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Cross-Border Security-Based Swap Rules and Guidance

Commissioner Kara M. Stein

June 25, 2014

I want to begin by thanking Brian Bussey, Richard Gabbert, Joshua Kans, and Margaret Rubin from Trading and Markets;  Brooks Shirey and Lori Price from the General Counsel’s office; and Liban Jama from the Chair’s staff for all of their hard work on this rule.    

Just a few weeks ago, I called upon this agency and others to finish our Dodd-Frank Act rulemakings.[1]

The Commission’s rules must be informed by the painful lessons that we learned from the financial crisis.   One critical lesson was the tremendous harm that can occur to our markets from swaps transactions that are consummated outside our borders. 

In August 2007, the head of AIG’s Financial Products proclaimed, “It is hard for us…to even see a scenario with any kind of realm of reason that would see us losing one dollar in any of those transactions.”[2]

He was talking about the London arm of AIG that was speculating in derivative products, many of which were credit default swaps (CDS) to European banks.  By the fall of 2007, AIG Financial Products had already begun a tailspin that helped spark the worst financial crisis in the United States since the Great Depression. 

Despite transacting its business in London with largely European banks, the risks could not be contained by geographic boundaries—because AIG was relying on support from its U.S. parent.[3]

As AIG started to struggle, attention turned to its connections to many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships and its securities lending.  The government ultimately concluded that the collateral impact from AIG’s impending demise would spill over creating a systemic event in our nation’s financial system.  Without a government bailout, AIG’s “collapse could have brought down its counterparties, causing cascading losses and collapses throughout the financial system.”[4]

Then-Federal Reserve Chairman Bernanke’s remarks mirrored the feelings of many:  “if there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG…. AIG exploited a huge gap in the regulatory system…. There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets– took huge losses. There was no regulatory oversight because there was a gap in the system.” [5]

AIG wasn’t the only firm exploiting this dangerous gap.  Lehman’s arm in London held a substantial number of swaps contracts, many of which provided guarantees from its U.S. parent.[6]   

In the years since, we’ve had other high-profile swaps-related issues where trading conducted abroad inflicted significant damage on US market participants, including MF Global[7] and the JPMorgan Chase “London Whale.”[8]  Again, despite the geography, the losses were ultimately absorbed here in the United States.  

Each of these incidents highlights a weakness in the U.S. regulatory regime:  the failure to meaningfully regulate swaps trades that occur outside of the United States, but that impact our markets and our market participants.  While we are responsible for only a small portion of that swaps regime, this Commission has struggled to move forward.[9]

I take this task very personally.

The events of 2008 are indelibly etched into my memory.  Congressional Committees conducted hundreds of briefings and hearings on the events, their causes, potential solutions, and anticipated consequences.   

I worked on hearings on the role of swaps in the crisis and how we should regulate them.  Ultimately, I worked on the Congressional effort to address swaps, embodied in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).      

Today’s rule regarding cross-border definitions is a small, but significant, step towards implementing that law.  Today’s rule is significant because it provides the foundation for all cross-border rules to follow.   Just as in any foundation, however, a small crack can lead to substantial problems down the line.  Unfortunately, this rule has some cracks. 

The rule primarily finalizes one definition –  who is a U.S. Person.  The rule does not address, and leaves for later:

  • What types of conduct give rise to SEC oversight;
  • What rules will apply to covered firms; and
  • When, whether, and how firms may comply with our requirements through complying with foreign regulatory requirements.

Thus, even today’s rule will leave a huge portion of the cross-border rules outstanding.  I want to get those rules done too.  And as we move forward with those rules, I hope we will mend some of the cracks in the rule before us today.

To be clear, the rule before us makes a number of significant improvements from the proposal.[10]  Most notably, the preamble articulates a much clearer understanding of a recourse guarantee.  But, even with these improvements, does this proposal do enough to help achieve the objectives of Title VII? 

I believe the rule could do more.  We know that foreign trading affiliates are inextricably linked to their U.S. parents.  And rightfully so.  Generally, a multi-national parent would not allow a subsidiary to fail or not perform, particularly if that subsidiary’s counterparties and business interests have significant overlap with those of the parent.  And time and time again, we’ve seen the risk transference from foreign affiliates to the U.S. parent.

Support arrangements between affiliates may take many forms.  They may be oral, written, implicit, or explicit.  This is why credit rating agencies consider both explicit support arrangements and the potential intervention of the parent when assessing a subsidiary’s credit profile. 

