# Clearing Exemption for Swaps Between Certain Affiliated Entities > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2013-07970 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** April 11, 2013 - **Citation:** 78 FR 21750 ## Text COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 50 RIN 3038-AD47 Clearing Exemption for Swaps Between Certain Affiliated Entities AGENCY: Commodity Futures Trading Commission. ACTION: Final rule. SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC) is adopting regulations to exempt swaps between certain affiliated entities within a corporate group from the clearing requirement under the Commodity Exchange Act (CEA or Act), enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The regulations include specific conditions, as well as reporting requirements, that affiliated entities must satisfy in order to elect the inter-affiliate exemption from required clearing. DATES: This final rule is effective June 10, 2013. FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director, 202-418-5684, sjosephson@cftc.gov; Nadia Zakir, Associate Director, 202-418-5720, nzakir@cftc.gov; Eric Lashner, Special Counsel, 202-418-5393, elashner@cftc.gov; Meghan Tente, Law Clerk, 202-418-5785, mtente@cftc.gov; Division of Clearing and Risk, Erik Remmler, Associate Director, 202-418-7630, eremmler@cftc.gov; Camden Nunery, Economist, 202-418-5723, cnunery@cftc.gov, Office of the Chief Economist, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581. SUPPLEMENTARY INFORMATION: Table of Contents I. Background II. Comments on the Notice of Proposed Rulemaking A. Overview of Comments Received B. Section 4(c) Authority C. Definition of Affiliate Status D. Inter-Affiliate Swap Documentation E. Centralized Risk Management Program F. Variation Margin G. Treatment of Outward-Facing Swaps and Relief H. Reporting Requirements and Annual Election I. Implementation III. Cost-Benefit Considerations A. Statutory and Regulatory Background B. Costs and Benefits of Exemption for Eligible Affiliate Counterparties C. Costs and Benefits of Exemption's Conditions D. Costs and Benefits to Market Participants and the Public E. Costs and Benefits Compared to Alternatives F. Consideration of CEA Section 15(a) Factors IV. Related Matters A. Regulatory Flexibility Act B. Paperwork Reduction Act I. Background On August 21, 2012, the Commission published a notice of proposed rulemaking proposing to exempt swaps between certain affiliated entities from the clearing requirement under section 2(h)(1)(A) of the CEA (NPRM). 1 As proposed, § 39.6(g) provides that counterparties to a swap may elect an inter-affiliate exemption from the clearing requirement if: (1) The financial statements of both counterparties are reported on a consolidated basis, and either one counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties; (2) both counterparties comply with the conditions set forth in the proposed rule; and (3) one of the counterparties provides certain information on behalf of both affiliated counterparties to either a registered swap data repository (SDR) or the Commission if a registered SDR does not accept the information. The Commission is hereby adopting proposed § 39.6(g), finalized as § 50.52, 2 subject to the changes discussed below. 1 Clearing Exemption for Swaps Between Certain Affiliated Entities, 77 FR 50425 (Aug. 21, 2012). 2 For ease of reference, the Commission is re-codifying proposed § 39.6(g) as § 50.52 so that market participants are able to locate all rules related to the clearing requirement in one part of the Code of Federal Regulations. Section 723(a)(3) of the Dodd-Frank Act amended the CEA to provide, under new section 2(h)(1)(A) of the CEA, that it shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization (DCO) that is registered under the CEA or a DCO that is exempt from registration under the CEA if the swap is required to be cleared. 3 Section 2(h)(2) of the CEA charges the Commission with the responsibility for determining whether a swap is required to be cleared, through one of two means: (1) Pursuant to a Commission-initiated review; or (2) pursuant to a submission from a DCO of each swap, or any group, category, type, or class of swaps that the DCO “plans to accept for clearing.” On November 29, 2012, the Commission adopted its first clearing requirement determination, requiring that swaps meeting the specifications outlined in four classes of interest rate swaps and two classes of credit default swaps (CDS) are required to be cleared. 4 3 Section 2(h)(7) of the CEA provides an exception to the clearing requirement when one of the counterparties to a swap (i) is not a financial entity, (ii) is using the swap to hedge or mitigate commercial risk, and (iii) notifies the Commission how it generally meets its financial obligations associated with entering into a non-cleared swap. 4 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 FR 74284 (Dec. 13, 2012) (hereinafter “Clearing Requirement Determination”). The Clearing Requirement Determination adopting release provided a specific compliance schedule for market participants to bring their swaps into compliance with the clearing requirement. 5 Swap dealers (SDs), major swap participants (MSPs), and private funds active in the swaps market were required to comply beginning on March 11, 2013, for swaps they enter into on or after that date. 6 Accounts managed by third-party investment managers, as well as ERISA pension plans, have until September 9, 2013, to begin clearing swaps entered into on or after that date. All other financial entities are required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date. With regard to the CDS indices on European corporate names, iTraxx, the Clearing Requirement Determination provided that, if no DCO offered iTraxx for client clearing by February 11, 2013, the Commission would delay compliance for those swaps until 60 days after an eligible DCO offers iTraxx indices for client clearing. On February 25, 2013, the Commission received notice from ICE Clear Credit LLC that it had begun offering customer clearing of the iTraxx CDS indices that are subject to the clearing requirement under § 50.4(b). In accordance with the timeframe previously set forth by the Commission, 7 the following compliance dates shall apply to the clearing of iTraxx indices: Category 1 Entities: Friday, April 26, 2013; Category 2 Entities: Thursday, July 25, 2013; and all other entities: Wednesday, October 23, 2013. 8 5 See Clearing Requirement Determination at 74319-21. 6 The first compliance date for required clearing applies to Category 1 Entities, as defined in § 50.25(a). SDs and MSPs and private funds active in the swaps market are defined as Category 1 Entities. Security-based swap dealers and major security-based participants also are included in the definition. However, as the Commission has stated, if a security-based swap dealer or a major security-based swap participant is not yet required to register with the Securities and Exchange Commission (SEC) at such time as the Commission issues a clearing determination, then the security-based swap dealer or a major security-based swap participant would be treated as a Category 2 Entity, as defined in § 50.25(a). See Swap Transaction Compliance Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA, 76 FR 58186, 58190 n.38 (Sept. 20, 2011). 7 Clearing Requirement Determination at 74319-21. 8 See Press Release, CFTC's Division of Clearing and Risk Announces Revised Compliance Schedule for Required Clearing of iTraxx CDS Indices (Feb. 25, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6521-13. II. Comments on the Notice of Proposed Rulemaking The Commission received 13 comments during the 30-day public comment period following publication of the NPRM on August 21, 2012, and one additional comment after the comment period ended. The Commission considered each of these comments in formulating the final regulation, § 39.6(g) (finalized as § 50.52). During the process of proposing and finalizing this rule, the Chairman and Commissioners, as well as Commission staff, participated in informational meetings with market participants, trade associations, public interest groups, and other interested parties. In addition, the Commission has consulted with other U.S. financial regulators including: (i) The SEC; (ii) the Board of Governors of the Federal Reserve System; (iii) the Office of the Comptroller of the Currency; and (iv) the Federal Deposit Insurance Corporation (FDIC). Staff from each of these agencies has had the opportunity to provide oral and/or written comments to this adopting release, and the final regulations incorporate elements of the comments provided. The Commission is mindful of the benefits of harmonizing its regulatory framework with that of its counterparts in foreign countries. The Commission has therefore monitored global advisory, legislative, and regulatory proposals, and has consulted with foreign authorities in developing the final regulations. A. Overview of Comments Received Of the 14 comment letters received by the Commission in response to its NPRM, ten commenters expressed general support for the concept of an inter-affiliate exemption from the clearing requirement. 9 These commenters offered comments addressing the proposed rule generally and comments addressing specific provisions of the proposed rule. Comments addressing specific provisions of the proposed rule are discussed in detail below. 9 Cravath, Swaine & Moore LLP (Cravath), the Coalition for Derivatives End-Users (CDEU), the Financial Services Roundtable (FSR), Chris Barnard, the Commercial Energy Working Group (The Working Group), the Edison Electric Institute (EEI), The Prudential Insurance Company of America (Prudential), Metropolitan Life Insurance Company (MetLife), the International Swaps and Derivatives Association and Securities Industry and Financial Markets Association, (together, ISDA & SIFMA), and DLA Piper. A number of commenters requested a broader exemption with few or no conditions. Cravath and DLA Piper requested that the Commission exempt swaps between affiliates from all clearing, margining, and reporting obligations. The Working Group, Cravath, CDEU, ISDA & SIFMA, DLA Piper, and EEI 10 recommended that the Commission eliminate, simplify or minimize the conditions imposed, or unconditionally exempt inter-affiliate swaps from clearing. These commenters stated that inter-affiliate swaps pose little or no risk to the U.S. financial system and do not increase the interconnectedness between major financial institutions, particularly if affiliates' financial statements are consolidated for accounting purposes. The Working Group commented that entities use inter-affiliate trades not only to net risk related to market-facing swaps, but also to transfer physical commodity or futures exposure between affiliates for compliance with international tax law, customs, or accounting laws. Similarly, MetLife and Prudential supported the proposed exemption and noted that transactions between affiliates do not present the same risks as market-facing swaps. 10 EEI commented that “corporate families typically face bankruptcy together” and that it is “unusual for only one member of a corporate group to go bankrupt.” EEI also noted that a bankruptcy could cause increased risk to clearinghouses that would face multiple entities going into default at the same time if all affiliates of one corporate group were required to clear their inter-affiliate swaps. ISDA & SIFMA commented that inter-affiliate swaps provide important benefits to corporate groups by enabling centralized management of market, liquidity, capital, and other risks, and allowing affiliated groups to realize associated hedging efficiencies and netting benefits. Imposing mandatory clearing on inter-affiliate swaps, according to ISDA & SIFMA, could compromise the ability of affiliated groups to realize these benefits. 