Financial Services Alert - May 14, 2013 May 14, 2013
In This Issue

SEC Proposes Rules for Cross-Border Security-Based Swap Activities

The SEC unanimously voted to propose rules and interpretive guidance for parties to cross-border security-based swap transactions.  The proposal sets out the SEC’s “preliminary views” regarding which regulatory requirements would apply when a security-based swap transaction takes place partially within and partially outside the United States.  It also addresses registration of certain entities.

The proposal would generally subject security-based swap transactions to the applicable SEC rules if they are entered into with a U.S. person or conducted within the United States.  “U.S. person” would be defined to mean:  any natural person resident in the United States; any partnership, corporation, trust, or other legal person organized or incorporated under the laws of the United States or having its principal place of business in the United States; or any account, whether discretionary or non-discretionary, of a U.S. person.  Transactions “conducted within the United States” would be defined to mean any security-based swap transaction that is solicited, negotiated, executed, or booked within the United States by or on behalf of either counterparty to the transaction, regardless of the location, domicile, or residence status of either counterparty to the transaction.  However, the term would exclude a transaction conducted through a foreign branch of a U.S. bank.

As with the proposed CFTC guidance, the proposed SEC rules divide the requirements of security-based swap dealers into “entity-level requirements” (including capital, margin, and risk management requirements) and “transaction-level requirements” (such as external business conduct requirements and segregation requirements applicable to the security-based swap dealer’s individual transactions).  The proposal would require registered foreign security-based swap dealers and foreign branches of registered U.S. security-based swap dealers to comply with the SEC’s entity-level requirements subject to the substituted compliance framework discussed below, but would generally require them to comply with external business conduct requirements and segregation requirements only with respect to transactions with U.S. persons.  U.S. security-based swap dealers would also generally not be required to comply with external business conduct standards with respect to security-based swap transactions conducted though their foreign branches with non-U.S. persons.

However, the proposal includes a “substituted compliance” framework that would allow a security-based swap dealer to satisfy certain entity-level requirements by complying instead with the requirements of a foreign regulatory regime.  The release states that the “availability of substituted compliance should reduce the likelihood that market participants would be subject to potentially conflicting or duplicative sets of rules.”  The ability to use such substituted compliance would depend on whether the SEC has determined the relevant foreign regulations to be comparable to U.S. regulatory requirements.  Such comparability would be determined separately in four different categories:

  • requirements applicable to registered non-U.S. security-based swap dealers;
  • requirements relating to regulatory reporting and public dissemination of information on security-based swaps;
  • requirements relating to clearing for security-based swaps; and
  • requirements relating to trade execution for security-based swaps.

A particular foreign regulatory regime may be deemed comparable with the U.S. requirements in some categories but not others, in which case substituted compliance would be available only for regulations in the categories deemed comparable.  Comparability determinations would be made on a holistic basis rather than a rule-by-rule comparison.

The release explicitly states that the SEC is not currently proposing to extend the substituted compliance framework to major security-based swap participants.  The release explains that major security-based swap participants are a potentially diverse group of entities that may be engaged in a variety of industries, and as a result “it is not clear what types of entity-level regulatory oversight, if any…a foreign major security-based swap participant would be subject to in the foreign regulatory system.”  The release suggests that the SEC will consider re-evaluating this in light of comments and other new information it receives in the future.

Non-U.S. entities would only need to include security-based swap transactions conducted with U.S. persons (other than with foreign branches of U.S. banks) or conducted within the United States towards the de minimis threshold calculations included in the “security-based swap dealer” definition.  A U.S. person, in contrast, would be required to count all of its security-based swap transactions conducted in a dealing capacity, including those conducted through a foreign branch, for purposes of the “security-based swap dealer” definition.  Similar rules would apply to the “major security-based swap participant” definition.

The proposal also addresses whether clearing agencies, security-based swap data repositories, and security-based swap execution facilities must register with the SEC.  It would generally require such entities to register if they are U.S. persons or if they perform their relevant function within the United States, although the release does propose or contemplate certain exemptions from the registration requirement.

