Financial Services Alert - May 3, 2011

As authorized under Section 1a(47)(E) of the Commodity Exchange Act (the “CEA”), as amended by Section 721 of the Dodd-Frank Act, the Department of the Treasury (“Treasury”) has proposed to make a written determination that “foreign exchange swaps” and “foreign exchange forwards” (a) should not be regulated as swaps under the CEA and (b) are not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the CFTC pursuant to Section 721(c) of the Dodd-Frank Act, and exempt foreign exchange swaps and foreign exchange forwards from the CEA’s definition of “swap.” 

Under the CEA, foreign exchange swaps and foreign exchange forwards are narrowly defined. 

• A foreign exchange swap is a transaction that involves an exchange of two currencies on a set date at an agreed-upon price followed by a reverse exchange of those two currencies at a later date at an agreed‑upon price. 
• A foreign exchange forward is a future exchange of two currencies on a set date at an agreed-upon price. 

Notably, other foreign exchange and currency derivatives, including foreign exchange options, currency swaps and non-deliverable forwards, would continue to be regulated as swaps under the CEA. 

The most significant consequence of exempting foreign exchange swaps and forwards from the definition of swap under the CEA is to exclude them from the mandatory central clearing and exchange trading requirements under the CEA introduced by the Dodd‑Frank Act.  However, even if they are exempted from the definition of swap under the CEA, foreign exchange swaps and forwards would remain subject to regulation by the CFTC, including the CFTC’s new trade-reporting requirements, enhanced anti-evasion authority, and strengthened business-conduct standards. 

Treasury considered the following factors in making its proposed determination:

• whether regulating FX swaps and forwards would create systemic risks to the market, lower transparency or threats to the financial stability of the U.S.;
• whether FX swaps and forwards are already subject to a regulatory scheme comparable to CEA for other types of swaps;
• the extent to which bank regulators provide adequate supervision, including through capital and margin requirements;
• the extent of adequate payment and settlement systems; and
• potential use of the exemption to evade other regulations.

In addressing these factors, Treasury noted that foreign exchange swaps and forwards have characteristics that distinguish their risk profile from the risk profiles of other swaps:  only fixed payment obligations, physical settlement and generally short terms.  Treasury observed that because of these characteristics, foreign exchange swap and forward participants generally face settlement risk rather than, as is the case with other derivatives, counterparty risk.  Treasury viewed this settlement risk as being effectively addressed through standard terms such as payment-versus-payment settlement arrangements (in which each party’s delivery is conditioned on the other party’s delivery), including through CLS Bank International, and other market characteristics. 

In support of the exemption, Treasury also cited the manner in which participants in foreign exchange swap and forward transactions are regulated and the nature of foreign exchange swap and forward markets themselves, observing that centralized trading could potentially increase costs and mandatory exchange trading would yield only marginal improvements in transparency. 

• Banks (on their own behalf and on behalf of their clients) account for approximately 95% of foreign exchange swap and forward transactions. Banks’ foreign exchange activities are already subject to coordinated supervision (e.g., through the Bank of International Settlements), including to ensure that they have adequate funding and capital, stability, internal control measures, and risk-management protocols, according to Treasury. 
• Central clearing would likely have a number of potentially negative consequences, according to Treasury, including potentially increasing risk and presenting operational challenges and costs:  combining clearing and settlement in a central clearing party (CCP) would create such large currency and capital needs for the CCP, potentially no CCP would be able to provide central clearing for the market; central clearing, with its margin and capital requirements, would significantly increase the cost of foreign exchange swaps and forwards for end-users (and, of particular note, non-financial end users); and requiring clearing would disrupt the existing, and otherwise well‑functioning, foreign exchange swap and forward markets. 
• Foreign exchange swaps and futures markets are also generally transparent (e.g., multiple sources of pricing within markets) and liquid with, as reported by Treasury, approximately 41% and 72% of foreign exchange swaps and forwards already being traded on electronic exchanges.

The public has 30 days to comment on Treasury’s proposed determination after publication of the proposal in the Federal Register. 