11 ISDA & SIFMA also commented that third parties face no increased risk from inter-affiliate swaps. In their view, the credit risks faced by a third party entering into an uncleared swap with a group member are a function of the group member's entire portfolio of assets and liabilities and other credit factors. 11 ISDA & SIFMA commented that inter-affiliate swaps do not introduce risk into a corporate group, stating, “[b]ecause capital, liquidity and risk allocation decisions, as well as the exercise of default remedies between group members are under unified management, group entities do not face default risk of other group entities, so long as the group as a whole is solvent.” Along the same lines, CDEU commented that non-financial entities typically enter into external swaps with swap dealers and other large banks that typically evaluate the risks of entering into swaps based on the overall creditworthiness of their counterparties. These financial entity counterparties, according to CDEU, have the opportunity to review financial statements, the creditworthiness of any guarantor, and a number of other credit-related items. After the credit review, according to CDEU, the counterparties may request credit risk mitigants such as corporate parent guarantees, collateral, and credit-based legal terms. On the other hand, Americans for Financial Reform (AFR) commented that a wide-ranging exemption for inter-affiliate swaps could create systemic risk and threaten the U.S. financial system. AFR cited a number of reasons for its concern such as: the risk transfer between separate corporate entities; the possibility for financial contagion to be transferred from one part of a large financial institution to different groups within the institution; restrictions on access to affiliate assets across national boundaries; and reduction in volumes at DCOs that could hurt liquidity and risk management. AFR further noted that because the end-user exception is available for non-financial and small financial entities in connection with swaps that hedge or mitigate systemic risk, the inter-affiliate exemption is primarily available for large financial institutions and speculative trades by large commercial institutions with many affiliates. Better Markets Inc. (Better Markets) also expressed concern that an inter-affiliate exemption could be contrary to Congressional intent, as expressed in the Dodd-Frank Act, if it is not a very narrow and strictly implemented exemption. Two individual persons commented against the proposed exemption. Steve Wentz requested that the Commission not issue any exemptions because the exemptions “would just open the door to divert trades through that open door to avoid protective oversight.” Aaron D. Small commented that the “unregulated derivatives market has been a disaster for the U.S. and world economy and must be reined in.” Having considered these comments, and the specific comments discussed below, the Commission is adopting the proposed inter-affiliate exemption rule, subject to several important modifications. The Commission recognizes the need for an exemption from clearing for inter-affiliate swaps, but believes it is important to establish certain conditions for entities electing the exemption. In reaching this conclusion, the Commission considered the benefits of clearing as recognized by the fact that Congress included a clearing requirement in the Dodd-Frank Act, against the benefit to market participants of being able to continue entering into inter-affiliate swaps on an uncleared basis. The Commission believes it has reached an appropriate balance by allowing an exemption from required clearing for certain inter-affiliate swaps while imposing necessary conditions on that exemption in order to ensure that all inter-affiliate swaps exempted from required clearing meet certain risk-mitigating conditions. 1. Benefits of Clearing and Its Role in the Dodd-Frank Act As the Commission has previously stated, 12 in the fall of 2008, a series of large financial institution failures triggered a financial and economic crisis that led to unprecedented governmental intervention to ensure the stability of the U.S. financial system. The financial crisis made clear that an uncleared, over-the-counter (OTC) derivatives market can pose significant risks to the U.S. financial system. 13 12 See Clearing Requirement Determination at 74284-86; Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 FR 41214, 41215-17 (July 12, 2012) (hereinafter “Proposed Cross-Border Interpretive Guidance”). 13 See Financial Crisis Inquiry Commission, “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” Jan. 2011, at 386, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (“The scale and nature of the [OTC] derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008: millions of contracts in this opaque and deregulated market created interconnections among a vast Web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults.”). One of the most significant examples of this risk was the accumulation of uncleared CDS entered into by an affiliate in the AIG corporate group providing default protection on more than $440 billion in bonds, leaving it with obligations that the AIG corporate family could not cover as a result of changed market conditions. 14 As a result of the CDS exposure of this one affiliate, the U.S. Federal government bailed out the AIG corporate group with over $180 billion of taxpayer money in order to prevent AIG's failure and a possible contagion event in the broader economy. 15 While the downfall of AIG was not caused by inter-affiliate swaps, the events surrounding AIG during the 2008 crisis demonstrate how the risks of uncleared swaps at one affiliate can have significant ramifications for the entire affiliated business group. 14 Adam Davidson, “How AIG fell apart,” Reuters, Sept. 18, 2008, available at http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918. 15 Hugh Son, “AIG's Trustees Shun `Shadow Board,' Seek Directors,” Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us. Recognizing the peril that the U.S. financial system faced during the financial crisis, Congress and the President came together to pass the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes a comprehensive new regulatory framework for swaps, and the requirement that certain swaps be cleared by DCOs is one of the cornerstones of that reform. The CEA, as amended by Title VII, now requires a swap to be cleared through a DCO if the Commission has determined that the swap, or group, category, type, or class of swaps, is required to be cleared, unless an exception to the clearing requirement applies. As noted above, the only exception to the clearing requirement provided by Congress was the end-user exception in section 2(h)(7) of the CEA. 16 16 Congress did not provide for an exception or exemption for inter-affiliate swaps in the Dodd-Frank Act. However, commenters have pointed to legislative history and statements made by members of Congress supporting such an exemption at the time the Dodd-Frank Act was enacted. The benefits of clearing derivatives have been recognized internationally, as well. In September 2009, leaders of the Group of 20 (G-20)—whose membership includes the United States, the European Union, and 18 other countries—agreed that: (1) OTC derivatives contracts should be reported to trade repositories; (2) all standardized OTC derivatives contracts should be cleared through central counterparties by the end of 2012; and (3) non-centrally cleared contracts should be subject to higher capital requirements. The Commission believes that required clearing through a DCO is the best means of mitigating counterparty credit risk and providing an organized mechanism for collateralizing the risk exposures posed by swaps. By clearing a swap, each counterparty no longer needs to rely on the individual creditworthiness of the other counterparty for payment. Both original counterparties now look to the DCO that has cleared their swap to ensure that the payment obligations associated with the swap are fulfilled. The DCO manages the risk of failure of a counterparty through appropriate margining, a mutualized approach to default management among clearinghouse members, and other risk management mechanisms that have been developed over the more than 100 years that modern clearinghouses have been in operation. Clearing can avert the development of systemic risk by reducing the potential knock-on, or domino, effect resulting from counterparties with large outstanding exposures defaulting on their swap obligations and causing their counterparties—counterparties that would otherwise be financially sound if they had been paid—to default. Failure of those counterparties could lead to the failure of yet other counterparties, cascading through the economy and potentially causing systemic harm to the U.S. financial system. Required clearing reduces this risk by ensuring that uncollateralized risk does not accumulate in the financial system. 2. Risks and Benefits Posed by Inter-affiliate Swaps The Commission is not persuaded by comments suggesting that inter-affiliate swaps pose no risk to the financial system or that clearing would not mitigate those risks. Entities that are affiliated with each other are separate legal entities notwithstanding their affiliation. As separate legal entities, affiliates generally are not legally responsible for each other's contractual obligations. This legal reality becomes readily apparent when one or more affiliates become insolvent. 17 Affiliates, as separate legal entities, are managed in bankruptcy as separate estates and the trustee for each debtor estate has a duty to the creditors of the affiliate, not the corporate family, the parent of the affiliates, or the corporate family's creditors. 18 This potential for separate treatment in bankruptcy, calls into question commenters' claims that third parties can rely on the creditworthiness of the entire corporate group when entering into swaps with affiliates. 17 Note, for example, that while the Rule 1015 of the Federal Rules of Bankruptcy Procedure (FRBP) permits a court to consolidate bankruptcy cases between a debtor and affiliates, FRBP Rule 2009 provides that, among other things, if the court orders a joint administration of two or more estates under FRBP Rule 1015, the trustee shall keep separate accounts of the property and distribution of each estate. See Federal Rules of Bankruptcy Procedure (2011). 