The proposal also includes proposed additions or changes to certain other proposed rules, such as the security-based swap reporting requirements.

Comments on the proposed rules and interpretive guidance are due no later than August 21, 2013.

In a related action, the SEC also unanimously voted to reopen the public comment period for all SEC rules not yet finalized that pertain to Title VII of the Dodd-Frank Act to permit re-evaluation of those proposals in light of the cross-border proposal.  The re-opened comment period expires July 22, 2013.

OCC Issues Bulletin Clarifying Treatment of Certain Sovereign and Securitization Positions Under Market Risk Capital Rule

On May 10, 2013, the OCC issued a bulletin (the “Bulletin”) to clarify two aspects of its final market risk capital rule (the “Rule”), which applies to

(a)        banks with aggregate trading assets and trading liabilities

            (i)         equal to 10% or more of their total assets; or

            (ii)        $1 billion or more; or

(b)        other specific banks to which the OCC determines to apply the Rule because of the applicable bank’s level of market risk or safety and soundness issues (“Covered Institutions”).

The Bulletin was issued by the OCC on August 30, 2012 and was issued in a similar form by the FRB and the FDIC.  The Rule, which amended the OCC’s market risk capital rule, is intended to, among other things, enhance the market risk capital provision’s sensitivity to certain risks, reduce pro-cyclicity, increase transparency through enhanced disclosures and “incorporate non-credit-ratings-based standards for the calculation of specific risk capital requirements for sovereign debt positions, certain other covered debt positions, and securitization positions.”  For a discussion of the Rule, see the September 4, 2012 Financial Services Alert.  In the Bulletin the OCC clarifies its treatment of certain foreign exposures and certain securitization exposures under the Rule.


Under the Rule the risk capital requirement for a sovereign exposure depends, in part, on the Organization for Economic Cooperation and Development’s (“OECD”) Country Risk Classification (“CRC”) for the applicable country.  After the Rule was issued, the OECD decided that certain high-income countries that received a CRC of zero in 2012 would no longer be assigned a CRC rating, but would remain subject to the same market credit risk pricing disciplines that are applied to all Category Zero countries.  The OCC states in the Bulletin that for purposes of assigning specific risk capital requirements under the Rule, the OCC has decided that the OECD members that no longer are assigned a CRC should nonetheless be treated as having the functional equivalent of a CRC of zero.  In addition, the OCC said, for purposes of assigning specific risk capital requirements under the Rule, the same treatment will be applied “to exposures to public sector entities, depository institutions, foreign banks or credit unions for which the specific risk capital treatment is based on the creditworthiness of those sovereign entities [that are no longer assigned a CRC].”


The OCC notes in the Bulletin that to measure the specific risk of a securitization position a Covered Institution may apply the Simplified Supervisory Formula Approach (“SSFA”), which takes into account the nature and quality of the collateral underlying the securitization.  The Bulletin points out that the SSFA “was designed to apply relatively higher capital requirements to the more risky junior tranches of a securitization that are the first to absorb losses and apply relatively lower requirements to the most senior positions.”  Under the Rule, the SSFA includes a variable “W” that is intended to increase the capital requirement for a securitization exposure as delinquencies in the underlying assets increase.  For purposes of calculating W, an exposure is delinquent  if it is 90 days or more past due, subject to a bankruptcy or insolvency proceeding, in the process of foreclosure, held as real estate owned, in default, or has contractually deferred interest payments for 90 days or more (12 CFR 3, appendix B, section 11(b)(2)(v)).  In the Bulletin the OCC clarifies, however, that for purposes of the SSFA, “deferrals of interest that are unrelated to the performance of the loan or the [creditworthiness of the] borrower, including contractually permitted payment deferrals provided for in certain federally guaranteed student loan programs” will not be regarded as delinquent.


The OCC concludes the Bulletin by stating that, as the opportunity arises, it intends to issue further guidance to clarify any other ambiguities in the Rule.

