requirements.  Chief Compliance Officer. Chief compliance officers of swap dealers and major swap participants are responsible for ensuring compliance with the new requirements applicable to such registrants under Dodd-Frank. As a result, the chief compliance officer requirements of Section 4s(k) should not take effect until the regulatory requirements under Section 4s for which the chief compliance officer is responsible are finalized and become effective. Any other interpretation would render the role of the chief compliance officer largely meaningless, although not free from costs. Another interpretation would also be inequitable for the particular individual who would be the chief compliance officer, who would not know the obligations for which he or she would be taking responsibility. For reasons analogous to those discussed above in relation to external business conduct standards, it is not likely that Congress intended these requirements to apply to entities that are not registered under the CEA. The considerations noted above regarding the pending status of key definitions are also relevant to this provision.  Segregation of Initial Margin for Uncleared Swaps. Section 4s(l)(1)(A) requires swap dealers and major swap participants to provide their swap counterparties with notice of their right to request segregation of initial margin for uncleared swaps. However, the content of that segregation arrangement – including the scope of permissible custodians, the type of permitted custody arrangements and the eligible investments for segregated collateral – are subject to further Commission rulemaking under Sections 4s(l)(1)(B) and (2)(B)(ii)(I). As a result, in order for there to be any content to the “right” that is the subject of the notice, and therefore for there to be practical meaning to the notice itself, Section 4s(l)(1)(A)’s notice requirement should not take effect until the effectiveness of the Commission’s rules regarding Dodd-Frank’s segregation requirements, as well as Commission rules providing for the definition and registration of swap dealers and major swap participants, for the reasons noted above. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 11  SEFs and SDRs. Similar considerations apply to swap execution facilities (“SEFs”) and swap data repositories (“SDRs”). Although the definitions of SEF and SDR are not subject to mandatory further definitional rules, and the relevant registration provisions (Sections 5h(a)(1) and 21(a)(1)(A), respectively) do not by their terms require independent Commission rules, the Commission is required to adopt rules generally regarding the regulation of SEFs and SDRs (Sections 5h(h) and 21(h), respectively). Moreover, it is simply not possible to comply with a registration requirement absent an effective registration regime. Additionally, in order to become registered, an SDR and SEF must comply with rules to be adopted by the Commission, but these rules will not be finalized and become effective as of July 16, 2011. As a result, the SEF and SDR provisions of Dodd-Frank should not take effect until the effectiveness of the Commission’s final rules for the registration of and regulatory requirements applicable to SEFs and SDRs.  Existing Commission Registrant Categories. Neither Dodd-Frank’s amendments to the definitions of “futures commission merchant,” “floor trader,” “floor broker,” “introducing broker,” “commodity trading advisor” and “commodity pool operator” nor the existing CEA provisions governing the regulation (or, in some cases, exemption) of such persons specifically provide for any mandatory CFTC rulemaking provisions. Similarly, Section 4d(f)(1)’s requirement that a person accepting margin for cleared swaps register as a futures commission merchant does not specifically provide for a mandatory CFTC rulemaking. The substantive requirements for such persons’ swap activities, and the conforming amendments that are necessary to the existing exemptions for such persons under CFTC regulations, will, however, almost certainly not be effective by July 16, 2011, leaving affected market participants with little practical ability to comply or have available to them appropriate exemptions.7 By way of a simple example of the significant issues that can arise prior to the Commission’s adoption of appropriate conforming amendments, there is no exemption from introducing broker registration for the activities of an individual who is a person associated with a swap dealer (in contrast to the very important exemptions that currently exist for associated persons of a futures commission merchant). 7 See, e.g., Notice of Proposed Rulemaking, Adaption of Regulations to Incorporate Swaps, 76 Fed. Reg. 33066 (June 7, 2011); Notice of Proposed Rulemaking, Registration of Intermediaries, 76 Fed. Reg. 12888 (Mar. 9, 2011); and Notice of Proposed Rulemaking, Amendments to Commodity Pool Operator and Commodity Trading Advisor Regulations Resulting from the Dodd-Frank Act, 76 Fed. Reg. 11701 (Mar. 3, 2011). Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 12 We believe the Commission has clear authority under CEA Section 4(c) to grant appropriate exemptive relief from the effectiveness of provisions regarding such registrant categories as they apply to activities in swaps during the period prior to Commission finalization and effectiveness of the necessary conforming amendments to the substantive regulatory and exemptive provisions applicable to these registrant categories. As noted above, we believe that Section 754 and the Commission’s exemptive authority enable the Commission to effectuate the orderly implementation of Dodd-Frank, including Dodd-Frank’s self-executing provisions, through the appropriate sequencing and effective dates of its regulations to avoid market disruption, widespread inadvertent non- compliance and potentially consequential litigation (particularly in the event of an intervening market break). Requested relief. Accordingly, we urge the Commission to grant relief by issuing an order (1) interpreting Section 754 in a manner consistent with the foregoing discussion8 and (2) to the extent that any uncertainty exists with respect to the appropriate application or construction of Section 754, (a) adopting a Commission non-enforcement policy with respect to non-compliance with self-executing provisions of Dodd-Frank prior to finalization and effectiveness of related rulemakings specified by the Commission, as discussed above and (b) exempting affected market participants, pursuant to CEA Section 4(c), from the private rights of action provisions of CEA Section 22(a) with respect to the self-executing provisions of Dodd-Frank prior to finalization and effectiveness of the specified related rulemakings. Additionally, as noted above, we urge the Commission to issue an exemption pursuant to CEA Section 4(c) for affected swap market participants with respect to non- compliance with the registration and regulatory requirements applicable to “futures commission merchants,” “introducing brokers,” “commodity trading advisors” and “commodity pool operators” during the period prior to Commission finalization and effectiveness of the necessary conforming amendments to the substantive and exemptive provisions applicable to these registrant categories.9 8 In the alternative, we request that the Commission exercise its further definitional authority in Section 721(b) of Dodd-Frank to define the words “requires a rulemaking” in Section 754 in a manner consistent with this discussion. Further definition of Section 754 is within the scope of the Commission’s authority under Section 721(b) because Section 754 amends the CEA by specifying the effective dates of Title VII’s amendments to the CEA. 9 Such relief is also necessary for the reasons stated by, and intended to be consistent with, the request for relief from Section 4d(f) previously submitted by the Futures Industry Association on behalf of members of ICE Clear Europe. See Letter from John Damgard, President, Futures Industry Association, to David A. Stawick, Secretary, the CFTC, dated June 1, 2011. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 13 B. Section 739 of Dodd-Frank Section 723(a)(1)(A)’s repeal of Sections 2(d), 2(e), 2(g) and 2(h) of the CEA will take effect on July 16, 2011. Additionally, as noted above, Dodd-Frank’s exclusion of futures contracts from the CEA’s “swap” definition does not establish a functional distinction between the two different instruments.10 As the CFTC is aware, for many years uncertainty existed as to whether OTC swaps might be regarded as futures contracts under the CEA. Congress addressed this issue initially through the CFMA and, more recently, through Dodd-Frank’s statutory framework for the regulation of swaps. Left unresolved, the ambiguity created by the definitional exclusion, however, seems destined to lead to serious uncertainty, and potentially consequential disputes, common before the enactment of the CFMA, about what is and what is not a swap or a futures contract. This, in turn, raises the prospect that common types of OTC transactions might be per se illegal if they are conducted in accordance with the framework for swaps but are subsequently held by the CFTC or a court to be futures contracts. In order to prevent certain of these consequences, Congress included Section 739 of Dodd-Frank (“Legal Certainty for Swaps”), which amends Section 22(a)(4) of the CEA to include the following provision: (B) SWAPS.—No agreement, contract, or transaction between eligible contract participants or persons reasonably believed to be eligible contract participants shall be void, voidable, or unenforceable, and no party to such agreement, contract, or transaction shall be entitled to rescind, or recover any payment made with respect to, the agreement, contract, or transaction under this section or any other provision of Federal or State law, based solely on the failure of the agreement, contract, or transaction . . . to meet the definition of a swap under section 1a . . . . 10 H.R. 4173, as engrossed in the House of Representatives, excluded “(i) any contract of sale of a commodity for future delivery (or any option on such a contract) or security futures product traded on or subject to the rules of any board of trade designated as a contract market under section 5 or 5f.” See H.R. 4173 (E.H.), Section 3101. The Senate incorporated a similar exclusion in the Bill in its considerations in March 2010: “any contract of sale of a commodity for future delivery or security futures product traded on or subject to the rules of any board of trade designated as a contract market under section 5 or 5f.” See Dodd Bill as amended by the Manager’s Amendment of March 23, 2010. H.R. 4173, as engrossed by the Senate, however, changed this language to the exclusion clause listed in the final bill: “(i) any contract of sale of a commodity for future delivery (or option on such a contract), leverage contract authorized under section 19, security futures product, or agreement, contract, or transaction described in section 2(c)(2)(C)(i) or section 2(c)(2)(D)(i).” See H.R. 4173 (E.A.S.), Section 721 and H.R. 4173 (ENR), Section 721. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 14 We believe this provision is intended to protect eligible contract participant (“ECP”) parties to an agreement, contract, or transaction conducted as a swap from rescission in circumstances where the agreement, contract or transaction is recharacterized by the CFTC (or a court) as a futures contract or other instrument other than a swap. Its reference to recovery of payment also seems intended to protect such ECPs from private rights of action under Section 22 of the CEA violations arising solely from such recharacterization. Requested relief. We request that the CFTC confirm our interpretation immediately above of Section 22(a)(4). We further request that, consistent with the objectives of Section 739, the CFTC adopt an order pursuant to Section 4(c) of the CEA exempting ECP parties to an agreement, contract, or transaction conducted in accordance with the swap provisions of the CEA and CFTC rules, as and to the extent effective, (and any person or class of persons offering, entering into, rendering advice, or rendering other services with respect to such agreements, contracts or transactions) from compliance with the provisions of the CEA and CFTC rules applicable to futures contracts (and options thereon), other than any agreement, contract, or transaction previously determined by the CFTC to be subject to the provisions of the CEA and CFTC rules applicable to futures contracts (or options thereon) in accordance with the CEA.11 Finally, we urge the Commission to adopt an interim order pursuant to CEA Section 4(c) exempting from the CEA persons who, prior to the Commissions’ adoption of final rules defining “swap,” engage in transactions proposed by the Commissions to be excluded from the definition of “swap” in the Commissions’ proposed rules regarding Further Definition of “Swap,” “Security-Based Swap,” and ”Security-Based Swap Agreement,”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping12 without compliance with the provisions of the CEA and Commission rules applicable to swaps (and any person or class of persons offering, entering into, rendering advice, or rendering other services with respect to any such transaction). We believe the interpretative and exemptive relief proposed above would be in the public interest and consistent with Congress’ legal certainty objective by protecting ECPs who, in good faith, comply with Dodd-Frank’s swap provisions. It would also permit the CFTC to retain the flexibility to determine, on a prospective, case-by-case or categorical basis, and subject to the CEA, whether particular swaps or types, classes or categories of swaps are instead 11 Additionally, we note that Section 723(c)(3) appears to make existing Commission Regulation 32.4 inapplicable to agricultural commodity options because Part 32 was adopted pursuant to CEA Section 4c(b), rather than Section 4(c). Pending adoption of final Commission rules regarding the treatment of agricultural commodity options, we urge the Commission to re-adopt Part 32 pursuant to Section 4(c), in order to preserve, on at least an interim basis, existing authority to transact in agricultural commodity options. 12 76 Fed. Reg. 29818 (May 23, 2011). Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 15 properly characterized as futures contracts. Finally, it would prevent the prohibition under Section 2(e) of the CEA of off-exchange transactions with non-ECPs in instruments never intended to be regulated as swaps, as well as the possible unintended preemption of all state insurance law under Section 12(h) of the CEA. * * * If you have any questions regarding this letter, please do not hesitate to contact Edward J. Rosen of Cleary Gottlieb Steen & Hamilton LLP, outside counsel to the undersigned in this matter, at 212-225-2820. Respectfully submitted, Futures Industry Association Institute of International Bankers International Swaps and Derivatives Association Investment Company Institute Securities Industry and Financial Markets Association U.S. Chamber of Commerce cc: Daniel Berkovitz, Esq. General Counsel Ananda K. Radhakrishnan, Esq. Director Division of Clearing and Intermediary Oversight Richard A. Shilts Acting Director Division of Market Oversight Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 16 Trade Association Signatories The Futures Industry Association (“FIA”) is the leading trade organization for the futures, options and OTC cleared derivatives markets. It is the only association representative of all organizations that have an interest in the listed derivatives markets. Its membership includes the world’s largest derivatives clearing firms as well as leading derivatives exchanges from more than 20 countries. As the principal members of the derivatives clearinghouses, our member firms play a critical role in the reduction of systemic risk in the financial markets. They provide the majority of the funds that support these clearinghouses and commit a substantial amount of their own capital to guarantee customer transactions. FIA’s core constituency consists of futures commission merchants, and the primary focus of the association is the global use of exchanges, trading systems and clearinghouses for derivatives transactions. FIA’s regular members, who act as the majority clearing members of the U.S. exchanges, handle more than 90% of the customer funds held for trading on U.S. futures exchanges. The Institute of International Bankers represents internationally headquartered financial institutions from 39 countries around the world; its members include international banks that operate branches and agencies, bank subsidiaries, and broker-dealer subsidiaries in the United States. Since 1985, the International Swaps and Derivatives Association (“ISDA”) has worked to make the global over-the-counter (OTC) derivatives markets safer and more efficient. Today, ISDA is one of the world’s largest global financial trade associations, with over 800 member institutions from 56 countries on six continents. These members include a broad range of OTC derivatives market participants: global, international and regional banks, asset managers, energy and commodities firms, government and supranational entities, insurers and diversified financial institutions, corporations, law firms, exchanges, clearinghouses and other service providers. Information about ISDA and its activities is available on the Association's web site: www.isda.org. The Investment Company Institute (“ICI”) is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). ICI seeks to encourage adherence to high ethical standards, promote public understanding, and otherwise advance the interests of funds, their shareholders, directors, and advisers. Members of ICI manage total assets of $13.41 trillion and serve over 90 million shareholders. The Securities Industry and Financial Markets Association (“SIFMA”) brings together the shared interests of hundreds of securities firms, banks and asset managers. SIFMA’s mission is to support a strong financial industry, investor opportunity, capital formation, job creation and economic growth, while building trust and confidence in the financial markets. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association. For more information, visit www.sifma.org. Chairman Gensler, Commissioners Dunn, Sommers, Chilton and O’Malia June 10, 2011 Page 17 The U.S. Chamber of Commerce is the world’s largest business federation, representing the interests of more than 3 million businesses of all sizes, sectors, and regions, as well as state and local chambers and industry associations. American Bankers Association Financial Services Roundtable Futures Industry Association Institute of International Bankers International Swaps and Derivatives Association Investment Company Institute Securities Industry and Financial Markets Association U.S. Chamber of Commerce June 10, 2011 Chairman Mary L. Schapiro Commissioner Kathleen L. Casey Commissioner Elisse B. Walter Commissioner Luis A. Aguilar Commissioner Troy A. Paredes Securities and Exchange Commission 100 F Street, NE Washington, D.C. 20549 Re: Request for Clarification and Relief Under Section 774 of the Dodd- Frank Wall Street Reform and Consumer Protection Act; Petition for Exemption Pursuant to Section 36(a)(1) of the Securities Exchange Act of 1934 and Section 28 of the Securities Act of 1933 Dear Chairman Schapiro and Commissioners Casey, Walter, Aguilar and Paredes: The undersigned associations sincerely appreciate the significant efforts of the Securities and Exchange Commission (“SEC”) over the last year to implement Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). We appreciate the SEC’s recent announcement that it is taking a series of actions to clarify the requirements that will apply on July 16 and to provide appropriate temporary relief.1 We believe that all of the provisions of Title VII, including those that do not require rulemaking, should follow an orderly implementation plan. We are therefore writing to request the deferral, during the rulemaking period, of all operative provisions of Title VII of Dodd-Frank, other than the amendments to the definitions of the term “security” and Section 767, that are scheduled to become effective on July 16, 2011. We also request a broad temporary deferral of application of the securities laws, except for the existing antifraud and anti-manipulation provisions, to security- 1 Press Release, Securities and Exchange Commission, SEC Announces Steps to Address One-Year Effective Date of Title VII of Dodd-Frank Act (June 10, 2011), available at http://www.sec.gov/news/press/2011/2011-125.htm. 2 based swaps (“SBS”) that would otherwise result from including SBS in the definition of “security.” 2 Section 774 of Dodd-Frank states that the provisions of Title VII take effect, unless otherwise specified, on the later of (i) 360 days after the date of enactment or (ii) to the extent a provision requires a rulemaking, not less than 60 days after publication of the final rule or regulation implementing such provision. While most of the provisions of Title VII require rulemaking to be effective, according to our reading, a number of provisions that relate to SBS are arguably scheduled to become effective on July 16 (“self-operative provisions”).3 In general, intractable compliance, interpretive and operational challenges will arise if such provisions go into effect in July. Compliance with these provisions is complicated in part because certain key terms, such as SBS, SBS dealer and major SBS participant, are subject to further definition, and because the self-operative provisions are integrally related to other provisions that require rulemaking. There is no basis for assuming that Congress intended all of the self- operative provisions of Dodd-Frank to become effective before the mandatory rulemaking process is complete. To the contrary, § 712 of Dodd-Frank requires the SEC to issue most of the final rules under Title VII by July 2011. We request that the SEC use its exemptive authority under Section 36(a)(1) of the Exchange Act4 and Section 28 of the Securities Act,5 and any other legal authorities available to the SEC, to exempt, interpret or otherwise provide relief to 2 Dodd-Frank §§ 761(a)(2) and 768(a)(1) (amending the definition of “security” in the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934, as amended (“Exchange Act”). 