18 See In re L & S Indus., Inc., 122 B.R. 987, 993-994 (Bankr. N.D. Ill. 1991), aff'd 133 B.R. 119, aff'd 989 F.2d 929 (7th Cir. 1993) (“A trustee in bankruptcy represents the interests of the debtor's estate and its creditors, not interests of the debtor's principals, other than their interests as creditors of estate.”); In re New Concept Housing, Inc., 951 F.2d 932, 938 (8th Cir. 1991) (quoting In re L & S Indus., Inc. ). While the concept of “substantive consolidation” of affiliates in a business enterprise when they all enter into bankruptcy is sometimes used by a bankruptcy court, substantive consolidation is generally considered an extraordinary remedy to be used in limited circumstances. See Substantive Consolidation—A Post-Modern Trend, 14 Am. Bankr. Inst. L. Rev. 527 (Winter 2006). On the other hand, inter-affiliate swaps offer certain risk-mitigating, hedging, and netting benefits as described by several commenters including ISDA & SIFMA, The Working Group, CDEU, and EEI. Furthermore, because affiliates in a corporate family generally internalize the risks of inter-affiliate transactions in the affiliated group, as described in the NPRM, the corporate family could face serious reputational harm if affiliates default on their swaps. Consequently, the entities within an affiliated group are incentivized to fulfill their inter-affiliate swap obligations to each other, to support each other to prevent outward-facing failures, and to resolve any disagreements about the terms of inter-affiliate swaps more quickly and amicably. As noted by ISDA & SIFMA, when an affiliated business group is fiscally sound, the capital, liquidity, and risk allocation decisions and default remedies between group members may be centrally managed thereby reducing the likelihood of group entities facing default risk of other group entities, “so long as the group as a whole is solvent.” While in many circumstances, these characteristics of inter-affiliate swaps may mitigate the risk of an affiliate defaulting on its obligations—particularly when the group as a whole is financially healthy—they do not constitute legally enforceable obligations pre-bankruptcy or in bankruptcy. 19 Accordingly, despite the existence of mutual support incentives, a corporate group facing insolvency risk may ultimately make the decision to allow some affiliates to fail and default on their swap obligations so that other affiliates can survive without becoming insolvent. 20 In cases where an insolvent affiliate has multiple obligations to third parties (swap-related or otherwise), those third parties may be subject to a pro rata distribution along with other creditors if the trust estate of the defaulting affiliate does not have sufficient liquid assets to cover losses on its uncleared swaps. It is at such times of financial stress that central clearing serves as the most effective systemic risk mitigant. 19 See Bankrupt Subsidiaries: The Challenges to the Parent of Legal Separation, 25 Emory Bankr. Dev. J. 65 (2008); Liability of a Parent Corporation for the Obligations of an Insolvent Subsidiary Under American Case Law and Argentine Law, 10 Am. Bankr. Inst. L. Rev. 217 (Spring 2002). 20 See, e.g., the bankruptcy of Residential Capital (ResCap) and its subsidiaries. ResCap was a mortgage subsidiary of Ally Financial Inc. ResCap declared bankruptcy independent of Ally Financial Inc., which is not part of the bankruptcy proceeding and continues to operate as a legally separate, solvent entity. See In re Residential Capital, LLC, No. 12-12020 (MG) (Bankr. S.D.N.Y. 2012), available at http://www.kccllc.net/rescap . While the bankruptcy of ResCap was not the direct result of inter-affiliate swaps, ResCap's bankruptcy demonstrates that an affiliate can be put into bankruptcy without forcing the affiliated parent to declare bankruptcy or to be legally responsible for the affiliate's debts. 3. The Commission's Consideration of the Risks and Benefits In providing an inter-affiliate exemption from required clearing, the Commission has considered the benefits that inter-affiliate swaps offer corporate groups against the risk of allowing an exemption from required clearing for swaps entered into by separate, but affiliated, legal entities. In considering the risks and benefits, the Commission was guided, in part, by comments pointing to the risk-mitigating characteristics of inter-affiliate swaps and the sound risk management practices of corporate groups that rely on inter-affiliate swaps. In crafting the rule, the Commission sought to codify these characteristics as eligibility criteria, or conditions, for the exemption from required clearing. The conditions imposed are designed to increase the likelihood that affiliates will take into consideration their mutual interests when entering into, and fulfilling, their inter-affiliate swap obligations. For example, the inter-affiliate exemption may be elected only if the affiliates are majority owned and their financial statements are consolidated, thereby increasing the likelihood that entities will be mutually obligated to meet the group's swap obligations. Additionally, the affiliates must be subject to a centralized risk management program, the swaps and the trading relationship between affiliates must be documented, and outward-facing swaps must be cleared or subject to an exemption or exception from clearing. Despite the conditions to the exemption adopted in this final rule, the Commission reminds market participants that the conditions included in the final rule do not mitigate potential losses between inter-affiliates to the extent that clearing would, particularly if one or more affiliated entities become insolvent. B. Section 4(c) Authority Section 4(c)(1) of the CEA grants the Commission the authority to exempt any transaction or class of transactions, including swaps, from certain provisions of the CEA, including the clearing requirement, in order to “promote responsible economic or financial innovation and fair competition.” Section 4(c)(2) of the Act further provides that the Commission may not grant exemptive relief unless it determines that: (1) The exemption is appropriate for the transaction and consistent with the public interest; (2) the exemption is consistent with the purposes of the CEA; (3) the transaction will be entered into solely between “appropriate persons”; and (4) the exemption will not have a material adverse effect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory responsibilities under the CEA. 21 In enacting section 4(c), Congress noted that the purpose of the provision is to give the Commission a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner. 22 21 7 U.S.C. 6(c)(2). 22 House Conf. Report No. 102-978, 1992 U.S.C.C.A.N. 3179, 3213. In the NPRM, the Commission requested comment as to whether exempting inter-affiliate swaps from the clearing requirement under certain terms and conditions would be an appropriate exercise of its section 4(c) authority. 23 A number of commenters supported the Commission's use of its section 4(c) authority to exempt inter-affiliate swaps from clearing. According to MetLife and Prudential, the inter-affiliate exemption as proposed promotes responsible economic or financial innovation and fair competition by allowing corporate groups to use inter-affiliate swaps to engage in effective and efficient risk management activities. As an example, MetLife and Prudential explained that corporate groups can use a single conduit in the market on behalf of multiple affiliates within the group, which permits the corporate group to net affiliates' trades. This netting effectively reduces the overall risk of the corporate group and the number of open positions with external market participants, which in turn reduces operational, market, counterparty credit, and settlement risk. MetLife and Prudential both expressed the view that inter-affiliate swaps do not pose risks to corporate groups and third parties, and both stated that inter-affiliate swaps may pose less risk to corporate groups given efficient netting across the corporate group. EEI also supported the Commission's use of its section 4(c) authority for similar reasons to those stated by MetLife and Prudential. 23 See NPRM at 50428. ISDA & SIFMA stated that the Commission's proposed exemption meets the requirements of section 4(c) of the CEA by promoting innovation and competition, and the exemption serves the public interest. ISDA & SIFMA noted that inter-affiliate swaps are integral to the strategies consolidated financial institutions rely upon to meet customer needs in an efficient, competitive, and sound manner. According to ISDA & SIFMA, inter-affiliate swaps maximize hedging efficiencies and allow customers to transact with a single client-facing entity in the customer's jurisdiction, which increases the scope of risk-reducing netting with individual customers as well as risk-reducing netting of offsetting positions within the financial group. This allows the institution to meet customer needs across jurisdictions and provide improved pricing or other risk management benefits to customers, thereby promoting financial innovation and competition. ISDA & SIFMA also commented that inter-affiliate swaps allocate and transfer risks among members of a corporate group rather than increasing risks. CDEU also supported the Commission's use of its section 4(c) authority. CDEU stated that the inter-affiliate exemption would promote financial innovation, fair competition, and the public interest by preserving the ability of corporate entities to centrally hedge the risks of their affiliates. CDEU stated that without such an exemption firms that currently use a central hedging model will be disadvantaged as compared to direct competitors that do not use the same, efficient risk management model. CDEU also noted the additional costs that would be incurred from subjecting inter-affiliate swaps to clearing. In the NPRM, the Commission requested comments on whether the inter-affiliate exemption would be in the public interest. In addition to responses noted above with regard to the public interest, 24 the Commission received two comment letters questioning whether the proposed exemption serves the public interest. 24 As noted above, CDEU, MetLife, Prudential, and ISDA & SIFMA stated that an inter-affiliate exemption is consistent with the public interest. According to AFR, there are serious doubts about whether the inter-affiliate exemption is in the public interest. AFR stated that any hedging and netting benefits gained from corporate groups engaging in inter-affiliate swaps must be weighed against the benefits of full novation to a central counterparty in the form of a clearinghouse, which is a more comprehensive level of risk management. Given the experience of the 2008 financial crisis, AFR noted that any risk-reducing benefit of corporate group risk management practices assumes that the corporate group actually implements and adheres to sufficient risk management procedures. AFR is concerned about relying on such an assumption in light of the fact that there was a large-scale failure of proper risk management prior to and during the 2008 financial crisis. Better Markets similarly commented that only a very narrow and strict inter-affiliate exemption could be in the public interest. Better Markets suggested ways in which the Commission should strengthen the proposed exemption to satisfy the public interest standard, including requiring a 100% majority ownership interest standard, requiring that both initial and variation margin be exchanged, and banning rehypothecation of posted collateral. 