Comptroller Curry Stresses the Importance of Bank Supervision and Examination, Interagency Collaboration, and Stronger Internal Oversight

In a May 9, 2013 speech to the 49th Annual Conference on Bank Structure and Competition, Comptroller of the Currency Thomas J. Curry defended and touted the enduring relevance of “the federal banking agencies’ traditional on-site examination programs,” in light of the Dodd-Frank Act and supervisory stress tests.  Comptroller Curry asserted that the “financial crisis underscored the importance of bank supervision and the role of examiner judgment,” and that supervision and examination, along with “strong regulation and robust analytics,” are the “cornerstones of a healthy financial system.”  The Comptroller also emphasized a need to “understand how risk is transmitted across different types of institutions,” and stressed that the OCC has increased its efforts to coordinate and collaborate with other federal agencies to “develop integrated strategies for joint supervision of complex institutions and new tools to aid oversight.”  Comptroller Curry also discussed the OCC’s efforts to foster more effective supervision, particularly of large banks.  As part of such efforts, the OCC is reorganizing its “program of lead experts,” “deploying lead experts across companies, to measure risk horizontally and validate the results of [the OCC’s] supervision.”

The Comptroller also stressed the importance of data and information, including the OCC’s nascent Semiannual Risk Perspective report (the “Report”).  Regarding the Report, the Comptroller said that its message is that the OCC “expect[s] greater diligence from our banks in managing their risks,” and that the OCC has raised its “expectations for corporate governance for the largest and most complex institutions.”  Comptroller Curry mentioned that the OCC has a corresponding “heightened expectations” program that it has communicated to senior management and independent directors at large national banks and thrifts.  As part of that program, the OCC has increased its expectations for independent directors and has placed a premium on the “highest fiduciary duty of management and independent directors.”  The Comptroller added “[the OCC is] no longer willing to accept audit and risk management systems that are simply satisfactory…we are looking for excellence.”

In his remarks, Comptroller Curry also addressed the importance of capital.  Specifically, he said, that it is important that regulators revisit “the issue of the leverage ratio in the context of the Basel rulemaking.”

FINRA Staff Provides Guidance on Use of Pre-Inception Index Performance Data in Institutional Communications

The staff of FINRA issued an interpretive letter providing guidance (the “Guidance”) regarding the use of pre-inception index performance data (“PIP Data”) in communications regarding certain publicly traded securities structured as exchange traded notes, grantor trusts or registered investment companies (“Exchange Traded Products”) distributed solely to “institutional investors” as defined in FINRA Rule 2210(a)(4) (“Institutional Investors”).  The requesting firm markets passively managed Exchange Traded Products based on newly created indexes that have been developed according to pre-defined rules that cannot be altered except under extraordinary market, political or macroeconomic conditions.  PIP Data models the performance of such an index had it existed prior to the inception of the index.  It has been FINRA’s long-standing position that the presentation of hypothetical back-tested performance data in communications with retail investors does not comply with FINRA Rule 2210(d) and its predecessor NASD rule, and FINRA noted that this interpretation, applicable only to Institutional Communications (as defined below), does not change that position.

Institutional Investor.  FINRA Rule 2210(a)(4) defines an Institutional Investor as any: (i) bank, savings and loan association, insurance company or registered investment company, a federal or state registered investment adviser, or any other person with total assets of at least $50 million, (ii) governmental entity or subdivision thereof; (iii) certain employee benefit plans with at least 100 participants that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code; (iv) qualified plans (or multiple qualified plans offered to the employees of the same employer), as defined in Section 3(a)(12)(C) of the Exchange Act that in the aggregate have at least 100 participants; (v) a FINRA member or registered associated person of such a member; and (vi) person acting solely on behalf of any such “institutional investor.”