3 We believe that there are strong arguments why substantially all of the provisions of Title VII could be interpreted as at least indirectly requiring rulemakings to be effective. Without guidance from the SEC, market participants would need to prepare for the possibility that all provisions that do not explicitly require rulemaking will be viewed as effective on July 16. We therefore appreciate the SEC’s plans to provide guidance regarding which provisions will become operable on July 16 and encourage the SEC to do so as soon as possible. 4 Section 36(a)(1) states: “Except as provided in subsection (b) of this section, but notwithstanding any other provision of this title, the Commission, by rule, regulation, or order, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” 5 Section 28 states: “The Commission, by rule or regulation, may conditionally or unconditionally exempt any person, security, or transaction, or any class of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation issued under this title, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” 3 market participants from the requirements of all of the self-operative provisions, other than the amendment to the securities definition to include SBS and Section 767. This relief should remain in effect until key definitional and other rules are effective, and the SEC has specified an implementation plan for Title VII. The implementation of the self-operative provisions should align with the principles and phase-in schedule that the SEC adopts for its Title VII rulemakings. In addition, we request that the SEC temporarily exempt market participants from all of the securities laws, except the existing antifraud protections, that would otherwise apply to SBS beginning on July 16 when SBS become securities. We recognize that the definitional change to include SBS in the term “security” must be effective on July 16 in order for the SEC to maintain its existing antifraud authority over SBS that were previously security-based swap agreements. This temporary exemption should last long enough to provide sufficient time for (i) the SEC to adopt rules defining SBS, SBS dealer, major SBS participant and eligible contract participant (“ECP”), as well as the rules on SBS capital, margin and business conduct requirements and clarification as to the extraterritorial reach of Title VII; (ii) market participants to submit requests for permanent exemptions and for the SEC to adopt exemptions where appropriate; (iii) the SEC to integrate the application of the securities requirements to SBS with the overall Title VII implementation schedule; and (iv) market participants to consider the appropriate legal entity registration framework to adopt in light of the SEC’s final rules; and (v) market participants to implement that framework. Within three months of July 16, we will provide to the SEC a detailed targeted request for permanent exemptions from particular inapposite securities laws. We also respectfully request that the SEC encourage FINRA to file a rule that would defer application of its rules to SBS and to adopt an implementation plan that is aligned with the SEC’s schedule. These exemptions are critical to ensuring an orderly and logical implementation of Title VII. We appreciate and are supportive of the SEC’s consideration of various approaches to a phased-in implementation schedule and believe that the implementation of the self-operative provisions should follow a similar logic.6 It is necessary to align the implementation of the self-operative 6 We encourage the SEC to carefully consider the recommendations made in a recent comment letter submitted by SIFMA and other trade groups to the SEC regarding the phase-in schedule for Title VII requirements. See Letter from the International Swaps and Derivatives Association, the Futures Industry Association, the Financial Services Forum and SIFMA to the Commissions, dated May 4, 2011, available at http://comments.cftc.gov/PublicComments/ ViewComment.aspx?id=42353. We also recommend that the SEC adopt an iterative rulemaking process, along with an implementation timetable, and provide market participants an opportunity to review and comment on revised versions of the rules, and their interdependencies. See Letter from the FIA, The Financial Services Roundtable, the Institute of International Bankers (Institute), the Insured Retirement Institute, ISDA, SIFMA and the U.S. Chamber of Commerce to the CFTC, dated May 26, 2011; available at http://comments.cftc.gov/PublicComments/View Comment.aspx?id=44562 and Letter from the ABA and the ABA Securities Association to the (…continued) 4 provisions with the provisions that are dependent on rulemaking to ensure a coherent realization of the new swaps regulatory regime. This letter is divided into two parts. Part I discusses five rulemaking areas and why deferral of the effectiveness of the related self-operative provisions is particularly necessary until final rulemaking is effective. It also includes specific examples of the challenges that will result if the self-operative provisions are not deferred. Part II outlines the problems associated with SBS becoming securities and discusses why a broad temporary exemption from application of the securities laws (other than existing antifraud and anti-manipulation provisions) to SBS is necessary. I. The Self-Operative Provisions Should Be Deferred Until Related SEC Rulemakings Are Effective A. Deferral Is Needed Until Key Rulemakings Are Effective This section identifies five critical rulemaking areas that require resolution before the self-operative provisions of Title VII should become effective. 1. SBS Definitional Rule Must Be Effective The definition of SBS is of central importance for the self-operative provisions. The SEC and the Commodity Futures Trading Commission (“CFTC,” and, together with the SEC, the “Commissions”) have proposed, but have not yet finalized their joint proposal defining swap, mixed swap and SBS.7 This Product Definition Proposal would prevent unintended consequences of imposing Title VII requirements on products that were not intended to be regulated as SBS. For example, the Commissions proposed that certain insurance products, such as surety bonds, true loan participations and forward sales of mortgage-backed securities in the TBA market would be outside the definition of SBS. As of July 16, however, these transactions could arguably fall within the definition of SBS. As a result, they could be treated as securities, and become subject to the new SBS collateral segregation and business conduct self-operative provisions, among others. (continued…) CFTC, dated June 3, 2011, available at http://comments.cftc.gov/PublicComments/View Comment.aspx?id=44614. 7 CFTC and SEC Proposed Rule on Product Definitions Contained in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 76 Fed. Reg. 29,818 (May 23, 2011) (hereinafter “Product Definition Proposal”) (adding 17 C.F.R. pt. 240). 