25 25 As discussed further below, both AFR and Better Markets contend that all the proposed conditions must be retained and the conditions must be strengthened in a number of ways. After considering the complete record in this matter, the Commission has determined that the requirements of section 4(c) of the Act have been met with respect to the exemptive relief described above. The Commission believes that the exemption, as modified in this release, is consistent with the public interest and with the purposes of the CEA. The Commission's determination is based, in large part, on the transactions that are covered under the exemption. Namely, as most commenters noted, inter-affiliate transactions provide an important risk management role within corporate groups. In addition, and as discussed in the NPRM, the Commission recognizes that swaps entered into between corporate affiliates, if properly risk-managed, may be beneficial to the entity as a whole. Accordingly, in promulgating this rule, the Commission concludes that an exemption subject to certain conditions is appropriate for the transactions at issue, promotes responsible financial innovation and fair competition, and is consistent with the public interest. As the Commission noted in the NPRM and as reiterated in AFR's comment, any benefits to the corporate entity have to be considered in light of the risks that uncleared swaps pose to corporate groups and market participants generally. For this reason, the Commission is adopting an inter-affiliate exemption that is narrowly tailored and subject to a number of important conditions, including that affiliates seeking eligibility for the exemption document and manage the risks associated with the swaps. Further, the Commission finds that the exemption is only available to “appropriate persons.” Section 4(c)(3) of the CEA includes within the term “appropriate person” a number of specified categories of persons, including “such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections.” 26 Given that only eligible contract participants (ECPs) can enter into uncleared swaps and that the elements of the ECP definition (as set forth in section 1a(18)(A) of the CEA and Commission regulation 1.3(m)) generally are more restrictive than the comparable elements of the enumerated “appropriate person” definition, the Commission finds that ECPs are appropriate persons within the scope of section 4(c)(3)(K) for purposes of this final release and that in so doing, the class of persons eligible to rely on the exemption will be limited to “appropriate persons” within the scope of section 4(c)(3) of the CEA. 26 7 U.S.C. 6(c)(3)(K). Finally, the Commission finds that this exemption will not have a material effect on the ability of the Commission to discharge its regulatory responsibilities. This exemption is limited in scope and, as described further below, the Commission will have access to information regarding the inter-affiliate swaps subject to this exemption because they will be reported to an SDR pursuant to the conditions of the exemption. In addition to the reporting conditions in the rule, the Commission retains its special call, anti-fraud, and anti-evasion authorities, which will enable it to adequately discharge its regulatory responsibilities under the CEA. For the reasons described in this release, the Commission believes it is appropriate and consistent with the public interest to adopt such an exemption. C. Definition of Affiliate Status As proposed, § 39.6(g)(1) provides that counterparties to a swap may elect the inter-affiliate exemption to the clearing requirement if the financial statements of both counterparties are reported on a consolidated basis, and either one counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties. The proposed rule further specified that a counterparty or third party directly or indirectly holds a majority ownership interest if it directly or indirectly holds a majority of the equity securities of an entity, or the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership. 1. Majority Ownership Interest Four commenters supported proposed § 39.6(g)(1), which set forth the requirements of an affiliate status. CDEU commented that the majority-ownership test strikes an appropriate balance between ensuring that the rule is not overly broad and providing companies with the flexibility to account for differences in corporate structures. EEI stated that majority ownership is sufficient to mitigate what EEI believes is “minimal” risk posed by uncleared inter-affiliate swaps. In addition, EEI noted that majority-owned affiliates will have strong incentives to internalize one another's risks because the failure of one affiliate impacts all affiliates within the corporate group. The Working Group generally supported the Commission's definition, but stated that inter-affiliate swaps should be unconditionally exempt from mandatory clearing when the affiliates are consolidated for accounting purposes. 27 MetLife stated that it would likely limit inter-affiliate trading to “commonly-owned” affiliates, but agreed with the flexibility of including majority-owned affiliates. 28 27 The Working Group also stated that it was unable to determine the scope of the proposed rule until the Commission provides further guidance on the definition of “financial entity” under section 2(h)(7) of the CEA. In particular, The Working Group asked that the Commission clarify the status of treasury affiliates acting on behalf of affiliates able to claim an exception or exemption from required clearing. The Working Group further requested that the Commission provide guidance regarding what constitutes being predominantly engaged in activities that are in the business of banking or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956, and clarify that trading physical commodities is not financial in nature. In response to The Working Group and other comments regarding the applicability of the end-user exception for certain inter-affiliate swaps, the Commission notes that it will address the use of treasury affiliates under a separate Commission action. With regard to the definition of financial entity, the Commission provided additional guidance in the end-user exception rulemaking, and declined to interpret statutory provisions within the jurisdiction of other U.S. authorities. See End-User Exception to the Clearing Requirement for Swaps, 77 FR 42560, 42567 (July 19, 2012) (explaining that “business of banking” is a term of art found in the National Bank Act and is within the jurisdiction of, and therefore subject to interpretation by, the Office of the Comptroller of the Currency and section 4(k) of the Bank Holding Company Act is within the jurisdiction of, and therefore subject to interpretation by, the Board of Governors of the Federal Reserve System). Accordingly, further guidance on this issue is beyond the scope of this rulemaking, except as provided in note 76 of this release. 28 Prudential stated that its affiliates are all wholly-owned affiliates and expressed no view on the issue of majority-owned affiliates. Two commenters objected to proposed § 39.6(g)(1) and requested the Commission require 100% ownership of affiliates. AFR stated that the systemic impact of swaps is based on ownership, not on corporate control. AFR also stated that permitting such a low level of joint ownership would lead to evasion of the clearing requirement through the creation of joint ventures set up to enable swap trading between banks without the need to clear the swaps. Similarly, Better Markets agreed that only 100% owned affiliates should be eligible for the exemption because allowing the exemption for the majority owner permits that owner to disregard the views of its minority partners 29 and creates an incentive to evade the clearing requirement by structuring subsidiary partnerships. Finally, Better Markets stated that the majority-ownership standard would result in corporate groups transferring price risk and credit risk to different locations, facilitating interconnectedness and potentially giving rise to systemic risk during times of market stress. 29 Two other commenters also discussed the issue of minority investors. ISDA & SIFMA stated that any concerns about the protection of minority investors in group entities is “the province of corporate and securities laws.” EEI noted that “to the extent minority owners have an opinion about electing the exemption, they may negotiate with majority-owners as they deem commercially appropriate for the right to participate in inter-affiliate clearing decisions.” Having considered these comments, the Commission is adopting proposed § 39.6(g)(1) (now § 50.52(a)) with the modifications discussed below. The Commission believes that the majority-owned standard is not overly broad and provides entities with flexibility to account for differences in corporate structure. In particular, requiring majority ownership serves to ensure that counterparty credit risk posed by inter-affiliate swaps is internalized by the corporate group. In addition, as the NPRM noted, it is important for the inter-affiliate clearing exemption to be harmonized with foreign jurisdictions that have or are developing comparable clearing regimes consistent with the 2009 G-20 Leaders' Statement. 30 For example, the European Parliament and Council of the European Union have adopted the European Market Infrastructure Regulation (EMIR). 31 Subject to the relevant provisions, technical standards, and regulations under EMIR, certain OTC derivatives transactions between parent and subsidiary entities, could be exempt from its general clearing requirement. Generally speaking, it appears that the intragroup exemptions under EMIR will require majority-ownership rights and consolidated accounting and annual reporting. 32 30 At the G-20 meeting in Pittsburgh in 2009, as noted above, the G-20 Leaders declared that, “[a]ll standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” G-20 Leaders' Final Statement at Pittsburgh Summit: Framework for Strong, Sustainable and Balanced Growth (Sept. 29, 2009). 31 See Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC Derivatives, Central Counterparties and Trade Repositories, 2012 O.J. (L 201) (hereinafter “EMIR”) available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF. 32 Id. at Articles 3 and 4. In response to the concerns of AFR and Better Markets regarding the need for the Commission to adopt a stricter requirement of 100% ownership, the Commission recognizes the potential for corporate entities to structure their affiliates in such a manner as to evade the clearing requirement. However, the Commission believes it has carefully crafted a narrow exemption based on the condition that the affiliate is majority-owned, along with the other conditions imposed under this exemption. In terms of the interests of minority shareholders, the Commission believes that the views of all shareholders should be taken into account when an entity decides whether to clear a swap, but ultimately, the decision is a matter for corporate and securities laws. 2. Consolidated Financial Statements In addition to the majority-ownership requirement, proposed § 39.6(g)(1) provided that counterparties to a swap may elect the inter-affiliate exemption to the clearing requirement if the financial statements of both counterparties are reported on a consolidated basis. The Commission received several comments on this provision. The FSR requested that the Commission clarify that alternative accounting standards can be used for purposes of meeting the requirement that the financial statements of both affiliates be reported on a consolidated basis. In response to a question in the NPRM regarding whether the exemption should be limited to the ownership threshold based on section 1504 of the Internal Revenue Code, MetLife and Prudential both explained that a U.S. taxpayer cannot file consolidated U.S. tax returns with its non-U.S. affiliate. Accordingly, both MetLife and Prudential stated that they did not support such a limitation on the exemption. In