July 12, 2013
I respectfully dissent from the Commodity Futures Trading Commission’s (the “Commission” or “CFTC”) approval of its interpretive guidance and policy statement (“Guidance”) regarding the cross-border application of the swaps provisions of the Commodity Exchange Act (“CEA”), as well as from the Commission’s approval of a related exemptive order (“Exemptive Order”).
When I voted in July 2012 to issue for public comment the proposed interpretive guidance and policy statement (“Proposed Guidance”),1 I made clear that if I had been asked to vote on the Proposed Guidance as final, my vote would have been no. I then laid out my concerns with the Proposed Guidance, all relating to the Commission’s unsound interpretation of section 2(i) of the CEA,2 which governs the extraterritorial application of the CEA’s swaps provisions. Regrettably, the Guidance fails to address these concerns and constitutes a regulatory overreach based on a weak foundation of thin statutory and legal authority.
Like the Proposed Guidance, the Guidance: (1) fails to articulate a valid statutory foundation for its overbroad scope and inconsistently applies the statute to different activities; (2) crosses the line between interpretive guidance and rulemaking; and (3) gives insufficient consideration to international law and comity. These shortcomings are compounded by serious procedural flaws in the Commission’s treatment of international harmonization and substituted compliance, as well as in its issuance of the Exemptive Order.
Lack of Statutory Foundation
Section 2(i) of the CEA3 as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”)4 provides, in part, that the Commission’s swap authority “shall not apply” to activities outside the United States unless those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States . . . .”5 This provision is clearly a limitation on the Commission’s authority.6 It follows that the Commission must properly articulate how and when the “direct and significant” standard is met in order to apply Commission rules to swap activities that take place outside of the United States.
The Guidance, however, fails to do so. Instead, it treats section 2(i) as a ready tool to expand authority rather than as a limitation. The statutory analysis section of the Guidance is insufficient to support the broad sweep of extraterritorial activities that the Guidance contemplates would fall under the Commission’s jurisdiction, relying heavily on a comparison to somewhat similar statutory language whose wholly different context renders the comparison unpersuasive. The Guidance makes no mention of statutes that may be more analogous to the CEA, such as the securities or banking laws.7 Because the “direct and significant” standard is never defined, the Guidance’s attempts to link certain requirements imposed on market participants to the “direct and significant” standard do not establish the requisite jurisdictional nexus.8
I would also like to point out that CEA section 2(i) contains a second clause, which allows for the limited application of the Commission’s swap rules to activities outside the United States when they violate the Commission’s anti-evasion rules.9 Pursuant to this clause, the Commission promulgated section 1.6 under Part 1 of its regulations.10 Rather than relying on section 1.6 to address its concerns about evasion, the Commission chose simply to reference the same concerns in justifying its overbroad reach in the Guidance.
With such an unsound foundation for the Commission’s extraterritorial authority under the “direct and significant” standard, I am not surprised that the Guidance often applies section 2(i) of the CEA inconsistently and arbitrarily. Examples of inconsistency abound.
For instance, just as with the Proposed Guidance, the Guidance does not provide a basis for its reasoning that all Transaction-Level Requirements described in the Guidance satisfy the “direct and significant” standard under section 2(i). As I stated in my concurrence to the Proposed Guidance, trade execution and real-time public reporting requirements, although important for transparency purposes, do not raise the same systemic risk concerns that clearing and margining for uncleared swaps do. The Guidance acknowledges this point, but does not go on to sufficiently explain why they should be, and are, treated equally. The Guidance also acknowledges that clearing and margining, because of their implications for systemic risk, could be classified as Entity-Level Requirements, but it does not explain why are they are not. The Guidance’s failure to give meaning to the “direct and significant” standard in its discussion of these requirements is glaring.