Yet, this rule ignores this reality of corporate finance by assuming that the U.S. parent is linked to the foreign affiliate only when an explicit recourse guarantee is provided to a third party.  The recent financial crisis is replete with examples of firms rescuing their affiliates.  Firms do not jettison them off to fend for themselves in times of crisis; they bail them out.  And that’s what we’re trying to deal with here —those risks flowing back to the United States.

Not surprisingly, recent reports suggest that firms are restructuring their form of agreements to restrict or remove explicit contractual guarantees,[11] but it appears that little of the substance has changed.  In fact, it’s reported that counterparties are not demanding price concessions or other changes to their contracts.  Why not?  Could it be because they believe that firms will continue to stand behind their subsidiaries’ trading? 

The rule before us ignores this relatively recent change to business practices.  While the economic analysis states that it takes as a baseline the security-based swaps market as it exists today, it instead relies upon data that is more than a year old – even though the market has since changed significantly.

The rule should not only account for the “de-guaranteeing” of such transactions, but also reflect why we should or should not modify our approach to address it.

I also am deeply concerned about the Commission’s narrow view of its own authority to adopt this rule. 

Much of this comes from how we got here.  The proposed rule, proposed before I joined the Commission, keyed jurisdictional authority on a narrow territorial approach, and this rule follows that approach.  Unfortunately, by taking this narrow approach, we have significantly limited the reach of our jurisdiction so that a number of significant security-based swaps-related risks that threaten U.S. persons and our markets are, nevertheless, too far to reach. 

Even working within this narrow territorial approach, we have not explicitly taken advantage of all available authority.  I have offered numerous suggestions over a period spanning several months on revisions to that approach, but many of these efforts are not reflected in the document before us today. 

For example, some assert that the Commission lacks legal authority to adopt a provision that would cover keepwell arrangements, despite the fact that we have authority to cover guarantees to third parties. 

Suppose a large US financial firm has a foreign subsidiary that is trading with a foreign hedge fund.  If the contract between the foreign subsidiary and its counterparty specifically allows the counterparty to look to the US parent for the fulfillment of the contract, that should be a guarantee.  And the rule gets that right.  So, if a U.S. parent is liable to a counterparty of its foreign subsidiary for $100 million as a result of a security-based swap, then that would be covered by our rules. 

But if the same U.S. parent alternatively promises its foreign subsidiary that it will absorb the losses arising from the same security-based swap, and that leads the U.S. parent to owe the exact same $100 million, then it would not be covered by the rule we adopt today. 

This is the epitome of form over substance—and an easy way to evade our rules.  In either case, despite the fact that the security-based swap transaction occurs abroad, the $100 million liability rests with the US parent, the risk of the security-based swap is squarely within the United States, and it should be covered.[12]

I have seen no court case or persuasive legal authority that would tie our jurisdiction to a particular form or type of risk or contract.  The statute doesn’t provide for such a distinction.  The statute doesn’t say one type of contract is within our jurisdiction, while another is not.  Nor have I been shown any case that would limit our authority based on the particular form a contract takes. 

To the contrary, the preamble even acknowledges longstanding principles that courts will focus on substance, not form, when identifying parties to a transaction.  But, rather than do that, the rule suggests that we have taken this extremely limited approach based on what some at the Commission believe is the better policy outcome.

In my view, I have been told that the policy objectives I seek, which are the policy objectives I remember Congress having when it passed this law, are simply unattainable.  That is because, I am told, Congress failed to clearly provide adequate authority to do the job.  I disagree.

The final rule does not appear to reconcile why we purportedly lack authority in the meaningful regulation of security-based swaps, but somehow retain authority to ensure accurate financial reporting involving foreign subsidiaries that roll into to the same consolidated financial statement, or that we retain authority to continue to examine and regulate foreign broker-dealers and investment advisers with US connections or investors. 

Perhaps more disturbingly, the final rule fails to even address that Congress explicitly authorized the Commission to have broad extraterritorial jurisdiction to enforce its anti-fraud powers.  Separate from our swaps regime, Section 929P of the Dodd-Frank Act explicitly grants the power to the Commission to protect American markets and people.  This provision modifies the Securities Act, the Exchange Act, and the Investment Advisers Act, and it was enacted just days after the Morrison decision.[13]

That language explicitly gives the Commission broad powers to bring actions when “significant steps” occurred in the United States.  It further gives the Commission power to bring actions even when all of the conduct occurs outside the United States, when it “has a foreseeable substantial effect within the United States.”  I note that this anti-fraud authority is not unlike the broad authority provided to the Commodity Futures Trading Commission (“CFTC”) by Title VII. 