an effort to clarify the consolidated financial reporting condition, the Commission is modifying the requirement that financial statements be reported on a consolidated basis in two ways. First, the Commission is clarifying which entities are subject to the consolidated reporting condition. Under revised § 50.52(a)(1)(i), if one of the two affiliate counterparties claiming the exemption holds a majority interest in the other affiliate counterparty (the “majority-interest holder”), then the financial statements of the majority-interest holder must be reported on a consolidated basis and such statements must include the financial results of the majority-owned counterparty. On the other hand, under revised § 50.52(a)(1)(ii), if a third party is the majority-interest holder of both affiliate counterparties claiming the exemption (the “third-party majority-interest holder”), then the financial statements of the third-party majority-interest holder must be reported on a consolidated basis and such statements must include the financial results of both affiliate counterparties to the swap. In essence, the rule requires that the financial statements of the majority-owner (whether a third party or not) are subject to consolidation under accounting standards and must include either the other affiliate counterparty's or both majority-owned affiliate counterparties' financial results. The Commission is using the term “financial results” to refer to the financial statements, reports, or other material of the majority-owned counterparty or counterparties that must be consolidated with the majority owner's financial statements. The second modification to the proposed rule responds to FSR's request that the Commission clarify that alternative accounting standards are permitted. Accordingly, the consolidated financial statements of the majority-interest holder or the third-party majority-interest holder, as appropriate, may be prepared under either Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The modification reflects the fact that entities claiming the exemption may be subject to different accounting standards. The Commission is not modifying the rule to limit the exemption to an ownership threshold based on section 1504 of the Internal Revenue Code. D. Inter-Affiliate Swap Documentation As proposed, § 39.6(g)(2)(ii) provided that eligible affiliate counterparties that elect the inter-affiliate exemption must enter into swaps with a swap trading relationship document that is in writing and includes all the terms governing the relationship between the affiliates. These terms include, but are not limited to, payment obligations, netting of payments, transfer of rights and obligations, governing law, valuation, and dispute resolution. This requirement will be satisfied if an eligible affiliate counterparty is an SD or MSP that complies with the swap trading relationship documentation requirements of § 23.504. Regulation 23.504 includes all the proposed terms under proposed § 39.6(g)(2)(ii) plus a number of other specific requirements. The NPRM stated that the burden on affiliates would not be onerous because all affiliates should be able to use a master agreement to document their swaps, however, in the NPRM the Commission did not require the use of such a master agreement. The Commission received a number of comments both supporting and opposing the swap documentation requirement. Better Markets, MetLife, and Prudential all supported the proposed documentation requirement. Specifically, MetLife and Prudential did not believe that the documentation requirement would be any more “burdensome or costly” for them because they already document all of their swaps. Additionally, MetLife and Prudential commented that the proposed documentation method is “preferable” to any other method and represents industry best practice. Better Markets agreed with the conditions imposed on the exemption, including the documentation requirements, and stated that the conditions should not be weakened. 33 33 While it did not address the documentation requirements specifically, AFR stated that the proposed conditions on the exemption should be fully retained. Similarly, Chris Barnard generally expressed support for the proposed rules but did not specifically mention the documentation provisions. Cravath, EEI, CDEU, and DLA Piper opposed the proposed documentation requirement. Cravath stated that the costs associated with the imposition of documentation requirements outweigh any benefits to the financial system, and that the Commission should leave the determination as to the appropriate level of documentation to boards of directors and management of companies, to determine based on the “reasonable exercise of their fiduciary responsibilities.” DLA Piper commented that inter-affiliate swaps are typically documented by a simple intercompany agreement, trade ticket or accounting entry rather than ISDA Master Agreements, and that the documentation requirements would be burdensome. CDEU expressed concern that proposed § 39.6(g)(2)(ii)(B) would require that full ISDA Master Agreements be used to document inter-affiliate swaps. CDEU explained that while many market participants use master agreements, some end users many not have full master agreements because inter-affiliate swaps are purely internal and do not increase systemic risk. 34 CDEU recommended that the proposed rule be revised to require that the swap documentation “include all terms necessary for compliance with its centralized risk management program” and eliminate the list of required terms. CDEU also requested that the Commission clarify that (1) market participants can continue to use documentation required by their risk management programs, and (2) the rule does not require market participants to use the ISDA Master Agreements. 34 CDEU recognized that SDs and MSPs and their counterparties, including affiliates, will be subject to the requirements of § 23.504, but stated that it is not appropriate to apply the same requirements to non-registrant affiliates. EEI recommended that the Commission eliminate the documentation requirement because the requirement is duplicative of corporate accounting records that affiliates maintain as a matter of prudent business practice. According to EEI, current accounting practices will address the Commission's tracking and proof-of-claim concerns related to inter-affiliate swaps. EEI commented that a documentation requirement imposes “an additional, costly layer of ministerial process and documentation that is unnecessary to achieve the Commission's stated objectives.” 35 EEI requested that the Commission allow market participants “to document their inter-affiliate risk transfers pursuant to standard commercial accounting and business records practices.” 35 EEI commented on the NPRM's consideration of costs and benefits and stated that the costs of the proposed documentation requirement are unjustified. The NPRM included an estimate that there would be a one-time cost of $15,000 to develop appropriate documentation for use by an entity's affiliates. EEI objected to this estimate because, in its view, the legal costs associated with individually negotiating and amending standard agreements between individual affiliates would exceed the NPRM's estimates. In addition, EEI objected to the NPRM's estimate of 22 affiliated counterparties for each corporate group as “far too low” for U.S. energy companies. However, EEI did not provide specific, quantitative information in terms of either the legal costs of complying with the proposed documentation requirement or number of affiliates for a corporate group subject to this rule. ISDA & SIFMA stated that the documentation requirements were overly prescriptive and would impose unnecessary costs on affiliates. Specifically, ISDA & SIFMA identified the valuation and dispute resolution requirements as serving little purpose. ISDA & SIFMA recommended a more flexible approach that would require adequate documentation of “all transaction terms under applicable law.” The Commission considered all of the comments relating to the proposed documentation requirement and is retaining the swap documentation requirement subject to certain modifications recommended by commenters. As discussed in the NPRM, the Commission is concerned that without adequate documentation entities will be unable to track and manage the risks arising from inter-affiliate swaps. Equally important, affiliates must be able to offer sufficient proof of claim in the event of insolvency. The Commission is adopting proposed § 39.6(g)(2)(ii)(A) (now § 50.52(b)(2)(i)), which essentially confirms the applicability of § 23.504 to swaps between affiliates where one of the affiliates is an SD or MSP. However, with regard to swaps between affiliates that are not SDs or MSPs, and in response to commenters' requests for a more flexible standard, the Commission is adopting ISDA & SIFMA's recommendation that the focus of the documentation requirement be on documenting all of an inter-affiliate transaction's terms. Accordingly, the Commission is modifying proposed § 39.6(g)(2)(ii)(B) (now § 50.52(b)(2)(ii)), to require that “the terms of the swap are documented in a swap trading relationship document that shall be in writing and shall include all terms governing the trading relationship between the eligible affiliate counterparties.” Under this modification, the Commission is eliminating the non-exclusive list of terms, which included payment obligations, netting of payments, transfer of rights and obligations, governing law, valuation, and dispute resolution. The change responds to commenters' requests for a more flexible approach that reflects current market best practices. While, in most instances, the Commission anticipates that documentation between affiliates will include all of the previously enumerated terms, the more general rule formulation signals that market participants retain the ability to craft appropriate documentation for their affiliated entities. This modification also serves to address concerns that the intent of the proposed rule was to require formal master agreements, such as the ISDA Master Agreement. As explained above, the proposed rule was not intended to require affiliates to enter into formal master agreements. Rather, the Commission observed that parties that already use master agreements to document their inter-affiliate swaps would likely meet the requirements of the inter-affiliate exemption without additional costs. 36 This observation was supported by commenters such as MetLife and Prudential. 