Inconsistent application can also be seen within a specific Transaction-Level Requirement, for example reporting to swap data repositories (“SDRs”). The Guidance allows non-U.S. swap dealers (“SDs”) and major swap participants (“MSPs”) to utilize substituted compliance for SDR reporting of their swaps with non-U.S. counterparties, but it does not allow for substituted compliance for non-U.S. SD and MSPs’ trades with U.S. counterparties. Again, the Commission fails here to give real meaning to “direct and significant” in order to adequately explain its reasoning for this distinction. The rationale is even weaker given the fact that substituted compliance is available for swaps with non-U.S. counterparties only under the condition that the Commission has direct access to the relevant data at the foreign trade repository. In either case, the Commission will have direct access to the relevant data, whether substituted compliance is available or not. This raises the question: if the outcome is the same, why is the distinction made? If it is different, the Guidance does not explain how or why – despite requiring data at foreign trade repositories to be essentially the same as data at domestic SDRs, before the Commission even contemplates substituted compliance for SDR reporting.
Yet another example of inconsistent application of section 2(i) involves the requirement of physical commodity large swaps trader reporting (“Large Trader Reporting”). In contrast to SDR reporting, the Guidance does not allow substituted compliance for Large Trader Reporting, even for swaps between a non-U.S. registrant and a non-U.S. counterparty. The Commission’s flimsy rationale is that Large Trader Reporting involves data conversion to “futures equivalent” units, and that it would cost too much time and resources for the Commission to conduct this conversion on data that it could access in a foreign trade repository. Here again, the “direct and significant” standard is nowhere to be found. Moreover, the Commission overstates the burden of the “futures equivalent” conversion and, more generally, the significance of Large Trader Reporting in its oversight duties, while understating the availability of data collected through SDR reporting, with its eligibility for substituted compliance, to achieve the same regulatory objectives.
Interpretive Guidance Versus Rulemaking
The imposition of requirements on market participants raises another of my major concerns with the Guidance. I strongly disagree with the Commission’s decision to issue its position on the cross-border application of its swaps regulations in the form of “interpretive guidance” instead of promulgating a legislative rule under the Administrative Procedure Act (“APA”).11
Simply putting the guise of “guidance” on this document does not change its content or consequences. Where agency action has the practical effect of binding parties within its scope, it has the force and effect of law, regardless of the name it is given.12 Legally binding regulations that impose new obligations on affected parties – “legislative rules” – must conform to the APA.13 On its face, the Guidance sets out standards that it contemplates will be regularly applied by staff to cross-border activities in the swaps markets. Market participants cannot afford to ignore detailed regulations imposed upon their activities that may result in enforcement or other penalizing action.14 This point is underlined by the fact that, as I discuss below, Commission staff no-action letters have been issued in connection with compliance obligations that have essentially been imposed by the Guidance.15 All of this leads to the logical conclusion that the Guidance has a practical binding effect and should have been promulgated as a legislative rule under the APA.
There are important policy and legal considerations that weigh strongly in support of rulemaking in accordance with the APA. Not only do the safeguards enacted by Congress in the APA ensure fair notice and public participation, they help to ensure reasoned decision-making and accountability. In addition, the APA requires that courts take a “hard look” at agency action.16
By issuing “interpretive guidance” instead of rulemaking, the Commission has also avoided analyzing the costs and benefits of its actions pursuant to section 15(a) of the CEA,17 because the CEA requires the Commission to consider costs and benefits only in connection with its promulgation of regulations and orders. Compliance with the Commission’s swaps regulations entails significant costs for market participants. Avoiding cost-benefit analysis by labeling the document as guidance is unacceptable.
In my concurrence to the Proposed Guidance, I suggested that the Commission should at least prepare a report analyzing the costs attributable to the breadth of the Commission’s new authority under CEA section 2(i). I am disappointed, but not surprised, that the Commission has not taken up my suggestion.
Insufficient Consideration of Principles of International Comity
Also in my concurrence to the Proposed Guidance, I pointed out that the Commission’s approach gave insufficient consideration to principles of international comity. The Guidance suffers from the same shortcoming.