What I am left wondering is why, given that the Commission has this new, broad anti-fraud authority, specifically drafted to address cross-border concerns raised by the Morrison case, we ignore it when drafting our cross-border rules.[14]  Do we suddenly think that our anti-fraud authority does not empower us to adopt rules to identify and prevent fraud?  We do it elsewhere.  Why not here in regards to security-based swaps? 

In fact, we have relied on anti-fraud powers to support regulatory requirements and oversight in the past.  For example, we have in the past, and will continue, to look to the broad anti-fraud provision of section 206 of the Investment Advisers Act to support substantive regulations and oversight of our investment advisers.[15]

This issue is not even referenced as a potential basis for our authority.  Instead, the rule suggests that we can only regulate a subset of the security-based swaps market that is relevant to our Title VII objectives.  And then it argues that we can potentially reach only a slightly larger subset by invoking the Commission’s anti-evasion powers under section 30(c) of the Exchange Act. 

We have a lot more authority than that.  We should be explaining it and fleshing that out.  And if some on the Commission disagree, and think that we don’t have the authority, then we need to ask Congress for enough authority to actually do the job they told us to do.

One of the greatest challenges to implementing a security-based swaps regime is that we haven’t overseen this market in the past.  It’s relatively new and has grown rapidly in recent years.  And while swaps trading has become a key component of financial intermediation, it is now governed by two market regulators. 

The CFTC and the SEC need to work together to adopt regimes that work together.  We need to coordinate, and learn from one another.  And we need to make sure that we don’t subject the firms we regulate to unnecessary duplication or conflicting standards. 

Luckily for us, the CFTC has already finalized its rules, and has issued guidance clarifying them.  That said, their regime is already subject to legal challenge.  So it isn’t entirely clear what we should be shooting for.  Further complicating matters, they have a different statutory framework than we do. 

What that means for me is that the Commission should do what it thinks is best, as informed by our own views of our different authority and our policy objectives.  Of course, I hope our regime will have as much overlap with the CFTC’s as possible, but I also recognize that we are different regulators, with different statutory mandates, and with significantly different responsibilities. 

The CFTC’s role in swaps regulation dwarfs the Commission’s.  Just as we should use our authority and judgment to achieve the best policy outcomes, I hope they will use their broad authority to do the same.

I am not seeking a more proscriptive rule.  I do not want to unnecessarily impinge upon our financial markets or the financial institutions involved in them.  Nor do I want to overburden our largest institutions with overlapping and sometimes conflicting regulatory regimes between regulators. 

But Congress enacted derivatives reforms to protect us from risks like the collapse of AIG.  And it gave the Commission and the CFTC a lot of tools to get that done.  Today, the Commission is pretending we don’t have some of these tools so that we can justify adopting this particular rule in this particular form.

Without question, this approach will, regardless of our future rules, leave the U.S. vulnerable to the risks arising from unregulated swaps trading.  But, it is a step forward. 

I appreciate the staff’s hard work with me and my staff over these past several months.  We have spent hundreds of hours poring over alternatives.  And while I am disappointed that the final product does not better address my key concerns, I also think we need to get this one done and move on to the next rule. 

[1] Remarks before the Peterson Institute of International Economics, June 12, 2014, available at

[2] Financial Crisis Inquiry Commission (FCIC), Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (“FCIC Report”)

268 (2011).

[3] FCIC Report at 140.

[4] FCIC Report at 352.

[5]  Economic and Budget Challenges for the Short and Long Term, Before the Senate Committee on the Budget, 111th Cong. 19 (2009) (Statement of Federal Reserve Chairman Bernanke).

[6] The U.S. parent, Lehman Brothers Holdings, Inc., provided guarantees for nearly all derivative transactions entered into by various Lehman affiliates.  See Michael Fleming and Asani Sarkar, The Failure Resolution of Lehman Brothers, Federal Reserve Bank of New York, 20 Economic Policy Review 2 (Mar. 2014).