FinCEN issued a proposed rule (the “ Proposed Rule“) that would implement section 104(e) of the Comprehensive Iran Sanctions, Accountability and Divestment Act of 2010 (“CISADA”) by requiring a U.S. bank (including a bank, savings bank, federal savings association, credit union, and certain other banking entities, each a “U.S. Bank”), within 30 days of receiving a specific written request from FinCEN, to report to FinCEN the following information about foreign banks (“Foreign Banks” and each a “Foreign Bank”) for which the U.S. Bank maintains a correspondent account: (1) whether the Foreign Bank maintains a correspondent account for an Iranian‑linked financial institution designated under the International Emergency Economic Powers Act (the “IEEPA”); (2) whether the Foreign Bank has processed one or more transfers of funds within the preceding 90 calendar days related to an Iranian-linked financial institution designated under the IEEPA, other than through a correspondent account; or (3) whether the Foreign Bank has processed one or more transfers of funds within the preceding 90 calendar days related to Iran’s Islamic Revolutionary Guard Corps (“IRGC”) or any of its agents or affiliates designated under the IEEPA.  If a U.S. Bank receives notification from a Foreign Bank that it has established a new correspondent account for an Iranian linked financial institution designated under the IEEPA, the U.S. Bank is required to report the information within 10 days of receiving that notification.  The Proposed Rule would also require that the Foreign Bank agree to notify the U.S. Bank if it subsequently established a new correspondent account for an Iranian‑linked financial institution designated under the IEEPA at any time within 365 calendar days from the date of the Foreign Bank’s initial response.  Additionally, when requested by FinCEN, the Proposed Rule would require a U.S. Bank to report instances in which the U.S. Bank does not maintain a correspondent account for a Foreign Bank specified by FinCEN in a written request.

Based on the reports, Treasury Officials would be able to take immediate action under Section 104(c) of CISADA, action that includes (but is not limited to) mandating the closure of the correspondent account or imposing sanctions against the U.S. Bank.  Treasury Officials could also, among other things, consult with a Foreign Bank that answered a request in the affirmative or that was unwilling to respond to a request.

Comments on the Proposed Rule are due by June 1, 2011.

The OCC issued a notice of proposed rulemaking (the “ NPR“) concerning off-exchange transactions in foreign currency.  A Dodd-Frank Act amendment to the Commodity Exchange Act provides that a U.S. depository institution with a federal regulator may not engage in retail foreign exchange (“forex”) transactions unless it acts pursuant to a rule or regulation adopted by its primary federal regulator allowing such transactions.  The OCC has issued the NPR to, if adopted, provide such a rule for national banks, their operating subsidiaries and branches and agencies of foreign banks (collectively, “National Banks”).  The NPR would authorize National Banks to engage in certain off-exchange forex transactions with retail customers.  The NPR also describes disclosure, recordkeeping, capital, margin, reporting to customers and other compliance requirements that a National Bank would be required to meet in order to engage in retail forex transactions.  The OCC further states that a National Bank engaging in retail forex transactions in accordance with the OCC’s final retail forex rule will also be expected to comply, when dealing with retail forex transactions, with the requirements of the Interagency Policy Statement on Retail Sales of Nondeposit Investment Products to the extent those requirements do not conflict with the requirements of the OCC’s final retail forex rule.  Comments on the NPR are due to the OCC by May 23, 2011.

The SEC issued Release No. 34-64352, proposing amendments to rules and forms under the Securities Exchange Act of 1934 (the “1934 Act”) that would remove references to credit ratings by rating agencies (including nationally recognized statistical rating agencies or NRSROs).  This rulemaking is mandated by Section 939A of the Dodd-Frank Act, which requires the SEC to “remove any reference to or requirement of reliance on credit ratings, and to substitute in such regulations such standard of credit-worthiness” as the SEC determines to be appropriate.  The SEC is also seeking comment, in advance of proposed rulemaking, with respect to the appropriate tests to be used in the definitions of “mortgage‑related security” (Section 3(a)(41) of the 1934 Act) and “small business related security” (Section 3(a)(53) of the 1934 Act) in lieu of credit ratings by an NRSRO.