5 2. SBS Dealer and Major SBS Participant Definitional and Registration Rules Must Be Effective The SBS dealer and major SBS participant registration requirement should be interpreted as implicitly requiring a rulemaking: specifically, these provisions depend on the rules that further define SBS dealer and major SBS participant and the registration rule. Section 764(a) of Title VII forbids SBS dealers and major SBS participants from operating unless they are registered as such with the SEC. That section also requires the SEC to adopt rules within one year of the enactment of Dodd-Frank that provide for the registration of SBS dealers and major SBS participants. Clearly, Congress did not intend to halt the activities of the SBS market’s primary participants on July 16, 2011 as a result of there being no registration regime set up by the SEC at that time. The SEC should interpret these provisions as implicitly requiring a rulemaking to prevent this paradoxical result. The statutory definitions of SBS dealer and major SBS participant do not provide sufficient guidance for market participants to determine which of their entities would be captured by these definitions and therefore subject to registration. The Commissions have proposed, but have not yet adopted, a rule further defining these terms.8 The interdependence of such definitional rule and the registration requirement is exemplified by the CFTC’s proposed registration rule 2121, which states that swap dealers “would be required to apply for registration not later than the effective date of the applicable Definitional Rulemaking” (i.e., the effective date of the swap dealer and major swap participant definitions).9 Even if market participants could rely on the statutory definitions, and the joint proposal defining SBS dealer and major SBS participant, ambiguities remain. In particular, key interpretive issues such as the treatment of inter-affiliate swaps, legacy swaps and affiliate guarantees, and the extraterritorial application of the registration requirement, are unaddressed in the statutory definitions and were not resolved by the proposal. 3. Rulemaking on Capital, Margin and Business Conduct Must Be Effective Market participants have not yet been able to determine which entities they will register as SBS dealers and major SBS participants and the regulatory requirements that will apply to them because the SEC has yet to propose rules on capital, margin, and business conduct, among other areas, for SBS dealers and 8 CFTC-SEC Proposed Rule on Further Definition of ‘”Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 75 Fed. Reg. 80,174 (Dec. 21, 2010) (hereinafter “Definitional Proposal”) (adding 17 C.F.R. pt. 240). 9 CFTC Proposed Rule on Registration of Swap Dealers and Major Swap Participants, 75 FR 71,379, 71,381 (Nov. 23, 2010) (adding C.F.R. pts. 3, 23 and 170). 6 major SBS participants. Dodd-Frank does not contemplate that market participants would have to make these decisions in the absence of final rules. Section 712 requires the rules governing SBS dealers and major SBS participants to be final within one year of the enactment of Dodd-Frank. We request that the SEC provide relief to avoid this unintended consequence. 4. New Antifraud Liability Must Be Clarified We have significant concerns that the new antifraud liability for SBS under Section 9 of the Exchange Act will be interpreted broadly on July 16 in light of the expanded scope of antifraud liability proposed by the SEC under Rule 9j-1.10 The Antifraud Proposal is overly broad and would expose SBS market participants to inappropriate enforcement liability because it creates uncertainty as to what is required to comply with the new antifraud provisions.11 For example, the Antifraud Proposal does not provide safe harbors analogous to Exchange Act Rule 10b5-1. SBS market participants need clarity that the Antifraud Proposal will not be applied on July 16 before a final rule is effective. Otherwise, market participants may be discouraged from entering into SBS transactions on July 16 in order to avoid the potentially significant liability that could arise under the new antifraud liability, if it is interpreted broadly. 5. Extraterritorial Guidance Is Needed In the absence of clear guidance regarding the extraterritorial application of Title VII, it is virtually impossible for global swaps entities to plan for the implementation of Title VII. Section 772(b) states, “No provision . . . shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate to prevent the evasion of any provision . . . .” The SEC has not provided any formal guidance on what this section means in practice and scope. As a result, market participants do not know what types of U.S. activities engaged in by their non-U.S. entities will trigger U.S. registration requirements and regulations, nor do they know the scope of capital or margin requirements that will apply. For those non-U.S. entities that expect to register as SBS dealers or major SBS participants, there remain major ambiguities 10 SEC’s Proposed Rule on Prohibition Against Fraud, Manipulation, and Deception in Connection With Security-Based Swaps, 75 FR 68,560 (Nov. 8, 2010) (hereinafter “Antifraud Proposal”) (adding 17 C.F.R. pt. 240). 11 For example, please refer to SIFMA’s comment letter to the SEC, dated December 23, 2010, available at http://www.sifma.org/WorkArea/DownloadAsset.aspx?id=22834. 7 as to how their SBS with non-U.S. persons will be treated and how U.S. requirements will be reconciled with foreign regulatory requirements.12 A number of important provisions that are scheduled to or could arguably go into effect on July 16 pose substantial problems for market participants absent further rulemaking by the Commissions. Faced with the unaddressed interpretive and compliance issues, market participants have little confidence that they will be able to assure compliance with the self-operative provisions. This is particularly problematic because of Section 29(b) of the Exchange Act, which may render void any contract made in violation of the Exchange Act. We request that the SEC explicitly provide that no SBS 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. B. Specific Examples Showing Why Security-Based Swap Self- Operative Provisions Should Be Deferred The challenges associated with provisions that are specific to SBS dealers and major SBS participants, and to market participants more generally, are discussed below. 1. Problematic SBS Dealer and Major SBS Participant Requirements As a preliminary matter, we believe that the SEC should interpret all of the provisions in § 764(a) that regulate SBS dealers and major SBS participants as provisions that require rulemaking, and therefore not effective on July 16. First, the intent of Dodd-Frank appears to only apply SBS dealer and major SBS participant requirements to persons that are registered with the SEC as such. Section 764(a) of Title VII forbids SBS dealers and major SBS participants from operating unless they are registered as such with the SEC. Second, Section 15F contains a general requirement in subsection (d) for the SEC to adopt rules for persons that register as SBS dealers and major SBS participants. There are also mandatory rulemaking provisions within Section 15F on business conduct, chief 12 We and our members have submitted comment letters and other materials to the SEC that discuss the extraterritorial application of Title VII. Please refer to the comment letters submitted by: the Institute on January 10, 2011, available at http://sec.gov/comments/s7-39- 10/s73910-8.pdf, by SIFMA on February 3, 2011, available at http://www.sec.gov/comments/s7- 39-10/s73910-81.pdf; 7 foreign financial institutions on January 11, 2011, available at http://www.sec.gov/comments/s7-39-10/s73910-9.pdf; 12 foreign financial institutions on February 17, 2011, available at http://www.sec.gov/comments/s7-39-10/s73910-25.pdf; and Sullivan & Cromwell LLP on behalf of Bank of America Corporation, Citigroup Inc. and JPMorgan Chase & Co. on February 22, 2011, available at http://www.sec.gov/comments/s7-39- 10/s73910-60.pdf; and the presentation submitted to the SEC by the Institute on April 13, 2011, available at http://www.sec.gov/comments/other/other-initiatives/otherinitiatives-50.pdf. 8 compliance officer duties and other requirements. We appreciate that the SEC is taking steps in the coming weeks to clarify the requirements that will apply to SBS transactions as of July 16 and encourage the SEC to interpret these provisions as requiring rulemaking. If the SEC does not take action to provide relief soon, market participants that are captured by the statutory definitions of SBS dealer and major SBS participant could be subject to provisions regulating SBS dealers and major SBS participants on July 16, even though they are not registered with the SEC. For one, market participants that are captured by the statutory definition of SBS dealer may be required to comply with fiduciary-like business conduct rules when advising pension funds, municipalities and other “special entities.” 