The Commission does describe principles of international comity in the Guidance, as it did in the Proposed Guidance. However, mere citation is meaningless if unaccompanied by adherence. With an interpretation of section 2(i) that essentially views the Commission’s jurisdiction as boundless, roping in all transactions with U.S. persons regardless of the location or the regulations that foreign regulators may have in place, the reality is that the Commission’s approach is unilateral and does not give adequate consideration to comity principles.
These principles are crucial given the global, interconnected nature of today’s swaps markets. Properly considering these principles – in addition to indicating respect for the international system and the legitimate interests of other jurisdictions – strengthens, not weakens, the Commission’s ability to effectively regulate swaps markets.
On the Path Forward to Harmonization, But a Flawed Process
In order to implement principles of international comity and develop a harmonized global regulatory system that is both effective and efficient, I have consistently called for meaningful cooperation with foreign regulators. I initially did so in my concurrence to the Proposed Guidance, and the necessity of greater collaboration was subsequently driven home by the number and tone of comment letters on the Proposed Guidance submitted by foreign regulators.18 Then, when the Commission finalized a cross-border exemptive order last December with an expiration date of July 12,19 in my concurring statement I again urged the Commission and foreign regulators to engage in meaningful, substantive discussions.
I am pleased that over the past several months, this engagement has taken place and progress has been made toward harmonization. However, we are not where we need to be: many outstanding issues and questions remain, from data privacy concerns, to the implications of other jurisdictions still finalizing their regulations, to a lack of a clear, consistent and transparent framework for substituted compliance. It would have made sense for these issues to be addressed in the Guidance – but they are not. The looming July 12 expiration of the December exemptive order and the resulting time crunch cannot reasonably be cited as the reason for this failure, because July 12 is an artificial date; it could have been pushed back in order to reach the right outcome with the right process.
Instead, while we are moving toward a workable outcome on harmonization, the process by which we are getting there is patently unacceptable. The most glaring example of this flawed process is this week’s publication of a Commission staff no-action letter allowing substituted compliance for certain of the Transaction-Level Requirements.20 It boggles the mind to think that a staff letter issued by a single division, with no input from the Commission, would be used as the vehicle for addressing such a major issue.21 Making matters worse, this no-action letter is outside the scope of a forthcoming Commission decision regarding the comparability of European rules. And the relief is not time-limited, thereby creating an effect similar to a rulemaking. Consequently, this indefinite exclusion not only preemptively overrides a Commission decision, but it also seems to provide relief beyond that contemplated by the Guidance, which calls for a re-evaluation of all substituted compliance determinations within four years of the initial determination.
Unfortunately, this is not the first instance in recent times of staff no-action letters being used to issue Commission policy. Not only are they an improper tool to get around formal Commission action, their prolific use is a reflection of the ad-hoc, last-minute approach that has been far too prevalent lately at the Commission. I cannot emphasize this enough: the Commission must stop this approach and get back to issuing policy in a more formal, open and transparent manner.
In my discussions with fellow regulators abroad and international regulatory bodies, it is clear that there are varying degrees of reforms being developed and implemented in respective jurisdictions: some are comparable to U.S. regulations and some are less stringent, but there are some that exceed the Commission’s own requirements. I would have preferred the Commission to take the past year following the release of the Proposed Guidance to engage our international colleagues and to involve the International Organization of Securities Commissions (“IOSCO”) in order to resolve the issue of harmonizing our rules. Under this approach, we could finalize our guidance upon completion of the international harmonization process, allowing us to take into account any shortcomings in that process. Instead, we have chosen the reverse order: to impose statutorily weak guidance, with all its no-action riders and exemptions, with only the promise of further negotiations with our foreign counterparts.
