Dodd-Frank Delay: SEC Issues Further Temporary Securities Law Exemptions for Security-based Swaps | Practical Law

Dodd-Frank Delay: SEC Issues Further Temporary Securities Law Exemptions for Security-based Swaps | Practical Law

An update on an interim final rule and exemptive order issued by the SEC further clarifying which US securities laws will apply to security-based swaps when the core provisions of Title VII of the Dodd-Frank Act take effect on July 16, 2011. The SEC also extended temporary exemptions for certain credit default swaps until related final rules become effective, and provided limited exemptions from certain Dodd-Frank clearing agency registration requirements.

Dodd-Frank Delay: SEC Issues Further Temporary Securities Law Exemptions for Security-based Swaps

by Practical Law Finance
Published on 07 Jul 2011 • USA (National/Federal)
An update on an interim final rule and exemptive order issued by the SEC further clarifying which US securities laws will apply to security-based swaps when the core provisions of Title VII of the Dodd-Frank Act take effect on July 16, 2011. The SEC also extended temporary exemptions for certain credit default swaps until related final rules become effective, and provided limited exemptions from certain Dodd-Frank clearing agency registration requirements.
On July 1, 2011, the SEC issued interim final rules and an exemptive order further clarifying which provisions of the US securities laws will apply to security-based swaps (SBS) as of July 16, 2011, the date that the core provisions of Title VII of the Dodd-Frank Act take effect. This follows the SEC's:
Public comments submitted in response to the June 15 order indicated that additional exemptions and guidance were needed to avoid uncertainty regarding which securities laws would apply to which SBS as of July 16, 2011. Together with the July 1 releases, these releases clarify that the SEC intends to preserve the pre-July 16, 2011 regulatory status quo for SBS until final rules on threshold issues in this area, such as basic definitions, are adopted.
Also on July 1, 2011, the SEC:
  • Extended temporary exemptions from the securities laws for certain credit default swaps (CDS).
  • Issued certain limited clearing agency registration exemptions.

Interim Final Rules Providing Exemptions for Security-based Swaps

Provisions of the Dodd-Frank Act that become effective on July 16, 2011 amend the definition of the term "security" in the Securities Act and the Exchange Act to include SBS (Sections 761(a)(2) and 768(a)(1) of the Dodd-Frank Act amending Section 3(a)(10) of the Exchange Act and Section 2(a)(1) of the Securities Act). As a result, absent an exemption, effective July 16, 2011, SBS would be subject to the provisions of the Securities Act and the Exchange Act applicable to securities. However, because the SEC will not complete rulemaking under the Dodd-Frank Act by that date (including finalizing the Dodd-Frank definition of SBS and other material terms), market participants would face uncertainty regarding the applicability of those laws.
While the June 9 release proposed permanent exemptions under the Securities Act, Exchange Act and TIA for SBS issued by clearing agencies, which effectively exempts many cleared SBS from most US securities laws, these exemptions do not apply to SBS that do not involve clearing agencies (that is, they do not apply to uncleared SBS nor to any SBS that may be cleared through a central counterparty other than a clearing agency).
The interim final rules (IFRs) adopted by the SEC on July 1, 2011, together with the June 15 exemptions, provide conditional exemptions for SBS from the Securities Act, the Exchange Act and the Trust Indenture Act of 1939 (TIA) that will allow SBS to continue to be transacted as they are today until SEC final rules that further define "security-based swap" and "eligible contract participant" become effective.

Securities Act Rule 240

In the IFRs, the SEC adopts Rule 240 under the Securities Act (Rule 240). Rule 240 exempts the offer or sale of SBS from all provisions of the Securities Act, except the anti-fraud provisions of Section 17(a), as long as:
  • The SBS meets the definition of "security-based swap agreement" under the pre-July 16, 2011 Securities Act, but will be defined as a "security" under the Securities Act on July 16, 2011 due solely to Dodd-Frank.
  • The SBS is entered into between two eligible contract participants (ECPs), as defined prior to July 16, 2011.
Rule 240 is being adopted to allow SBS that are not currently defined as securities under the securities laws to continue to be transacted after July 16, 2011 and until SEC final rules that further define "security-based swap" and "eligible contract participant" become effective.

Exchange Act Rule 12a-11 and Rule 12h-1 and Trust Indenture Act Rule 4d-12

In the July 1 IFRs, the SEC also adopted Rules 12a-11 and 12h-1 under the Exchange Act. These rules exempt any SBS offered or sold in reliance on Rule 240 from the registration requirements of Exchange Act Sections 12(a) and 12(g). Rule 240 will permit SBS trading activities between ECPs without triggering Exchange Act registration requirements as long as the parties rely on the Rule 240 exemption.
While the release notes that the SEC does not know whether there will be any class of SBS that would satisfy the registration threshold of Section 12(g), it believes that it is appropriate to provide the exemptions contained in Rule 12h-1 while it gathers more information.
Under the July 1 interim final rules, the SEC also adopted Rule 4d-12 under the TIA. Rule 4d-12 exempts any SBS offered or sold in reliance on Rule 240 from the provisions of the TIA.
The SEC is accepting comments on the IFRs until 45 days after website posting. The effective date for the interim final rules is the date of publication in the Federal Register.