Internal Credit and Liquidity Risk Assessment

In several of the proposed rule changes where references to NRSRO ratings would be deleted as a measure of creditworthiness, broker-dealers would be permitted to use internally generated credit and liquidity risk assessments, provided that they establish, maintain and enforce written policies and procedures designed to assess such risks.  Among the factors the broker-dealer could consider in making risk assessments would be credit spreads, securities-related research, internal or external credit risk assessments (including those of credit rating agencies, whether or not they are NRSROs), default statistics and inclusion on a recognized index of instruments that are subject to a minimal amount of credit risk.  The rules and forms under the 1934 Act that fall in this category are:

• Rule 15c3-1, the Net Capital Rule, which specifies percentage discounts (or “haircuts”) in the market value of securities.  Where lower haircut percentages are currently applied to securities rated investment grade, under the new standard they would be applied to securities determined by the broker-dealer, using its internal credit risk assessment procedures, to have a “minimal amount of credit risk.”
• Appendix E to Rule 15c3-1.  Broker-dealers using alternative net capital (“ANC”) computations under Appendix E are required to deduct, from net capital, credit risk charges that take counterparty risk into consideration.  Currently, this can be based either on NRSRO credit ratings or the broker-dealer’s internal counterparty credit rating.  The proposal would delete the NRSRO alternative, requiring broker-dealers to use internal credit ratings, the methodology of which must be approved by the SEC.
• Appendix F to Rule 15c3-1.  OTC derivatives dealers with strong internal risk management practices are allowed to utilize the mathematical modeling methods they use in their own business in order to compute deductions from net capital for market and credit risks from OTC derivatives transactions.  There are two elements to that computation:  counterparty risk and the concentration charge (where net replacement value in the account of any one counterparty exceeds 25% of the OTC derivatives dealer’s tentative net capital).  The provisions of Appendix F currently permit the dealer to use either NRSRO credit ratings or internal credit ratings to calculate both elements.  The proposed rule would delete the NRSRO alternative, requiring dealers to use internal credit ratings, the methodology of which must be approved by the SEC.

The SEC has also requested comment on whether internal credit ratings should be used, in rulemaking to supplement the definitions of “mortgage related securities” and “small business related securities” in Sections 3(a)(41) and 3(a)(53) of the 1934 Act, to replace the NRSRO credit rating standard deleted by the Dodd-Frank Act.

Major Market Foreign Currency

Appendix A to Rule 15c3-1 provides favorable treatment, for purposes of the Net Capital Rule, to currency options involving “major market foreign currency,” which is currently defined with reference to NRSRO credit ratings.  The proposed amendment would change the definition to refer to foreign currencies for which there is a substantial inter-bank forward currency market.

Customer Protection Rule

Rule 15c3-3, Note G, permits a broker-dealer to include required customer margin for transactions in securities products as a debit in the reserve formula computation if that margin is required and on deposit at a clearing agency or derivatives clearing organization that meets any one of four criteria, including maintaining the highest investment-grade rating from an NRSRO.  That criterion would be deleted, leaving the remaining three, which do not reference NRSRO ratings.

Regulation M

Rules 101 and 102 of Regulation M currently except transactions in “investment grade nonconvertible and asset-backed securities” from their prohibitions.  That standard would be replaced with an exception for non-convertible debt securities, non-convertible preferred securities and asset-backed securities if they:

• are liquid relative to the market for that asset class;
• trade in relation to general market interest rates and yield spreads; and
• are relatively fungible with securities of similar characteristics and interest rate yield spreads.

A person seeking to rely on this exception would be required to obtain third party verification of its determination.  The SEC seeks comment on whether it should impose qualification standards on persons providing third party verification, what those qualification standards should be, and whether there should be limitations on how often a particular third party verifier can be used by a person seeking to use the exception.

Rule 10b-10 Confirmations

Rule 10b-10(a)(8) currently requires a broker-dealer to inform the customer in the confirmation if a debt security, other than a government security, is unrated by an NRSRO.  Although the SEC believes that deletion of this requirement is not technically required by Section 939A of the Dodd-Frank Act, because the reference is not designed to establish a standard of creditworthiness, the SEC proposes to delete the requirement as a change consistent with the intent of the Dodd-Frank Act.