Given the way the Commission has proceeded up to this point, it is my hope that the harmonization work lying ahead will be undertaken in a more transparent manner and not done through the abused no-action process that lacks any formal Commission process or oversight. Further, I hope that the process of substituted compliance will offer the opportunity for other regulatory bodies to engage directly with the full Commission, so that we can better understand how our rules and theirs will work and can minimize the likelihood of regulatory retaliation and inconsistent, duplicative, or conflicting rules. I believe the Commission has worked too hard to develop principles and standards that will encourage greater transparency, open access to clearing and trading and improved market data to let them go to waste due to a lack of global regulatory harmonization.
I want to work with other home country regulators to ensure there is not an opportunity for entities to exploit regulatory loopholes. The stark reality is that this Commission is not the global regulatory authority and does not have the resources to support such a mission. Therefore, our best and most effective solution is to engage in a fully transparent discussion on substituted compliance and to do so immediately.
In an effort to mitigate the broad reach of the Guidance and accommodate its last-minute finalization, and in a moment of humility, the Commission has agreed to delay the application of certain elements of the Commission’s swaps regulations with its approval of the Exemptive Order. The Exemptive Order provides relief ranging from 75 days (for application of the expanded U.S. person definition, for example) to December 21, 2013 (for Entity-Level and Transaction-Level Requirements for non-U.S. SDs and MSPs in certain jurisdictions). The Commission is issuing the Exemptive Order pursuant to section 4(c) of the CEA.22
Even though the Exemptive Order goes into effect immediately, the Commission has included a post hoc 30-day comment period. I support the additional time that the Exemptive Order provides for market participants to comply with the Commission’s last-minute Guidance, but I cannot support a final order that blatantly ignores the APA-mandated comment periods for Commission action, especially when I advocated for a relief package that would have provided for public comment over a month ago.23
In addition to the above, the Guidance leaves me concerned in a number of other areas. I am concerned about whether the definition of U.S. person contained herein provides the necessary clarity for market participants, particularly as its enumerated prongs are explicitly deemed to form a non-exhaustive list. I question whether the Commission has done enough to harmonize its cross-border approach with that of the Securities and Exchange Commission (which is being issued through notice-and-comment rulemaking instead of interpretive guidance, I should note), in particular with regard to the definitions of U.S. person and foreign branches. I also am concerned about whether the Guidance creates an uneven playing field for U.S. firms, which would be a plainly unacceptable outcome to me. I am concerned that the Guidance is overlapping, duplicative, and perhaps even contradictory with other provisions in the Dodd-Frank Act that mitigate systemic risk and allocate responsibility for administering its complex and comprehensive regulatory regime to multiple agencies under Title I, Title II, and even within Title VII.24 In addition, I am concerned that the Guidance practically ignores the hugely important matter of protecting customer funds, specifically in connection with bankruptcies, which has critical cross-border implications as vividly demonstrated by the recent collapse of MF Global.25 Finally, I am concerned about whether in overreaching to rope in entities into U.S. jurisdiction that would more appropriately be regulated elsewhere pursuant to an effective system of substituted compliance, the Guidance will have the perverse effect of creating more risk to the U.S. system and more risk to U.S. taxpayers.
For an administrative agency, good government combines good substance – based on a faithful, appropriate reading of the guiding statute – and good process. The Guidance falls woefully short on both counts. Therefore, I respectfully dissent from the decision of the Commission to approve the Guidance and Exemptive Order for publication in the Federal Register.
1 Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214 (July 12, 2012).
2 7 U.S.C. §§ 1 et seq.
3 § 2(i).
4 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).
5 § 2(i)(1).
6 Stated another way, section 2(i)(1) may be read as the following: “[The CEA’s swaps provisions enacted by the Dodd-Frank Act] may apply to activities outside the United States only if those activities have a direct and significant connection with activities in, or effect on, commerce of the United States.”
7 For a recent statutory analysis of the extraterritorial application of the Securities and Exchange Act of 1934, see Morrison v. Nat’l Australia Bank, 561 U.S. __ (2010).