Exemptive Order under the Exchange Act

The SEC's July 1, 2011 exemptive order grants temporary relief from compliance with certain Exchange Act provisions that would otherwise apply when the revised definition of "security" goes into effect on July 16, 2011. The order is intended to maintain the regulatory status quo during the Dodd-Frank Act implementation process. Generally, the exemptions apply until the compliance date for SEC final rules that further define "security-based swap" and "eligible contract participant," or, in some cases, until the compliance date for other future Dodd-Frank Act rulemaking.
The order is effective as of July 1, 2011. Public comments on the order must be received by July 15, 2011.
Under the exemptive order, the SBS activities of any party meeting the definition of "eligible contract participant," as defined in the Commodity Exchange Act (as in effect on July 20, 2010) are exempt from the provisions of the Exchange Act. However, this does not extend to certain provisions of the Exchange Act, including the:
  • Antifraud and anti-manipulation provisions, including Rule 10b-5 of the Exchange Act, which prohibits insider trading in addition to other forms of securities fraud.
  • Provisions added or amended by subtitle B of Title VII of Dodd-Frank, which regulates security-based swap markets. The SEC separately addressed these new provisions and amendments, except for the change to the "security" definition, which is addressed in this order.
  • Broker registration requirements under Section 15(a)(1) and other Exchange Act requirements applicable to unregistered brokers. This exclusion from the exemption will only apply to clearing members of clearinghouses that hold customer funds or securities in connection with SBS.
  • Dealer registration requirements under Section 15(a)(1) and other Exchange Act requirements applicable to unregistered dealers. This exclusion from the exemption will only apply to dealing activities involving SBS with counterparties that are not ECPs.
The order also provides a temporary exemption from certain provisions and rules covering SBS activities of registered brokers and dealers to the extent that the provisions or rules do not apply to the broker's or dealer's SBS positions or activities as of July 15, 2011, including:
  • Section 7(c) and Regulation T, regarding extensions of credit.
  • Sections 17(a)-(b) and Rules 17a-3 through 17a-5 and 17a-8, regarding books and records.
  • Section 15(c)(3) and Rules 15c3-1 and 15c3-3, regarding the SEC's rulemaking authority relating to broker-dealer financial responsibility, net capital, and reserves and custody of securities, respectively. However, Rule 15c3-3 will still apply to those activities and positions of registered brokers and dealers relating to cleared SBS if the broker or dealer is a clearing member of a clearing agency that functions as a clearinghouse for SBS and holds customer funds or securities in connection with SBS.
The exemptive order grants further temporary relief from compliance with Sections 5 and 6 of the Exchange Act until the earliest compliance date of any SEC final rules covering the registration of security-based swap execution facilities (SB SEFs). The order exempts:
  • Persons, other than a clearing agency, who act as a central counterparty in SBS from registering as a national securities exchange under Sections 5 and 6 of the Exchange Act. The exemption applies solely in connection with the person's SBS activities.
  • Brokers and dealers from Section 5 of the Exchange Act, which would otherwise prohibit brokers and dealers from effecting transactions in SBS on an exchange that is not a national securities exchange.
  • ICE Trust US LLC, Chicago Mercantile Exchange Inc. and ICE Clear Europe, Limited (collectively, CDS CCPs) from the requirements under Sections 5 and 6 of the Exchange Act in connection with their calculation of mark-to-market prices for open positions in cleared CDS, as long as each CDS CCP:
    • Reports certain information to the SEC regarding their mark-to-market price calculations within 30 days of the end of each quarter.
    • Establishes and maintains adequate safeguards and procedures to protect members' confidential trading information.
    • Directly or indirectly makes publicly available, on terms that are fair and reasonable and not unreasonably discriminatory, all end-of-day settlement prices, certain other prices with respect to cleared CDS that it may establish to calculate mark-to-market margin requirements and any other pricing or valuation information with respect to cleared CDS that the CDS CCP publishes or distributes.

Exchange Act Section 29(b)

The exemptive order also grants exemptive relief from Section 29(b) of the Exchange Act. Section 29(b) generally provides that contracts made in violation of the Exchange Act or its rules are void with respect to the rights of certain parties. The release notes that the SEC does not believe Section 29(b) would apply with respect to any of the provisions it has granted relief from. In spite of this, in order to foster market certainty, the order expressly exempts SBS from being considered void or voidable under Section 29(b) on the basis that a party has violated a provision of the Exchange Act from which the SEC has provided exemptive relief.

Extension of Temporary Exemptions for Eligible Credit Default Swaps

On July 1, 2011, the SEC extended to April 16, 2012 the expiration date for rules providing exemptions for certain CDS from the provisions of the Securities Act, the Exchange Act and the TIA (see Legal Update, SEC Issues Second Extension of Temporary Exemptions for Eligible Credit Default Swaps).

Exemptive Order Granting Temporary Exemptions from Clearing Agency Registration Requirements

The SEC also issued a second exemptive order on July 1, 2011 providing temporary exemption to SBS clearing agencies from compliance with Section 17A(b)(1) of the Exchange Act, which requires clearing agencies to register with the SEC. Clearing agencies that are exempted from the registration requirement in Section 17A(b)(1) are those that would be required to register only because they perform exempted activities, such as collateral management services, trade matching services, tear up and compression services, and other similar services.
This temporary exemption is intended to help ensure that clearing functions are appropriately used to reduce risk in the OTC derivatives market.
To learn more about swaps and derivatives rulemaking under the Dodd-Frank Act, see Practice Notes, Summary of the Dodd-Frank Act: Swaps and Derivatives and Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
To learn more about previous Dodd-Frank delays, see Legal Updates, Dodd-Frank Delay: CFTC and SEC Propose Temporary Exemptions from Swap Requirements and Clarify July 16 Compliance Obligations and Dodd-Frank Delays Mount as Agencies Extend Comment Period for ABS Risk Retention Rules.