36 See Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 FR 55904, 55906 (Sept. 11, 2012) (recognizing that the ISDA Master Agreement, and other associated documents in their pre-printed form as published by ISDA are capable of compliance with the rules, but noting that such agreements are subject to customization by counterparties and such customization may or may not comply with Commission requirements). This modification also responds, in part, to CDEU's request that the documentation “include all terms necessary for compliance with its centralized risk management program.” While the Commission is modifying the rule to delete the specific references to valuation and dispute resolution procedures, ensuring that affiliates entering into swaps have sound procedures in place to value their swaps and resolve any disputes is critical to risk management. Accordingly, as discussed further below, the Commission anticipates that affiliates will include rigorous valuation provisions and procedures for elevating and resolving disputes in their risk management programs. In response to comments from Better Markets and AFR that the proposed regulations should be retained and not weakened, the Commission does not believe that eliminating the non-exclusive list of terms and replacing it with a simple requirement that all terms of the swap transaction and the relationship between the affiliates be documented will weaken the rule. Rather, eligible affiliates will have some discretion, but also have the obligation to ensure that their documentation contains an accurate and thorough written record of their swaps. The Commission clarifies, however, that book entries would not suffice for purposes of complying with the swap documentation condition because such entries do not contain sufficient information to adequately document the swap or the trading relationship between affiliates. EEI requested that, if the Commission retains the documentation requirement, the Commission clarify that swap confirmations are not required because executing confirmations would impose substantial costs. In response to this request, the Commission clarifies that for swaps between affiliates where one or both of the affiliates is an SD or MSP, the confirmation rules under § 23.501 are incorporated into § 23.504. 37 As a result, those affiliates must confirm all the terms of their transactions according to the applicable timeframes set forth under § 23.501. 38 By contrast, for swaps between affiliates that are not SDs or MSPs, the provisions of § 23.501 do not apply and formal confirmation pursuant to § 23.501 is not required. However, the Commission notes that the terms of the swap will be documented by the affiliates and confirmation of those terms will be reported to an SDR under the Commission's reporting rules. 39 37 See 17 CFR 23.504(b)(2); 77 FR 55907-08. 38 See 17 CFR 23.501. 39 See, e.g., 17 CFR 45.3(c)(1)(iii) (requiring the reporting counterparty to report all confirmation data for the swap as soon as technologically practicable after confirmation, but no later than 30 minutes after confirmation if confirmation occurs electronically or 24 business hours after confirmation if confirmation does not occur electronically). E. Centralized Risk Management Program Proposed § 39.6(g)(2)(iii) requires the swap to be subject to a centralized risk management program that is “reasonably designed to monitor and manage the risks associated with the swap.” If at least one of the eligible affiliate counterparties is an SD or MSP, the centralized risk management requirement is satisfied by complying with the requirements of § 23.600. 40 40 17 CFR 23.600; Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflict of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 FR 20128 (Apr. 2, 2012). Five commenters generally supported proposed § 39.6(g)(2)(iii). AFR supported the proposed risk management program requirement and stated that dispensing with or weakening this condition, or any of the conditions, would heighten systemic risk and call into question the Commission's exemptive authority. Better Markets agreed that requiring a centralized risk management program was wholly appropriate and should be maintained as a requirement. Prudential and MetLife confirmed that both companies currently have centralized risk management programs and consider them to be consistent with current practice in the industry. Prudential noted that it structured its risk management system to allow only one affiliate to enter into swaps with third parties, which permits Prudential to impose a single credit limit on its market-facing counterparty relationships. MetLife's enterprise-wide risk management system provides all affiliates trading derivatives with affiliate-specific sets of guidelines and limits that are also included in enterprise-wide guidance and limits. Finally, CDEU expressed support for the centralized risk management program requirement, but requested that the Commission clarify that the level of risk management for inter-affiliate swaps not be interpreted as requiring the same level of risk management that end-users maintain for external third-party swaps. CDEU noted that most end users that use inter-affiliate swaps currently have robust centralized risk management programs in place to monitor all external swap risks and affiliates are required to follow group-wide risk polices. CDEU was supportive of the proposal so long as the requirement is interpreted reasonably and permits entities to “implement risk policies and procedures appropriate to the risks of a corporate group's inter-affiliate swaps.” Four commenters objected to the proposed requirement, suggested alternatives, and/or requested clarification. FSR stated that the condition should be eliminated because integrated risk management systems “are generally not established across international boundaries” and are not consistent with general risk practices in large, multinational organizations. FSR suggested that the requirement be dropped in favor of each entity making “its own evaluations of the risk associated with an inter-affiliate position.” Cravath stated that in many cases, for companies outside of the financial sector, the proposed rule will require a substantial change in the processes and procedures currently maintained by such companies, and the cost of complying with the risk management program requirements outweigh any benefits to the financial system. Cravath commented that rather than subject companies to a risk management rule, “[c]ompanies should have the flexibility to engage in prudent risk management for their corporate group in a manner consistent with the overall level of risks to their business.” EEI suggested that the Commission eliminate the centralized risk management program requirement on the grounds that it would be duplicative for corporate groups that already have risk management programs in place. According to EEI, it is standard industry practice for both private and public companies to have a risk management program. EEI accordingly does not see a “need to impose a separate, discrete regulatory requirement to document with an SDR or the Commission the existence of a centralized risk management program.” If the Commission decides to retain the requirement, EEI requested that the Commission require a program be “reasonably designed to monitor and manage the risks associated with the swap” and provide the flexibility to design risk management programs that address the unique risks of an entity's business. The Working Group requested that the Commission clarify whether non-SDs and non-MSPs would be subject to the same enterprise-level risk management program as required for SDs and MSPs under § 23.600. If the Commission intended to require the same level of risk management, The Working Group commented that there are “a number of commercially and legally valid reasons” why a centralized risk management program in accordance with § 23.600 would be inconsistent with current industry practice. The Working Group cited cost as a reason companies do not provide for centralized risk management on different continents, in addition to antitrust and other regulatory reasons. The Working Group requested that the Commission clarify that the rule requires only that both counterparties be subject to a “robust risk management program.” In response to comments, the Commission observes a general consensus that market participants have risk management policies and procedures in place, at least with regard to affiliates located in the same jurisdiction. FSR and The Working Group questioned whether entities have centralized risk management programs for affiliates in different jurisdictions and whether such cross-border risk management systems are prohibitively costly. In response to these comments, the Commission points to comments stating that inter-affiliate swaps play a critical role in an entity's overall management of risk and provide netting benefits among affiliates. Consequently, it stands to reason that inter-affiliate swaps between affiliates in different jurisdictions are as much a part of an entity's overall risk management framework as swaps between affiliates located in the same jurisdiction. The Commission does not believe that it would be prudent business practice for affiliates to enter into inter-affiliate swaps without risk management systems integrated across international boundaries to the extent that the entity permits affiliates across jurisdictions to enter into swaps with one another. In response to comments asking that the Commission clarify the level of risk management required for non-SDs and non-MSPs, the Commission confirms that the requirements of proposed § 39.6(g)(2)(iii) (now § 50.52(b)(3)) are intended to be flexible and do not require the same level of policies and procedures as required under § 23.600 for SDs and MSPs. Under the rule, a company is free to structure its centralized risk management program according to its unique needs, provided that the program reasonably monitors and manages the risks associated with its uncleared inter-affiliate swaps. In all likelihood, if a corporate group has a centralized risk management program in place that reasonably monitors and manages the risk associated with its inter-affiliate swaps as part of current industry practice, it is likely that the program would fulfill the requirements of proposed § 39.6(g)(2)(iii) (now § 50.52(b)(3)). The Commission did not receive comments regarding the requirement that SD and MSP affiliates must comply with § 23.600. 41 The Commission is adopting that provision of the rule as proposed. 41 17 CFR 23.600(c)(1)(ii) (“The Risk Management Program shall take into account risks posed by affiliates and the Risk Management Program shall be integrated into risk management at the consolidated entity level.”). Given that a number of commenters stated that it is common practice for market participants, including end users, to have risk management programs in place, the Commission is not persuaded by Cravath's comment that the rule will require a substantial change in the processes and procedures currently maintained by companies to manage risk. Accordingly, costs will be limited where an entity only needs to make modifications to existing risk management programs. Moreover, a corporate group may not have to incur any costs if it already has a risk management system that meets the requirements of the inter-affiliate exemption in place. F. Variation Margin Proposed § 39.6(g)(2)(iv) required that variation margin be collected for swaps between affiliates that are financial entities, in compliance with the proposed variation margin requirements in proposed § 39.6(g)(3). 42 The rule further proposed an exception to the variation margin requirement for 100% commonly-owned and commonly-guaranteed affiliates, provided that the common guarantor is under 100% common ownership. 42 The Commission also requested comments on, among other things, whether the Commission should promulgate regulations that set forth minimum standards for initial margin for inter-affiliate swaps. Some commenters expressed support for the proposed variation margin requirement. Prudential commented that it did not take issue with the variation margin requirement, but noted that variation margin may not be appropriate or required in every circumstance. 43 Prudential also commented that the Commission should not impose initial margin requirements for the inter-affiliate exemption. 