8 See Appalachian Power Co. v. Envtl. Prot. Agency, 208 F.3d 1015, 1027 (D.C. Cir. 2000) (vacating agency guidance interpreting statutory language with practical binding effect because it did not define subparts of the interpreted term and should have been promulgated as a legislative rule under the APA).
9 7 U.S.C. § 2(i)(2) ([The CEA’s swaps provisions enacted by the Dodd-Frank Act] “shall not apply to activities outside the United States unless those activities . . . contravene such rules or regulations as the Commission may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of [the CEA enacted by the Dodd-Frank Act]”).
10 17 CFR § 1.6.
11 5 U.S.C. §§ 551 et seq.
12 See Gen. Elec. Co. v. Envtl. Prot. Agency, 290 F.3d 377, 380 (D.C. Cir. 2002) (finding that a guidance document is final agency action); Appalachian Power, 208 F.3d at 1020-21.
13 See Chrysler Corp. v. Brown, 441 U.S. 281, 302-03 (1979) (agency rulemaking with the force and effect of law must be promulgated pursuant to the procedural requirements of the APA).
14 “A document will have practical binding effect before it is actually applied if the affected private parties are reasonably led to believe that failure to conform will bring adverse consequences . . . .” Gen. Elec., 290 F.3d at 383 (quoting Anthony, Robert A., Interpretive Rules, Policy Statements, Guidances, Manuals, and the Like—Should Federal Agencies Use Them to Bind the Public?, 41 Duke L. J. 1311 (1992)) (vacating an agency’s guidance document that the court found to have practical binding effect and where procedures under the APA were not followed).
15 A no-action letter is issued by a division of the Commission and states that, for the reasons and under the conditions described therein, it will not recommend that the Commission commence an enforcement action against an entity or group of entities for failure to comply with obligations imposed by the Commission.
16 The “arbitrary and capricious” standard of review of agency action under the APA is a rationality analysis also known as the hard-look doctrine:
Under the leading formulation of this doctrine, “the agency must examine the relevant data and articulate a satisfactory explanation for its action including a ‘rational connection between the facts found and the choices made.’ ” The court “consider[s] whether the decision was based on a consideration of the relevant factors and whether there has been a clear error of judgment.” In addition, the agency may not “entirely fail to consider an important aspect of the problem,” may not “offer an explanation for its decision that runs counter to the evidence before the agency,” nor offer an explanation that is “so implausible that it could not be ascribed to a difference in view or the product of agency expertise.” The agency must also relate the factual findings and expected effects of the regulation to the purposes or goals the agency must consider under the statute as well as respond to salient criticisms of the agency’s reasoning.
Stack, Kevin M., Interpreting Regulations, 111 Mich. L. Rev. 355, 378-79 (2012) (internal citations omitted).
17 7 U.S.C. § 19(a).
18 The Commission received comment letters from, among others: Jonathan Faull, European Commission; Steven Maijoor, European Securities and Markets Authority; David Lawton and Stephen Bland, UK Financial Services Authority; Pierre Moscovici, France Ministry of Economy and Finance, Christian Noyer, Autorite de controle prudential, and Jacques Delmas-Marsalet, Autorite des marches financiers; Patrick Raaflaub and Mark Branson, Swiss Financial Market Supervisory Authority; Masamichi Kono, Japan Financial Services Agency, and Hideo Hayakawa, Bank of Japan; K.C. Chan, Financial Services and Treasury Bureau of the Hong Kong Special Administrative Region; Belinda Gibson, Australian Securities and Investments Commission, Malcolm Edey, Reserve Bank of Australia, Arthur Yuen, Hong Kong Monetary Authority, Keith Lui, Hong Kong Securities and Futures Commission, and Teo Swee Lian, Monetary Authority of Singapore. These and all public comment letters on the Proposed Guidance are available at: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1234&ctl00_ctl00_cphContentMain_MainContent_gvCommentList.
