SEC Publishes Notice of German Substituted Compliance Application and Proposed Order

The Securities and Exchange Commission today voted to publish a notice of a substituted compliance application by Germany’s Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) as well as a proposed order that would conditionally provide substituted compliance for German firms that are registered with the Commission as security-based swap dealers and security-based swap participants.  These are the latest of a series of actions that the Commission has taken to stand up Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, including cross-border regulation.

Substituted compliance is an alternative method by which the Commission can allow non-U.S. dealers and major participants to satisfy certain requirements under the Securities Exchange Act of 1934 by complying with comparable foreign requirements.  The Commission retains the authority to inspect, examine and supervise non-U.S. firms and take enforcement action as appropriate.

“Today’s proposed order reflects a pragmatic approach to the operational and jurisdictional challenges associated with cross-border regulation of security-based swaps,” said Chairman Jay Clayton.  “By allowing non-U.S. firms to leverage the systems and processes they use to comply with home country requirements that are comparable to U.S. requirements, substituted compliance can lead to more effective and efficient regulation and oversight. I thank our colleagues at the BaFin and the many EU officials who have worked constructively and cooperatively to move meaningful cross-border oversight forward.  I also thank Commissioner Peirce for her continued work to stand up the Dodd-Frank Title VII regime.”

The proposed order is tailored to reflect the Commission’s preliminary assessment of the comparability of German and EU requirements, and incorporates conditions intended to help promote comparability in practice. BaFin’s application does not extend to margin and capital requirements.  The Commission welcomes applications that address margin and capital requirements.

“I am very grateful for the collaboration and cooperation of our EU and German colleagues, which demonstrates our shared commitment to workable regulation of the global security-based swap markets,” said Commissioner Hester Peirce.  “In the coming months I fully expect that the Commission will continue to consider substituted compliance for additional EU and other jurisdictions, so that potential registrants will have ample time to prepare for registration in November of 2021.”

The public comment period will remain open for 25 days following publication of the notice and proposed Order in the Federal Register.  Additional information about substituted compliance applications is available here.

Fact Sheet

German Substituted Compliance Application and Proposed Commission Order

November 9, 2020

Action

The Commission is publishing notice of a substituted compliance application by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) – the financial supervisory authority in the Federal Republic of Germany.  The application requests that German firms registered with the Commission as security-based swap dealers or major security-based swap participants may be allowed to satisfy certain requirements under the Securities Exchange Act of 1934 by complying with comparable German and EU requirements. 

In connection with this application, the Commission also is publishing a proposed Order that conditionally would provide substituted compliance to German firms. 

Substituted Compliance Framework

Exchange Act rule 3a71-6 conditionally provides that non-U.S. security-based swap dealers and major security-based swap participants may satisfy certain requirements under Section 15F of the Exchange Act by instead complying with foreign requirements that the Commission has found to be comparable.  The Commission’s comparability assessment must consider the scope and objectives of the foreign requirements and also the effectiveness of the foreign financial supervisory and enforcement frameworks.   

Rule 3a71-6 further conditions substituted compliance on the Commission and the foreign financial regulatory authority entering into a supervisory and enforcement memorandum of understanding and/or other arrangement addressing supervisory and enforcement cooperation and other matters related to substituted compliance.   The Commission and BaFin are in the process of negotiating a memorandum of understanding to address cooperation matters related to substituted compliance.

Substituted compliance does not constitute exemptive relief, but instead provides an alternative method by which non-U.S. dealers and major participants may comply with applicable U.S. requirements.  The Commission would retain the authority to inspect, examine and supervise those firms and take enforcement action as appropriate.

BaFin’s Application

BaFin requests that the Commission grant substituted compliance in connection with requirements under the Exchange Act regarding: 

• Risk control – requirements related to risk management systems, trade acknowledgment and verification, portfolio reconciliation, portfolio compression and trading relationship documentation.
• Recordkeeping and reporting – requirements related to record creation, record maintenance, reporting and notices.
• Internal supervision and compliance – requirements related to supervision, conflicts of interest and chief compliance officers, and certain related matters.
• Counterparty protection – requirements related to fair and balanced communications; disclosure of risks, characteristics, incentives or conflicts of interest; daily mark disclosure; “know your counterparty;” suitability; and clearing rights disclosure.

The application does not seek substituted compliance in connection with capital or margin requirements under the Exchange Act. 

In support, BaFin’s application includes analyses that compare German and EU requirements with relevant requirements under the Exchange Act.  The application also includes information regarding the financial supervisory and enforcement frameworks in Germany.

BaFin’s application is available on the Commission’s website.

Proposed Order

The Commission is publishing for comment a proposed order in connection with BaFin’s application.  The proposed order reflects the Commission’s preliminary assessments regarding the comparability of applicable German and EU requirements, and the effectiveness of the German financial supervisory and enforcement frameworks.  The proposed order incorporates certain conditions or other limits including:

• Portfolio reconciliation and dispute reporting – Firms would have to report counterparty valuation disputes directly to the Commission, based on EU timing requirements.
• Trading relationship documentation – Firms could not apply the MiFID “eligible counterparty” exception in connection with applicable German and EU requirements, and would not receive substituted compliance in connection with certain disclosure-related provisions.
• Internal supervision and chief compliance officer requirements – Firms’ internal supervision and chief compliance officer frameworks must also promote compliance with certain residual U.S. requirements and the conditions to the order.
• Compliance reports – Firms must provide compliance reports directly to the Commission.
• Suitability – The firm’s counterparty must be treated as a “per se professional client” under German and EU requirements and must not be a “special entity” as defined in Exchange Act section 15F(h)(2)(C) and Exchange Act rule 15Fh-2(d).
• Daily mark disclosure – The firm must be required to reconcile, and in fact reconcile, the portfolio containing the relevant security-based swap on each business day.
• Recordmaking – The firm would need to: (a) preserve the data elements to create certain records required by the Commission’s rule and furnish the record in the format (e.g., blotter or ledger) required by that rule; (b) make certain records related to the security-based swap dealer segregation rule if the firm is not exempt from that rule; and (c) make certain records related to business conduct requirements for which substituted compliance is not available.
• Record preservation – The firm would need to: (a) preserve records related to the security-based swap dealer segregation rule if the firm is not exempt from that rule; and (b) preserve certain records related to Regulation SBSR and business conduct requirements for which substituted compliance is not available.
• Financial and Operational Reporting – The firm would need to report financial and operational information in the manner and format specified by Commission order or rule.
• Notification – The firm would need to: (a) simultaneously transmit to the Commission a copy of any notice required to be sent by comparable German and EU laws and include contact information of a person who can provide further details about the notice; and (b) comply with the requirement in the Commission’s rule to provide notice of failure to make a required deposit into the reserve account required by the segregation rule for security-based swap dealers.

Finally, firms would remain subject to Exchange Act requirements to keep books and records open to inspection by the Commission and to furnish promptly to the Commission legible, true, complete, and current copies of those records of the firm that are required to be preserved.

The Commission is requesting comment on each of these proposed determinations and conditions.

Next Steps

The Commission will seek public comment on the application and proposed order for 25 days following publication in the Federal Register.