44 Chris Barnard agreed that the Commission should require the exchange of variation margin for financial entities and noted that the exchange of variation margin is consistent with the key principles proposed by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO). 45 Better Markets expressed support for the variation margin requirement and commented that it should be expanded to non-financial entities. 46 AFR expressed support for the variation margin proposal. Both Better Markets and AFR also expressed support for the requirement that affiliates post initial margin for inter-affiliate swaps subject to the exemption. 47 43 Prudential also commented that there is “no less costly risk-management tool” than variation margin. 44 MetLife also commented that the Commission should not impose initial margin requirements for the inter-affiliate exemption. 45 See Margin Requirements for Non-Centrally-Cleared Derivatives, Consultative Report (July 2012), available at http://www.bis.org/publ/bcbs226.pdf. 46 Better Markets also suggested that the Commission ban the rehypothecation of collateral. 47 Better Markets commented that initial margin should be required because initial margin is the true “statistical estimate of the potential consequences of a default” and that variation margin is merely the “daily recalibration” of the risk estimation of initial margin. Several commenters stated that the proposed variation margin requirement for swaps between affiliates that are financial entities is not necessary and should not be a condition of the inter-affiliate exemption to clearing. 48 ISDA & SIFMA commented that the benefits of variation margin for inter-affiliate swaps are “tenuous” because the third party to a swap is exposed to the credit risk of the entire group not just the specific affiliate with which it enters into a swap. ISDA & SIFMA maintain that it is not necessary to protect group entities from the credit risk of other group entities because group management possesses the tools needed to resolve potential defaults within the group. According to ISDA & SIFMA, the Commission can fully achieve its regulatory mandate to protect third-party swap counterparties through the application of the clearing requirement to those outward-facing swaps that are subject to the Commission's regulation, as well as regulation of those group entities whose outward-facing swap activities are sufficiently large to subject them to SD and MSP registration. 49 48 Cravath commented that variation margin requirements “tie up capital that could otherwise be used for investment purposes to create jobs and goods and services for the economy.” MetLife commented that while it is subject to variation margin under state insurance law, MetLife believes that the Commission should eliminate the variation margin requirement for 100%-owned affiliates and should not require “inter-affiliate guarantees.” DLA Piper also urged the Commission to provide corporate groups with legal certainty that no margin requirements will be imposed on any inter-company swaps. 49 ISDA & SIFMA claimed that the additional liquidity demands resulting from variation margin will distort the group's risk management choices. ISDA & SIFMA further claimed that while they have previously stated that inter-affiliate margin occurs “routinely,” this does not mean that it occurs “uniformly” or that imposing variation margin would not increase cost. FSR commented that affiliates should be required to post margin only in instances where their primary regulator imposes such a requirement for affiliate transactions. 50 FSR states that requiring variation margin for inter-affiliate swaps involving non-bank financial entities will limit the ability of companies to efficiently allocate risk among affiliates and manage risk centrally. 51 FSR further commented that initial margin should not be required between affiliates, and requested that the Commission clarify that the exemption does not require the exchange of initial margin between affiliates. 50 Citing to sections 23A and 23B of the Federal Reserve Act and Regulation W as well as public utility, insurance, and investment company law, FSR commented that a number of regulated entities may be subject to various restrictions on affiliate transactions and that for purposes of the inter-affiliate exemption, margin requirements should only apply “to the extent other applicable law . . . imposes such restrictions on affiliate transactions.” FSR also points out that subsidiaries of banks are “generally not treated as `affiliates' ” within the restrictions of sections 23A and 23B of the Federal Reserve Act. 51 FSR further requested that the Commission clarify that to the extent that financial entities are required, through credit support arrangements with their affiliates, to have minimum transfer amounts, thresholds, and other similar arrangements in place, that such arrangements would be permitted in connection with inter-affiliate swaps relying on the inter-affiliate exemption. CDEU commented that the Commission should not require variation margin, or initial margin, with respect to inter-affiliate swaps between end-user affiliates. According to CDEU, while margin requirements may serve as a risk-management tool for market-facing swaps, inter-affiliate swaps do not increase counterparty credit risk or contribute to interconnectedness among market participants. CDEU stated that a number of specific entities, including banks and insurance companies, already post variation margin for inter-affiliate swaps, largely because of prudential requirements, and that applying variation margin requirement to these entities is unnecessary. 52 CDEU requested that if the Commission retains the variation margin requirement, that it limit the exchange of variation margin to SDs and MSPs, and that the requirement should not apply to entities that are considered “financial entities.” 52 Moreover, CDEU claims that many inter-affiliate swaps between end-user corporate groups are not subject to variation margin requirements, and that these entities likely will not have the liquidity to exchange variation margin, and would likely be required to borrow the money from the centralized hedging unit with which it is entering the internal swap. Such an arrangement, according to CDEU, would transfer the loan back to the centralized hedging unit and effectively eliminate any perceived benefit from the exchange of variation margin. With respect to the proposed common guarantor exception to the variation margin requirement, ISDA & SIFMA commented that the Commission has not provided adequate rationale for requiring a common guarantor as a condition for exempting group members from the proposed variation margin requirement, nor has the Commission made it clear which obligations must be guaranteed. ISDA & SIFMA requested that the Commission further clarify the guarantee exception in proposed § 39.6(g)(2)(iv), including to clarify that it includes “direct or indirect” ownership, and that swaps between the common guarantor and its affiliates are eligible for the exception. 53 53 ISDA requested that the Commission clarify that the shareholders of a publicly-owned holding company are the common owners and that its 100% owned subsidiaries meet the definition of “100% commonly owned,” and further stated that the Commission should address the consequences of a guarantee of a swap being considered a swap itself. CDEU commented that the Commission should not limit the guarantee exception to 100% commonly-owned affiliates and should allow the exception for majority-owned affiliates. CDEU requested that the Commission clarify that only the related market-facing swaps with third parties are required to be guaranteed by the common owner or parent. CDEU suggested that the Commission clarify that the parent company has the option to act as the guarantor of the transactions. FSR commented that the variation margin requirement should not apply to 100% commonly-owned affiliates even if they do not have a common guarantor that is under 100% common ownership. According to FSR, the 100% common ownership requirement creates sufficient alignment of interests between swap counterparties and places the risk of the swap on the ultimate parent entity, and thus, the exchange of variation margin would do little to mitigate intercompany risk. MetLife and Prudential commented that inter-affiliate swaps should not be commonly guaranteed by a 100% wholly-owned affiliate in order to be exempt from the variation margin requirement. Specifically, MetLife stated that the Commission should not require guarantees or explicit credit support as a condition for an exception from the variation margin requirement and should rely instead on the direct or indirect common ownership requirement. Both MetLife and Prudential stated that the corporate group of 100% wholly owned affiliates should be able to decide whether internal swaps need to be guaranteed by an affiliate. After considering the comments submitted in response to the proposed variation margin requirement, the Commission is determining not to require variation or initial margin as a condition for electing the inter-affiliate exemption. In so doing, the Commission was guided by comments expressing concern that a variation margin requirement will limit the ability of U.S. companies to efficiently allocate risk among affiliates and manage risk centrally. Notwithstanding the Commission's determination not to impose variation margin as a condition of the inter-affiliate exemption, the Commission is encouraged by comments noting that many companies already exchange variation margin, and agrees with commenters that collateralizing risk exposure with respect to any swaps, including inter-affiliate swaps, is critical, and encourages market participants to do so as a matter of sound business practice. G. Treatment of Outward-Facing Swaps and Relief Proposed § 39.6(g)(2)(v) provided that eligible affiliate counterparties to a swap may elect the inter-affiliate exemption from clearing provided that each affiliate counterparty either: (i) Is located in the United States; (ii) is located in a jurisdiction with a clearing requirement that is comparable and comprehensive to the clearing requirement in the United States; (iii) is required to clear swaps with non-affiliated parties in compliance with U.S. law; or (iv) does not enter into swaps with non-affiliated parties. 54 54 In this release, the requirements of proposed § 39.6(g)(2)(v), which are now being adopted in new § 50.52(b)(4), are referred to as the “treatment of outward-facing swaps condition.” The Commission received several comments both in support of and in opposition to various aspects of the conditions related to the treatment of outward-facing swaps in proposed § 39.6(g)(2)(v). The Commission has considered each of the comments and has determined to adopt the treatment of outward-facing swaps conditions of the inter-affiliate exemption, with certain modifications described below, because such conditions are necessary to prevent evasion of the clearing requirement and to help protect the U.S. financial markets. The remainder of this Section II.G describes the comments received in response to proposed § 39.6(g)(2)(v) (now § 50.52(b)(4)), along with the Commission's responses and clarifications with respect to those comments. 