19 Final Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 858 (January 7, 2013). The document was adopted by the Commission in December 2012 and published in the Federal Register in January 2013.
20 No-Action Relief for Registered Swap Dealers and Major Swap Participants from Certain Requirements under Subpart I of Part 23 of Commission Regulations in Connection with Uncleared Swaps Subject to Risk Mitigation Techniques under EMIR, CFTC Letter No. 13-45 (July 11, 2013).
21 I have set forth in note 18 some of the comment letters that the Commission has received from foreign supervisors and regulators. By allowing substituted compliance to be addressed through a no-action letter, is the Commission implying that, e.g., the Bank of Japan should accede to, e.g., decisions of the CFTC Division of Swap Dealer and Intermediary Oversight? If so, I find such implication inappropriate.
22 Section 4(c) of the CEA grants the Commission the authority to “exempt any agreement, contract, or transaction (or class thereof) that is otherwise subject to subsection (a) (including any person or class of persons offering, entering into, rendering advice or rendering other services with respect to, the agreement, contract, or transaction) . . . .” 7 U.S.C. § 6(c). Section 4(a) applies to “any person to offer to enter into, to enter into, to execute, to confirm the execution of, or to conduct any office or business anywhere in the United States, its territories or possessions, for the purpose of soliciting, or accepting any order for, or otherwise dealing in, any transaction in, or in connection with, a contract for the purchase or sale of a commodity for future delivery (other than a contract which is made on or subject to the rules of a board of trade, exchange, or market located outside the United States, its territories or possessions) . . . .” 7 U.S.C. § 6(a).
23 The Exemptive Order claims, unconvincingly, that it falls under a good-cause exception to notice-and-comment requirements provided for by the APA under section 553(b)(B): “Except when notice and hearing is required by statute, this subsection does not apply… (B) when the agency for good cause finds (and incorporates the finding and a brief statement of reasons therefore in the rules issued) that notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest.” 5 U.S.C. § 553(b)(B) (emphasis added). However, section 4(c) of the CEA clearly provides that the Commission may grant exemptive relief only by “rule, regulation, or order after notice and opportunity for hearing” (emphasis added). 7 U.S.C. § 6(c). The APA further provides under section 559 that it does not “limit or repeal additional requirements imposed by statute or otherwise recognized by law.” 5 U.S.C. § 559. The CEA also grants emergency powers to the Commission under exigent circumstances. See, e.g., 7 U.S.C. § 12a(9). In addition, courts have narrowly construed the good-cause exception and placed the burden of proof on the agency. See Tenn. Gas Pipeline Co. v. Fed. Energy Regulatory Comm’n, 969 F.2d 1141 (D.C. Cir. 1992); Guardian Fed. Sav. & Loan Ass’n v. Fed. Sav. & Loan Ins. Corp., 589 F.2d 658, 663 (D.C. Cir. 1978).
24 See, e.g., 7 U.S.C. § 6s(d)(2) (“The Commission may not prescribe rules imposing prudential requirements on swap dealers or major swap participants for which there is a prudential regulator.”); 7 U.S.C. § 6b-1(b) (“The prudential regulators shall have exclusive authority to enforce the provisions of section 4s(e) with respect to swap dealers or major swap participants for which they are the prudential regulator.”)
25 In a recent op-ed article James Giddens, the bankruptcy trustee for MF Global’s U.S.-registered entities, points out that serious concerns regarding the harmonization, or lack thereof, of bankruptcy regimes were identified during the resolution of Lehman Brothers in 2008 (he was then the liquidation trustee for Lehman Brothers’s U.S. broker-dealer), only for similar failings to appear with MF Global. He urges clearer and more consistent cross-border rules regarding the protection of customer money in advance of any future multinational financial company meltdown. Giddens, James, How to Avoid the Next MF Global Surprise: Change Cross-Border Rules to Stop Raids on U.S. Customer Accounts, Wall St. J., July 9, 2013.
Last Updated: July 18, 2013