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SEC Proposes End-User Requirements Under Dodd-Frank Act for Security-Based Swaps Exempt From Mandatory Clearing


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Washington, D.C., Dec. 15, 2010 — The Securities and Exchange Commission today voted unanimously to propose requirements of end-users when they engage in a security-based swap transaction that is not subject to mandatory clearing.

The proposed rule, required under the Dodd-Frank Act, specifies the steps that end-users must follow to notify the SEC of how they generally meet their financial obligations when engaging in a security-based swap transaction exempt from the mandatory clearing requirement.

The SEC also sought comment on whether to provide an additional exemption for certain financial institutions that would permit those institutions to use the exception to mandatory clearing that is available to end-users.

"This proposal lays out the critical types of information that entities must provide in order to qualify for the end-user exception," said SEC Chairman Mary L. Schapiro. "Importantly, the proposal seeks to prevent abuse of the end-user clearing exception by requiring a non-financial entity to notify the SEC each time it elects to use the exception. Together with today's mandatory clearing rules, we are fulfilling key requirements under the Dodd-Frank Act."

Public comments on the proposed rules should be received by the Commission within 45 days after their publication in the Federal Register.

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The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter swaps markets. Among other things, Title VII of the Dodd-Frank Act requires security-based swap transactions to be cleared through a clearing agency if those transactions are of a type that the SEC determines must be cleared.

Essentially, the clearing agency generally acts as a middleman between the parties to a transaction, and assumes the risk should there be a default. When structured and operated appropriately, such clearing agencies can provide benefits such as improving the management of counterparty risk and reducing outstanding exposures through multilateral netting of trades. In other words, by "clearing" security-based swap transactions, a clearing agency helps to reduce the risk of cascading harm throughout the financial system in the event a party to a transaction fails to meet its obligations.

Through clearing agencies, regulators are more easily able to monitor transactions, including prices and positions taken by traders.

In some cases, though, the Dodd-Frank Act exempts certain types of transactions from the mandatory clearing requirement. In particular, the Dodd-Frank Act creates an "end-user clearing exception" that exempts clearing for a security-based swap transaction if one party to the transaction:

  • Is not a financial entity.

  • Is using the swap to hedge or mitigate commercial risk.

  • Notifies the SEC (in a manner set forth by the SEC) how it generally meets its financial obligations associated with entering into non-cleared security-based swaps (the "end-user clearing exception").

In addition, the Dodd Frank Act requires the SEC to consider whether to provide an exemption for certain financial institutions — small banks, savings associations, farm credit systems institutions and credit unions — including specifically those with total assets of $10 billion or less, that would permit them to use the end-user clearing exception. The SEC is considering such an exemption as an additional proposal.

Proposed Rule Regarding the End-User Exception

Title VII of the Dodd-Frank Act requires that a counterparty electing to use the end-user clearing exception must notify the SEC of how it generally meets its financial obligations associated with non-cleared security-based swaps.

The proposed rule would require that a counterparty relying on the end-user clearing exception submit information to the SEC regarding how it generally expects to meets its financial obligations associated with a security-based swap by using one of the following:

  1. A written credit support agreement.

  2. A written agreement to pledge or segregate assets.

  3. A written third-party guarantee.

  4. Solely the counterparty's available financial resources.

  5. Means other than those described in 1, 2, 3, and 4

The proposed rule also requires counterparties relying on the end-user clearing exception to submit additional information to the SEC intended to aid the SEC in its efforts to prevent abuse of the end-user clearing exception. The information required includes:

  1. The identity of the counterparty relying on the clearing exception;

  2. Whether the counterparty invoking the clearing exception is a "financial entity" as defined in the Dodd-Frank Act;

  3. Whether the counterparty invoking the clearing exception is a finance affiliate meeting certain requirements described in the Dodd-Frank Act;

  4. Whether the security-based swap is used by the counterparty invoking the clearing exception to hedge or mitigate commercial risk as defined in the Exchange Act and through rules separately proposed by the SEC; and

  5. Whether the counterparty electing to use the clearing exception is an issuer of securities registered under Section 12 of the Exchange Act or subject to reporting requirements pursuant to Section 15(d) of the Exchange Act ("SEC Filer"). SEC filers are also required to provide two additional pieces of information:

    • The relevant Commission Central Index Key number for the counterparty invoking the clearing exception.

    • Whether an appropriate committee of the board of directors (or equivalent body) of the counterparty invoking the clearing exception has reviewed and approved the decision to enter into a security-based swap subject to the clearing exception.

The information reported to the SEC under this proposed rule would be delivered to a security-based swap data repository together with other information that will be required to be submitted to a security-based swap data repository concerning all non-cleared security-based swaps. The rules detailing how data will be reported to a security-based swap data repository are the subject of a separate SEC proposal published last month.

Proposed Rule Regarding Exemptions for Certain Financial Institutions

The SEC is required under the Dodd-Frank Act to consider whether to allow small banks, savings associations, farm credit system institutions and credit unions with total assets under $10 billion to use the end-user clearing exception on the same terms as end-users. The SEC is considering a proposed rule that would implement such a proposal.

Recent Rulemaking

Under the Dodd-Frank Act, the Commission has been engaging in significant rulemaking:

  • Defining Security-based swap terms: Proposed — jointly with the Commodity Futures Trading Commission — new rules that would further define a series of terms related to the security-based swaps market, including "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant" and "eligible contract participant."

  • Security-based swap reporting and dissemination: Proposed new rules entailing how security-based swap transactions should be reported and publicly disseminated.

  • Security-based swap data repositories: Proposed new rules that would specify the requirements for security-based swap data repositories.

  • Security-based swap fraud: Proposed a new rule to help prevent fraud, manipulation, and deception in connection with the offer, purchase or sale of any security-based swap — as well as in connection with ongoing payments and deliveries under a security-based swap.

  • Security-based swap conflicts: Proposed rules intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading.

  • Reporting of pre-enactment security-based swaps: Adopted an interim rule that requires certain swaps dealers and other parties to report any security-based swaps entered into prior to the July 21 passage of the Dodd-Frank Act. This rule applies only to such swaps whose terms had not expired as of July 21.

  • Strengthening oversight of investment advisers: Proposed new rules to facilitate the registration of advisers to hedge funds and other private funds with the SEC; implement a mandate to require reporting by certain advisers that are otherwise exempt from SEC registration; increase the asset threshold for advisers to register with the SEC; and define "venture capital fund."

  • Asset-backed securities: Proposed rules that would enhance ABS disclosure by:

    • Requiring registered ABS issuers to perform a review of the assets that underlie the ABS.

    • Requiring an ABS issuer to disclose the nature, findings and conclusions of this review of assets.

    • Requiring the issuer or underwriter for both registered and unregistered ABS offerings to disclose the findings and conclusions of any review performed by a third party that was hired to conduct such a review.

  • Whistleblower: Proposed a whistleblower program and rules that would reward individuals who provide the agency with high-quality tips that lead to successful enforcement actions.

  • Say-on-Pay: Proposed rules that would enable shareholders to cast advisory votes on executive compensation and "golden parachute" arrangements.

  • Municipal advisor registration: Adopted a temporary rule requiring municipal advisors to register with the SEC.

What's Next?

The proposal seeks public comment and data on a broad range of issues relating to the proposed rule, including the costs and benefits associated with the proposal. Public comments are due 45 days after the proposal is published in the Federal Register. After careful review of comments, the SEC will consider whether or not to adopt or modify the proposed rule regarding the end-user exemption and the additional proposal regarding exemptions for certain financial institutions.

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Modified: 12/15/2010