13 These duties include acting in the best interests of the special entity, using reasonable efforts to obtain information, and disclosing the firm’s capacity when acting as a counterparty to a special entity. Some dealers may cease or limit their SBS business with “special entities” as the legal and financial risks resulting from these provisions is too substantial absent clarity on the application of the “special entity” rules on July 16. There is also substantial uncertainty around what constitutes acting “as an advisor to,” and in the “best interests” of, a special entity. 14 The statutory requirement is also silent as to what constitutes “reasonable efforts”: would an SBS dealer be able to rely on the special entity’s representations to satisfy its obligations to use “reasonable efforts” to obtain information necessary to determine that a recommended SBS is in the special entity’s best interests? The SEC should provide relief to market participants from complying with the special entity requirements until the SEC has provided guidance for how to comply with these requirements in an effective business conduct rule. Application of the statutory special entity requirements, in the absence of an effective SEC business conduct rule, will result in substantial compliance risk due to possible SEC enforcement actions, as well as litigation risk: failure to comply with the special entity rules could subject persons that meet the statutory definition of SBS dealer to private litigation actions under Section 10(b) of the 13 We note that new subsection 15F(h)(4) of the Exchange Act is ambiguous as to whether it requires further rulemaking. However, we believe that this subsection is dependent on rulemaking because new subsection 15F(h)(6) requires the SEC to prescribe rules under subsection (h) governing business conduct standards. 14 While the SEC has not yet proposed or finalized a rule on business conduct, the CFTC’s proposed rule recognizes that Dodd-Frank does not define the key terms “advisor,” “best interests” and “reasonable efforts” and, as a result, proposes to define these terms and specify how to comply with the special entity rules. CFTC Proposed Rule on Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 75 Fed. Reg. 80,638 (Dec. 22, 2010) (adding 17 C.F.R. pts. 23 and 155). 9 Exchange Act and could also subject broker-dealers advising special entities to private litigation actions under Section 9 of the Exchange Act. Furthermore, market participants that fall within the statutory definition of SBS dealer or major SBS participant could be required to: • cease all SBS dealing activities and divest SBS, or be in violation of the law for failing to be registered with the SEC, notwithstanding that the SEC has not yet provided a process for registration;15 • designate a chief compliance officer who must review and ensure compliance with Title VII, administer policies and procedures, and establish procedures for remediation of noncompliance;16 and • create new, and amend existing, customer documentation, educate customers and notify all bilateral uncleared swap counterparties of their right to have initial margin segregated at an independent third-party custodian.17 2. Substantial Challenges in the Application of Provisions that Affect Market Participants Generally Market participants may also be subject to new requirements on July 16 that will be difficult to implement in the absence of final and effective SEC rules. For instance, in the absence of an effective Rule 9j-1, market participants will need to closely analyze their businesses to ensure operation of information walls (to the extent such barriers are recognized by the SEC for this purpose) to comply with the gloss imposed on these new antifraud provisions by the SEC’s Antifraud Proposal.18 Until the SEC’s final rules are effective, implementation or modification of information barriers as they relate to SBS activity is unworkable. There are also new requirements related to margin collection that could be disruptive to the markets. Broker-dealer registration or SBS dealer registration would be required for any person that accepts margin for cleared SBS. This may require persons that are not registered as broker-dealers to cease clearing customer SBS until the SBS registration rules are finalized and effective. In addition, asset managers that invest collateral on behalf of broker-dealers may 15 Dodd-Frank § 764(a). 16 Id. 17 Id. 18 Id. §§ 762, 763. 10 need to reallocate these segregated funds into a narrow category of eligible investments that includes obligations of the United States, any state or political subdivision of a state, and obligations fully guaranteed by the United States.19 II. Problems with Treating Security-Based Swaps as “Securities” Necessitate Relief The most problematic self-operative Title VII provisions are those that will expand the definition of “security” in the Securities Act and the Exchange Act to include SBS. We appreciate that the SEC recognized the need for such temporary relief in the press release it issued earlier today. These definitional changes will result in substantial new compliance requirements and implementation challenges that the SBS market is just beginning to comprehend. At the same time, we recognize that delaying the effectiveness of the definitional change is unworkable because of the collateral effect on the SEC’s existing antifraud provisions for SBS that were previously security-based swap agreements. Therefore, rather than delay the effectiveness of the definitional change, we request that the SEC provide a broad temporary exemption from compliance with the requirements that will result from SBS being defined as securities, other than existing antifraud and anti-manipulation rules that apply to securities. This temporary exemption should last long enough to provide sufficient time for (i) the SEC to adopt rules defining SBS, SBS dealer, major SBS participant and ECP, as well as the rules on SBS capital, margin and business conduct requirements and clarification with respect to the extraterritorial reach of Title VII; (ii) market participants to submit requests for permanent exemptions and for the SEC to adopt exemptions where appropriate; (iii) the SEC to integrate the application of the securities requirements to SBS with the overall Title VII implementation schedule; (iv) market participants to consider the appropriate legal entity registration framework to adopt in light of the SEC’s final rules; and (v) market participants to implement that framework. Within three months of July 16, we will provide to the SEC a detailed targeted request for permanent exemptions from particular inapposite securities laws. The SEC should also encourage FINRA to file a rule that (i) defines the term “security” by reference to the Exchange Act and temporarily excludes SBS from such definition, and specifically excludes SBS from the definition of security in NYSE Rule 3, or (ii) temporarily exempts market participants’ SBS activities from FINRA requirements. Without such action from FINRA, broker- dealer SBS transactions would be subject to FINRA Rule 4210 margin requirements; markup rules for dealer trades with non-ECPs; best execution rules; anti-money laundering requirements; Know Your Customer and other account 19 Id. § 763. 