The SEC also proposes non-substantive conforming changes to other rules and forms.  Comments on the proposal are due 60 days after its publication in the Federal Register.

Goodwin Procter issued a Client Alert that analyzes the U.S. Supreme Court’s decision in AT&T Mobility LLC v. Concepcion and its likely impact.  In that decision, the Court held that the Federal Arbitration Act requires courts to enforce an arbitration provision in a consumer contract even if the provision bars class‑wide arbitration and even if otherwise applicable state law declares such a provision to be void.

The SEC extended until May 19, 2011 the deadline for submitting comments on its rule proposal that would direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer that is not in compliance with the requirements of new Section 10C to the Securities Exchange Act of 1934 Act added by the Dodd-Frank Act.  In broad terms, the proposal would direct national securities exchanges to establish listing standards that impose independence standards on a compensation committee’s members and on its compensation advisers and that require a compensation committee to have the authority to engage, oversee and compensate compensation advisers.  The Proposal would also revise the disclosure requirements for proxy materials relating to the election of directors at an annual meeting to include additional disclosures regarding a compensation committee’s use of a compensation consultant.  See the April 5, 2011 Alert for more details on the SEC’s rule proposal.

In consultation with the FRB, the SEC and CFTC jointly issued proposed rules and proposed interpretive guidance further defining the terms “swap,” “security-based swap,” and “security‑based swap agreement,” and addressing “mixed swaps” and books and records with respect to “security-based swap agreements.”  The joint rulemaking is mandated under the Dodd‑Frank Act.  Comments on the proposed rules and interpretive guidance are due 60 days after their publication in the Federal Register.

The CFTC staff issued a concept document sets forth a number of concepts that CFTC staff is considering in framing recommendations on how to sequence the implementation of final rules for swaps being adopted pursuant to the Dodd-Frank Act.

The Commodity Futures Trading Commission (the “CFTC”) issued a proposal that would establish recordkeeping and reporting requirements for swaps entered into before July 21, 2010, the date of enactment of the Dodd-Frank Act, whose terms had not expired as of that date, and data relating to swaps entered into on or after July 21, 2010 and prior to the compliance date specified in the CFTC’s final swap data reporting rules.  The proposal addresses the records, information and data that must be retained for historical swaps, the timeframe for reporting data to a swap data repository or the CFTC and the specific data to be reported.  Comments on the proposal are due by June 9, 2011.

The CFTC proposed rule changes that would establish capital requirements and related financial condition reporting and recordkeeping requirements for swap dealers (“SDs”) and major swap participants (“MSPs”) that are not subject to prudential regulation by the FRB, OCC, FDIC, Farm Credit Administration or Federal Housing Finance Agency.  The proposal would also amend existing capital and financial reporting regulations for futures commissions merchants (“FCMs”) that also register as SDs or MSPs, and provide for supplemental FCM financial reporting relating to the segregation of swap customers’ funds.   Comments on the proposed rule changes must be received no later than 60 days after their publication in the Federal Register.

The CFTC issued a proposal that would adopt capital and initial and variation margin requirements for certain swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules would not impose margin requirements on nonfinancial end users.  The CFTC stated that it will propose rules regarding capital requirements for SDs and MSPs at a later date and intends to align the comment periods of these two proposals so that commenters will have an opportunity to review each before commenting on either.  Comments on the current proposal are due by June 27, 2011.

The CFTC issued a proposal that would impose segregation requirements on futures commission merchants and derivatives clearing organizations regarding the treatment of cleared swaps customer contracts and related collateral.  The proposal would also make conforming amendments to bankruptcy provisions applicable to commodity brokers under the Commodity Exchange Act.  Comments on the proposal are due within 60 days after its publication in the Federal Register.

The CFTC issued proposed amendments to its rules that are designed to ensure the full integration of changes to the regulatory framework for swaps resulting from the Dodd‑Frank Act into CFTC regulations.  The CFTC describes its proposal as including “ministerial, accommodating and substantive” amendments, with the substantive amendments being designed to align requirements or procedures across futures and swap markets.  Comments on the proposal are due within 60 days after its publication in the Federal Register.