[7]  See Report of Investigation of Louis J. Freeh, Chapter 11 Trustee of MF Global Holdings, Ltd. (“Report”).   On October 31, 2011, MF Global declared bankruptcy with losses estimated to be in excess of $2 billion.  (Report at 76 and Report Appendix at 50).  MF Global operated a trading arm in the United Kingdom that engaged in an “aggressive trading strategy, investing heavily in European sovereign debt, which was financed through repurchase to maturity transactions (“Euro RTMs”). (Report at 9).    MF Global, Inc. (“MFGI”) and MF Global U.K. Limited (“MFG UK”) were the MF Global entities that directly engaged in the Euro RTMs.  MFGI would purchase securities, and MFG UK acted as agent for the purchase because it was the only MF Global entity that was a member of the clearinghouses in Europe. (Report at 9).  The trades were held by MFGI so that it, rather than MFG UK, bore the risk of default or restructuring of the sovereign debt. (Report at 33).  MFGI met its initial margin obligations to MFG UK, and subsequent variation margin calls as required by MFG UK, using liquidity at MFGI as well as intercompany loans provided by MF Global Finance USA, Inc. (“FinCo”) and MF Global Holdings Ltd (the U.S. public parent). (Report at 35). 

[8] Gregory Zuckerman and Katy Burne, “‘London Whale’ Rattles Debt Market,” WALL ST. JOURNAL, April 6, 2012.  See also Michael A. Santoro, “Would Better Regulations Have Prevented the London Whale Trades?” THE NEW YORKER (Aug. 21, 2013) noting that the London Whale was able to swim undetected. 

[9] The Commission has proposed a number of implementing rules.  See, e.g., Conflicts of Interest Involving Security-Based Swaps, proposed 75 FR 65882 (Oct. 26, 2010); Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps, proposed 75 FR 68560 (Nov. 8, 2010); Security-Based Swap Reporting and Dissemination and Obligations of Security-Based Swap Repositories, proposed 75 FR 75208 (Dec. 2, 2010); Mandatory Clearing of Security-Based Swaps, proposed 75 FR 82490 (Dec. 30, 2010); End-User Exception to Mandatory Clearing of Security-Based Swaps, proposed 75 FR 79992 (Dec. 21, 2010); Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 76 FR 42396 (July 18, 2011); Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 76 FR 65784 (Oct. 24, 2011); Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants, proposed 77 FR 70214 (Nov. 23, 2012); Application of Title VII in the Cross Border Context, proposed 78 FR 30968 (May 23, 2013); and Recordkeeping, reporting and notification requirements for Security-based Swap Dealers and Major Security-Based Swap Participants, proposed 79 FR 25194 (May 2, 2014).  However, the SEC has not yet finalized the vast majority of the Title VII provisions.  Further, the SEC has delayed the application of most of the provisions of the federal securities laws to security-based swaps until February 11, 2017. See  Extension of Exemptions for Security-Based Swaps, 79 Fed. Reg. 7570 (Feb. 10, 2014). 

[10] It also counts towards the dealer de minimis and major swap participant thresholds transactions that are guaranteed by U.S. affiliates; clarifies the principal place of business concerns; and covers some of the risks posed by conduit affiliates. 

[11] See, e.g., Peter Eavis, Wall Street’s Quiet Turnabout on Swaps, N.Y. Times (May 2, 2014).

[12] Recent case law similarly suggests that keepwell arrangements like this example could be covered.  See Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 62 (2nd Cir. 2012) (“[W]e hold that to sufficiently allege the existence of a “domestic transaction in other securities,” plaintiffs must allege facts indicating that irrevocable liability was incurred or that title was transferred within the United States.”).  Even further, this case law articulates additional supporting factors that may render a transaction sufficiently domestic, such as “facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money.”  Absolute at 70.  While these issues may be relevant to the “conduct” rule, which may be subject to future re-proposal, it is not yet clear whether, or to what extent, our regulatory framework may further address these issues.

[13]  Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010).

[14] I note that a number of courts have accepted that Section 929P effectively reversed MorrisonSee, e.g., S.E.C. v. Tourre, 2013 WL 2407172, at *1 n. 4 (S.D.N.Y. June 4, 2013) (“Because the Dodd–Frank Act effectively reversed Morrison”); In re Optimal U.S. Litig., 865 F.Supp.2d 451, 456 n. 28 (S.D.N.Y.2012) (“To the extent that a broad reading of Morrison may raise policy concerns that parties will engage in foreign transactions to avoid the reach of the Exchange Act, Congress has attempted to remedy that problem by restoring the conducts and effects test”); S.E.C. v. Compania Internacional Financiera S.A., No. 11 Civ. 4904(DLC), 2011 WL 3251813, at *6 n. 2 (S.D.N.Y. July 29, 2011).

[15] See, e.g., Custody of Funds or Securities of Clients by Investment Advisers, IA Release No. 2968 (Dec. 30, 2009), Political Contributions by Certain Investment Advisers, IA Release No. 3043 (July 1, 2010).

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