11 opening requirements; and suitability requirements, among others. We further believe that FINRA should adopt an implementation plan that is aligned with the SEC’s schedule. The inclusion of SBS in the definition of security beginning on July 16 raises the following three key problems: • Application of regulatory requirements under the securities laws may be virtually impossible to ascertain with any precision because they raise questions concerning, or are related to, issues that will be addressed in rules that are not yet final. Furthermore, until these rules are effective, application of securities requirements to SBS is premature. • Application of some of these regulatory requirements will make little sense in the context of SBS and should be permanently exempted. Other provisions will involve significant interpretive issues for which SEC guidance is needed. • A number of requirements raise technical or operational hurdles that require more time to surmount. Significant time will be necessary to catalogue the full implications of the inclusion of SBS in the definition of security and to determine appropriate next steps. The discussion below identifies examples where the inclusion of SBS in the definition of security is particularly problematic. A. Securities Requirements Are Impossible to Implement with Precision Prior to Final Rulemakings A foremost concern with the treatment of SBS as securities is that the definition of SBS is not settled. Nonetheless, if the application of the securities laws and regulations to SBS is not deferred, market participants will need to start reacting to this change now. As a legal, risk management and compliance matter, market participants will need to view as an SBS every transaction that could be an SBS under the statutory definition, and implement compliance and operations controls and procedures, even if the Product Definitions Proposal would exclude such transactions. Until the definition of SBS is final, market participants will not know which of their agreements will be regulated as securities subject to SEC registration, and which will be swaps regulated by the CFTC, nor will they know whether their transactions trigger broker-dealer, SBS dealer or major SBS participant registration. Subjecting SBS to securities requirements prior to the effectiveness of the SBS definition rule would be premature because it would mean that certain transactions captured by the statutory definition of SBS would be treated as securities solely for the interim period until the SBS definition is effective. 12 This confusion is further exacerbated by the uncertainty in the interrelated definitions of ECP and securities dealer. While there is an exclusion from the definition of dealer for dealing in SBS, this exclusion is limited to dealing in SBS with or for ECPs. The definition of ECP was amended by Dodd-Frank, and the Commissions have sought comments in their Definitional Proposal on how to further define such term, including how to interpret the phrase “discretionary basis.” Until the term ECP is further defined in a final rulemaking, market participants will not know whether they are dealing with an ECP, and where the line is between their institutional and retail businesses. As a result, they will not know whether they are captured by the definition of “dealer” in the Securities Act and whether certain transactions are subject to the new requirement for non-ECP transactions to be executed on an exchange, or, if executed on a private placement basis, are subject to the requirement to be executed pursuant to an effective registration statement. As a result, market participants may cease or severely limit their business with counterparties that could potentially be considered non- ECPs under the Dodd-Frank statutory definition of ECP. Finally, applying the securities laws and regulations to SBS prior to the finalization of key Title VII definitions and rules, such as the rules on capital, margin and business conduct, and guidance on extraterritorial application of Title VII, would require market participants to make premature decisions about how to structure their SBS activities. For example, it is difficult for market participants to decide whether to use a dually registered broker-dealer, SBS dealer for their SBS activities, or instead conduct all SBS activities out of an SBS dealer, until they know how much capital is required for SBS dealers. B. Particular Securities Requirements May Require Permanent Exemptive Relief or SEC Guidance as Applied to Security-Based Swaps As a preliminary matter, we believe that a number of securities requirements are inappropriate for SBS and inconsistent with the purposes of Dodd-Frank. Market participants are analyzing the implications of the SBS definition as a security to determine the need for specific relief where the application of the securities laws to SBS would be unworkable and inappropriate. This process of identifying the need for permanent relief is likely to extend well beyond the effective date of the self-operative provisions. C. Practical Implementation Issues Support Deferral of Applying the Securities Laws to Security-Based Swaps Because none of the critical SEC rulemakings identified earlier in this letter are final, market participants have not been able to fully analyze the changes to systems, policies, procedures and technology that are needed to comply with the requirements applicable to SBS as securities. It will take a number of months to catalogue requirements, analyze their impact on businesses, make decisions 13 about how to structure SBS activities in light of these impacts and implement such structural changes once rulemaking has been finalized. In particular, the application of broker-dealer requirements to SBS poses a number of challenging implementation issues. First, nonbank firms involved in SBS activities may be required to register as broker-dealers. For example, a firm that intermediates SBS transactions as agent for offshore affiliates or executes SBS as agent on a trading facility would be a “broker” under the Securities Act, thereby subjecting it to broker-dealer registration. In addition, nonbank firms that act as dealers with respect to non-ECPs in SBS transactions will be required to register as broker-dealers. At the same time, the interaction of broker-dealer and SBS dealer regulatory requirements is as yet unknown because rules are not yet final, thus complicating key business structuring decisions. In several circumstances, banks that act as brokers or dealers in equity swaps with persons that are non-ECPs would also be required to register as broker-dealers. SBS activities by a broker-dealer would be subject to extensive regulatory and compliance requirements currently only applicable to the securities activities by a broker-dealer, including registration of certain associated persons, supervision of the activities of those persons in compliance with securities laws and compliance with broker-dealer books and records requirements. Broker- dealers also could be subject in SBS transactions to Regulation T of the Board of Governors of the Federal Reserve System; Rule 10b-10 confirmation disclosure and periodic customer statements; Section 11(d) restrictions on extensions of credit; and Rule 15c2-8 prospectus delivery requirements, among others. The implications of