Alert September 29, 2009

Chairman of Senate Banking Subcommittee on Securities, Insurance and Investment Introduces Derivatives Regulation Legislation

Senator Jack Reed, Chairman of the Banking Subcommittee on Securities, Insurance and Investment, introduced the Comprehensive Derivatives Regulation Act of 2009 (the “CDRA”) on September 22, 2009.  This third legislative proposal to regulate derivative transactions follows the Treasury’s proposed Over-the-Counter Derivatives Markets Act of 2009 (the “Treasury Proposal”) and the draft Derivatives Markets Transparency and Accountability Act of 2009, H.R. 977.  (See the August 27, 2009 Goodwin Procter Client Alert.)  Congressmen Barney Frank, Chairman of the House Financial Services Committee, and Collin Peterson, Chairman of the House Agriculture Committee, also published last July a concept paper outlining their forthcoming legislation to address the regulation of derivatives.  (See the AlertAugust 4, 2009 .)

Senator Reed’s bill goes farther in its scope than the Treasury Proposal in that it would apply to derivative products more broadly, subject to specific exclusions and exemptions.  Similar to the Treasury Proposal, this new proposal would divide regulatory authority over products and market participants based on a distinction between security-based swaps and security derivatives and commodity-based swaps and commodity derivatives.  In contrast to the Treasury Proposal, however, under the CDRA “security-based swaps” and “security derivatives” would be broadly defined.  Security‑based swaps and security derivatives would also (as under the Treasury Proposal) be securities and subject to regulation by the SEC, while the CFTC would have regulatory authority over commodity-based swaps and commodity derivatives.  Accordingly, the SEC’s authority with respect to derivatives would be significantly broader under the CDRA than under the Treasury Proposal.

The SEC and CFTC would have rulemaking authority with respect to any new derivative products introduced to the market under the new proposal.  Before issuing any rule to exempt any product from regulation, the SEC and CFTC would be required to notify each other and the Federal Reserve Board (the “Board”).  Proposed exemptions would be subject to veto by each agency and the Board.  Any dispute between the two agencies regarding the status of a derivative as a security-based derivative or a commodity-based derivative (including any exemption) would be appealable to the U.S. Court of Appeals for the District of Columbia. 

On the other hand, Senator Reed’s bill appears to not go as far as the Treasury Proposal in other areas.  For example, under the CDRA “standardized” derivatives would be required to be centrally cleared (as under the Treasury Proposal) through a clearing agency registered with the SEC or a derivatives clearing organization registered with the CFTC, as applicable.  They would not, however, be required to be traded on an exchange (or a commodity-based swap execution facility) except in certain circumstances, for example, if offered to persons other than eligible contract participants.  The new proposal, like the Treasury Proposal, would leave the term “standardized” to be defined by the SEC and CFTC (each, in consultation with the Board) based on certain objectives, including to “be consistent with the public interest, the protection of investors, the safeguarding of securities and funds, the maintenance of fair competition among market participants and among clearing agencies.”  Any security-based swap or commodity-based swap not centrally cleared (for example because it was not “standardized”) would be required to be reported to a trade repository registered with the SEC or CFTC (or both), as applicable. 

The CDRA, like the Treasury Proposal, would regulate certain market participants as “significant security-based (or commodity-based) derivatives market participants.”  Notably, these definitions generally would encompass “major swap market participants” (and “major security-based swap market participants”), as well as dealers, identified in the Treasury Proposal, but would exclude investment companies registered under the Investment Company Act of 1940, as amended.  Notably, also like the Treasury Proposal, the CDRA aims to exclude parties engaged exclusively in certain hedging transactions from regulation as significant market participants, but otherwise includes “buy-side” market participants within the ambit of the proposed new regime.

Significant security-based (or commodity-based) derivatives market participants would be required to register with the SEC or CFTC (or both), as applicable. They (along with clearing agencies and derivatives clearing organizations) would also be subject to certain minimum capital and margin requirements.  Banking regulators along with the SEC and CFTC would participate in setting capital requirements for banks that act as clearing agencies, derivatives clearing organizations and significant security-based (or commodity-based) derivatives market participants.  Under the new proposal, these significant market participants would also be subject to new, substantial business conduct requirements – with potentially the same standards applying to dealers and other significant market participants.

The SEC would be permitted to establish position limits for security-based swaps and security derivatives.  It would also be able to direct self-regulatory organizations (“SROs”) to establish position limits for members and members’ clients.

The requirements for “eligible contract participants” would be tightened under the CDRA as under the Treasury Proposal.  Security-based swaps not between eligible contract participants would only be permitted to be traded on SEC registered exchanges, as well as being required to be registered under the Securities Exchange Act of 1934, as amended.  It would be unlawful for any counterparty not an eligible contract participant to enter into a commodity-based swap.

Regulators under the parallel SEC and CFTC regimes would be required to “maintain comparability” between the two regimes, but generally would not be required to make rules jointly.  For example, there would no longer be joint SEC-CFTC rulemaking with respect to security futures products.  The SEC and CFTC would be required only to consult with each other with respect to defining “standardized,” trade repository regulation, clearing agency/derivative clearing organization regulation, and market manipulation and anti-fraud regulations.  They would be required to prescribe jointly business conduct requirements for significant swap-based (and commodity-based) derivatives market participants, but would be able to set independently minimum capital and margin requirements for applicable significant market participants.

Finally, Senator Reed’s proposed legislation would require the SEC and CTFC to promulgate rules to promote “robust” recordkeeping and reporting requirements for significant security-based (or commodity-based) derivatives market participants, as well as clearing agencies, derivatives clearing organizations, trade repositories, commodity-based swap execution facilities and exchanges, in an effort to improve market transparency, efficiency and stability.  The agencies would also have broad authority to protect against market manipulation, fraud and “excessive speculation.”