Institutional Communications.  FINRA Rule 2210 subjects any written (including electronic) communication (with the exception of a member's internal communications) that is distributed or made available only to Institutional Investors  (“Institutional Communications”) to certain content and supervision standards.  Under these standards, each FINRA member firm must establish written procedures appropriate to its business, size, structure, and customers that provide for the review by an appropriately qualified registered principal of Institutional Communications used by the member and its associated persons.  These procedures must be reasonably designed to ensure that Institutional Communications comply with applicable standards (as set forth in FINRA rules), which generally require that Institutional Communications must be fair and balanced, must provide a sound basis for evaluating the facts in regard to any particular security, and may not omit material information, include false, exaggerated, or misleading statements, or misstate material fact.

Conditions to Use of PIP Data.   The Guidance states that FINRA staff believes that the use of PIP Data in Institutional Communications is not prohibited if certain conditions described in the Guidance are met.  Among these conditions are the following: (i) PIP Data may be used only to market a passively managed Exchange Traded Product; (ii) each Institutional Communication containing PIP Data must be clearly labeled “For use with institutions only, not for use with retail investors”; (iii) PIP Data may be used only if it relates to an index created according to a pre-defined set of rules that cannot be altered except under extraordinary market, political or macroeconomic conditions index (an “Underlying Index”); (iv) Institutional Communications containing PIP Data must offer to provide the rule set or methodology of the Underlying Index upon request and any electronic marketing material must include a hyperlink to such information; and (v) PIP Data will not be inconsistent with information in an Exchanged Traded Product’s prospectus (but may be used even if the prospectus contains no PIP Data).  The Guidance also sets forth certain content requirements for Institutional Communications that include PIP Data, including criteria relating to the time periods presented, the currentness of PIP Data, and the presentation of PIP Data in relation to performance data of the Exchange Traded Product.

The Guidance states that any Institutional Communication containing PIP Data must include statements advising the Institutional Investor that (i)  the Exchange Traded Product is a new product, and any performance of the Underlying Index prior to the date of inception of the index is hypothetical; (ii) the PIP Data results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance, and cannot account for all financial risk that may affect the actual performance of the Exchange Traded Product; and (iii) actual performance of the Exchange Traded Product may vary significantly from the PIP Data.  The Institutional Communication must also disclose (a) any known reasons, such as, assumptions regarding transaction costs, liquidity, or other market factors, why the PIP Data would have differed from actual performance during the period shown; and (b) if the sponsor of the Exchange Traded Product pays an index provider to produce the PIP Data, that arrangement and the identity of the index provider.

Whether to Use PIP Data.  The Guidance provides guidance to members regarding the factors that FINRA staff believes should be considered in determining whether the use of PIP Data is consistent with the content standards of FINRA Rule 2210.  Among other things, the Guidance notes that in determining whether the use of PIP Data in an Institutional Communication is appropriate a member must consider its suitability obligations under FINRA Rule 2111 with respect to making recommendations to Institutional Investors.  In this regard, the Guidance states that the firm must be careful to not give excess weight to PIP Data, and to the extent PIP Data informs the firm’s understanding of the security and its performance characteristics, the firm must consider the correlation between PIP Data and actual performance for similar Exchange Traded Products managed by the sponsor, investment adviser or index provider.

Additionally, the Guidance identifies the following specific factors that a member should consider in determining whether PIP Data should be used in Institutional Communications:

  1. The assumptions, rules and criteria used to create the PIP Data, in sufficient detail as to permit the firm to clearly understand how the PIP Data could be replicated, using readily-available market data;
  2. The reputation of the entity that created the PIP Data, and if the sponsor of the Exchange Traded Product paid for creation of the model, how any material conflicts of interest have been addressed or mitigated;
  3. The conditions under which the PIP Data may not be effective in predicting how the Exchange Traded Product may perform (e.g., very low or high interest rate environments);
  4. The source of the data used to produce the PIP Data;
  5. The extent to which the PIP Data has been tested under varying market conditions and scenarios, based on both an analysis of historical data and simulations or stress tests; and
  6. Any reasons why the PIP Data would have differed from actual performance of the Exchange Traded Product during the period shown (e.g., transaction costs, market liquidity).