Rules 15c3-1 and 15c3-3 also would need to be analyzed. For example, the haircut and margin requirements under Rule 15c3-3 as applied to SBS are difficult to discern; this is particularly true given that the SEC has not yet proposed margin requirements for SBS dealers and major SBS participants. Firms have not yet been able to fully assess the impact of Title VII and design their compliance strategies because the definitions of SBS dealer, major SBS participant, ECP and SBS are not yet final. If the SEC does not act to defer application of the securities laws and regulations to SBS, some firms may decide to move their SBS brokering business with ECPs to offshore entities that would later register as SBS dealers when the SEC has established a registration process, or severely limit their U.S. SBS brokering business. Finally, we understand that SBS must be subject to provisions addressing fraud and manipulation on July 16. Application of the existing securities antifraud and anti-manipulation provisions to SBS provides important investor protections. We support the SEC’s view that all SBS should be subject to the antifraud and anti-manipulation provisions that currently apply to securities and security-based swap agreements, including under established guidance, until revised by further rulemaking. 14 * * * Title VII will fundamentally transform the SBS markets. We appreciate the SEC’s efforts to design an orderly implementation schedule for Title VII and the steps it is taking to clarify and provide appropriate temporary relief from the requirements that will apply to SBS on July 16. We respectfully request that the SEC use its exemptive authority under Section 36(a)(1) of the Exchange Act and Section 28 of the Securities Act, or any other legal authorities it deems appropriate, to exempt, interpret or otherwise provide relief to market participants from the self-operative provisions that are scheduled to take effect on July 16 (other than the amendments to the definitions of “security” and Section 767), and the securities laws (other than the existing antifraud and anti-manipulation provisions) that would apply to SBS as securities until key rulemakings are effective and an orderly process for implementation of Title VII is in effect. In the absence of SEC action on this issue, the market must begin to make difficult business and compliance decisions without knowing what regulatory requirements will be applicable. This could result in overbroad and inefficient implementation, and almost certainly would also result in significant duplication of implementation and compliance efforts once the rules are final. It is therefore critical that the SEC take action as soon as possible to allow for a logical implementation of Title VII and to avoid unintended consequences. We are grateful for the efforts of the SEC to implement Dodd-Frank and for the opportunity the SEC has provided for us to express our views. We stand ready to provide whatever technical assistance the SEC would find useful as it continues its significant efforts. We would welcome the opportunity to meet with the SEC and FINRA to discuss areas where significant interpretive guidance or specific exemptive relief may be required. Sincerely, American Bankers Association Financial Services Roundtable Futures Industry Association Institute of International Bankers International Swaps and Derivatives Association Investment Company Institute Securities Industry and Financial Markets Association U.S. Chamber of Commerce 15 cc: Mark D. Cahn, General Counsel Securities and Exchange Commission Richard G. Ketchum, Chairman FINRA 16 Trade Association Signatories The American Bankers Association represents banks of all sizes and charters and is the voice for the nation’s $13 trillion banking industry and its 2 million employees. ABA’s extensive resources enhance the success of the nation’s banks and strengthen America’s economy and communities. Learn more at www.aba.com. The Financial Services Roundtable (the “Roundtable”) represents 100 of the largest integrated financial services companies providing banking, insurance, and investment products and services to the American consumer. Member companies participate through the Chief Executive Officer and other senior executives nominated by the CEO. Roundtable member companies account directly for $92.7 trillion in managed assets, $1.1 trillion in revenue, and 2.3 million jobs. The Futures Industry Association is the leading trade organization for the futures, options and OTC cleared derivatives markets. It is the only association representative of all organizations that have an interest in the listed derivatives markets. Its membership includes the world’s largest derivatives clearing firms as well as leading derivatives exchanges from more than 20 countries. As the principal members of the derivatives clearinghouses, our member firms play a critical role in the reduction of systemic risk in the financial markets. They provide the majority of the funds that support these clearinghouses and commit a substantial amount of their own capital to guarantee customer transactions. FIA’s core constituency consists of futures commission merchants, and the primary focus of the association is the global use of exchanges, trading systems and clearinghouses for derivatives transactions. FIA’s regular members, who act as the majority clearing members of the U.S. exchanges, handle more than 90% of the customer funds held for trading on U.S. futures exchanges. The Institute of International Bankers represents internationally headquartered financial institutions from 39 countries around the world; its members include international banks that operate branches and agencies, bank subsidiaries, and broker-dealer subsidiaries in the United States. Since 1985, the International Swaps and Derivatives Association (“ISDA”) has worked to make the global over-the-counter (OTC) derivatives markets safer and more efficient. Today, ISDA is one of the world’s largest global financial trade associations, with over 800 member institutions from 56 countries on six continents. These members include a broad range of OTC derivatives market participants: global, international and regional banks, asset managers, energy and commodities firms, government and supranational entities, insurers and diversified financial institutions, corporations, law firms, exchanges, clearinghouses and other service providers. Information about ISDA and its activities is available on the Association's web site: www.isda.org. 17 The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange- traded funds (ETFs), and unit investment trusts (UITs). ICI seeks to encourage adherence to high ethical standards, promote public understanding, and otherwise advance the interests of funds, their shareholders, directors, and advisers. Members of ICI manage total assets of $13.41 trillion and serve over 90 million shareholders. The Securities Industry and Financial Markets Association (“SIFMA”) brings together the shared interests of hundreds of securities firms, banks and asset managers. SIFMA’s mission is to support a strong financial industry, investor opportunity, capital formation, job creation and economic growth, while building trust and confidence in the financial markets. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association. For more information, visit www.sifma.org. The U.S. Chamber of Commerce is the world’s largest business federation, representing the interests of more than 3 million businesses of all sizes, sectors, and regions, as well as state and local chambers and industry associations.