1. Basis for the Cross-border Conditions While recognizing the benefits of exempting certain inter-affiliate transactions from the clearing requirement, in the NPRM, the Commission described two separate grounds for proposing the treatment of outward-facing swaps condition to the inter-affiliate exemption. First, the Commission explained that an inter-affiliate exemption from required clearing could enable entities to evade the clearing requirement through trades with affiliates that are located in foreign jurisdictions that do not have a comparable and comprehensive clearing regime. In addition, the Commission noted in the NPRM that uncleared inter-affiliate swaps may pose risk to other market participants, and therefore, the financial system if the affiliate enters into swaps with third parties that are related on a back-to-back or matched book basis with inter-affiliate swaps. In support of the proposed treatment of outward-facing swaps conditions, AFR stated that inter-affiliate swaps could, without appropriate restrictions, bring risk back to the U.S. from foreign affiliates. AFR commented that an inter-affiliate swap might be used to move parts of the U.S. swaps market outside of U.S. regulatory oversight by transferring risk to jurisdictions with little or no regulatory oversight, whereby a non-U.S. affiliate of a U.S. entity could enter into an outward-facing swap. AFR stated that an inter-affiliate swap could contribute to financial contagion across different groups within a complex financial institution, making it more difficult to “ring-fence” risks in one part of an organization. AFR further commented that laws and regulations of a foreign country might prevent U.S. counterparties to swaps from having access to the financial resources of an affiliate in the event of a bankruptcy or insolvency. 55 The inability of an affiliate to access resources in other jurisdictions, according to AFR, may threaten the ability of U.S. creditors to retrieve assets and may put U.S. taxpayers at risk. 56 Better Markets also supported the proposed treatment of outward-facing swaps condition. 57 55 AFR suggested that the Commission consult with the U.S. banking agencies, such as the FDIC, regarding the potential issues relating to bankruptcy of non-U.S. affiliates. As noted above, the Commission has consulted with both U.S. and international authorities in preparing this adopting release. In response to AFR's comments pertaining to the limitations of foreign bankruptcy laws, the Commission notes that the specific bankruptcy limitations attendant to U.S. counterparties with respect to their non-U.S. affiliates are outside the scope of this rulemaking. The Commission further notes that the conditions imposed by the rules being adopted in this release, in large part, are aimed at ensuring that the benefits of central clearing, particularly with respect to counterparty and systemic risk mitigation, are maintained with respect to inter-affiliate swaps involving non-U.S. affiliates. Specifically, the Commission believes that the conditions imposed by the rules being adopted in this release will help to mitigate potential issues that could arise in uncleared inter-affiliate swaps when financial solvency is not an issue for the corporate enterprise. Furthermore, these conditions may, to some extent, diminish the impact of swaps in transmitting losses across affiliates, and in turn, to third-party creditors, following a default. 56 AFR also noted restrictions under U.S. banking law with respect to the transfer of risk from non-depository to depository institutions, and stated that it may be necessary to require “ring-fencing” and separate capitalization of swaps affiliates. The Commission believes that these issues are outside of the scope of this rulemaking, and as AFR correctly noted, may be an issue that is more appropriate for the prudential regulators of such entities to consider. 57 Prudential also commented that in relation to its own structure, it did not have concerns with the proposed cross-border conditions applicable to inter-affiliate swaps involving foreign affiliates. By contrast, ISDA & SIFMA, The Working Group, and CDEU all stated that the treatment of outward-facing swaps condition of the proposed rule is not necessary or appropriate and that the Commission should eliminate it altogether. FSR commented that the inter-affiliate exemption should extend to swaps between non-U.S. affiliates, such that the swaps should not be subject to mandatory clearing or margin requirements, even if the affiliated parties are financial entities. Certain commenters stated that the proposed treatment of outward-facing swaps condition is not necessary to prevent evasion. ISDA & SIFMA noted that the Commission's existing anti-evasion authority 58 can address the anti-evasion objectives of the proposed condition, and the CDEU made a similar argument with respect to the Commission's new anti-evasion authority under section 721(c) of the Dodd-Frank Act. ISDA & SIFMA further noted that the Commission should limit application of its anti-evasion authority to instances where a foreign affiliate engages in a pattern of back-to-back swaps with the U.S. affiliate and where neither the affiliates nor the third-party counterparty are subject to capital regulation. 59 58 See e.g., Section 2(i)(2) of the CEA (providing authority to promulgate rules addressing activities outside of the U.S. to prevent evasion of the Dodd-Frank Act); section 2(h)(4) of the CEA (requiring the Commission to issue rules to prevent evasion of the mandatory clearing requirement); section 721(c) of the Dodd-Frank Act (requiring the Commission to promulgate a rule defining certain terms to prevent evasion of the Dodd-Frank Act). 59 Entities that are subject to capital regulations include SDs, MSPs, and banking entities subject to prudential regulation. Other commenters opposed the proposed treatment of outward-facing swaps condition based on their view that inter-affiliate swaps involving non-U.S. affiliates do not pose a risk to the U.S. financial markets. CDEU commented that the proposed “comparable and comprehensive” condition is not necessary or appropriate to reduce risk and prevent evasion because, according to CDEU, transactions between affiliates do not increase systemic risk, regardless of the location of the affiliate. 60 ISDA & SIFMA stated that the concern that foreign inter-affiliate swaps pose risk to the U.S. financial system is unfounded because internal swaps have no conclusive effect on systemic risk. 61 60 CDEU further stated that inter-affiliate swaps do not create systemic risk. 61 Prudential also stated that it does not believe that there are any additional risk implications of cross-border inter-affiliate swaps for the U.S. market, to the extent that the market-facing entity is located in the U.S. The Commission has considered these comments, and for the reasons described below, has determined to retain the treatment of outward-facing swaps condition to the inter-affiliate exemption, with certain modifications and amendments, in order to address comments and provide greater clarity. i. Prevention of Evasion As an initial matter, as discussed above, the Commission believes that the benefits of inter-affiliate swaps for entities in affiliated groups warrant the Commission's use of its exemptive authority under section 4(c) of the Act to exclude certain inter-affiliate swaps from the clearing requirement. However, the Commission must exercise its exemptive authority in view of the Commission's charge under the CEA to prevent evasion of the clearing requirement. 62 The Commission remains concerned that absent the treatment of outward-facing swaps condition, the inter-affiliate exemption from clearing may create a ready means through which some U.S. entities may be able to evade the clearing requirement. Accordingly, the Commission believes that the treatment of outward-facing swaps condition to the inter-affiliate clearing exemption is necessary to address the potential for evasion. 62 See sections 2(h)(4) and 2(i)(2) of the CEA. Section 2(h)(4)(A) of the CEA requires that “the Commission shall prescribe rules * * * as determined by the Commission to be necessary to prevent evasions of the clearing requirement under this Act.” 63 As the Commission explained in the NPRM, and as AFR also described in its comments, a broad inter-affiliate exemption from the clearing requirement could enable entities to evade the clearing requirement potentially through third-party trades with their foreign affiliates that are located in jurisdictions that do not have a clearing regime that is comparable to, or as comprehensive as, the Commission's clearing requirement. For example, rather than execute a swap opposite a U.S. counterparty, which would be subject to the clearing requirements of section 2(h) of the Act, a U.S. entity could execute an uncleared swap with its foreign affiliate or subsidiary, which could then execute a swap with a non-affiliated third-party in a jurisdiction that is either unregulated or does not have a clearing requirement that is comparable to or as comprehensive as the U.S. clearing requirement. 63 7 U.S.C. 2(h)(4). The Commission disagrees with commenters that suggest that the treatment of outward-facing swaps condition is not necessary to deter evasion because the Commission can rely on its general anti-evasion authority under the CEA or under section 721(c) of the Dodd-Frank Act to address the Commission's evasion concerns pertaining to the inter-affiliate exemption. The Commission notes that section 2(h)(4)(A) of the CEA specifically imposes an obligation on the part of the Commission to “prescribe rules” and “issue interpretations of rules” that are necessary to prevent evasions of the clearing requirement. 64 Furthermore, from an enforcement perspective, a specific regulation provides more transparency to market participants with respect to the Commission's enforcement program. While the Commission has ample general authority to prevent evasion of the CEA and the swaps-related provisions of the Dodd-Frank Act, the Commission believes it is appropriate to impose the treatment of outward-facing swaps condition to the inter-affiliate exemption to prevent evasion of the clearing requirement. 64 Under the authority of sections 2(h)(4)(A), 2(h)(7)(F), and 8a(5) of the CEA, the Commission recently adopted § 50.10 to prohibit evasions of the requirements of section 2(h) of the CEA, including the end-user exception or any other exception or exemption that the Commission may provide by rule, regulation, or order. See Clearing Requirement Determination at 74317-19. In response to ISDA & SIFMA's claim that anti-evasion authority should only be applied in limited scenarios where there are back-to-back trades involving affiliates and non-affiliates who are not subject to capital requirements, the Commission declines to pre-judge the potential incentives or ways of evading, or complying with, the Commission's clearing requirement and the inter-affiliate exemption from clearing. To the extent that ISDA & SIFMA suggest that the treatment of outward-facing swaps condition should be limited to transactions involving back-to-back trades where the affiliates and the respective third-party are subject to capital requirements, the Commission is not persuaded that the rule should be so narrowly tailored to address only the scenario ISDA & SIFMA describe. In particular, the Commission notes that back-to-back transactions may not serve as the only potential means by which affiliates can evade the U.S. clearing mandate, and for that matter, transfer risk to one another. Accordingly, the Commission does not believe that the treatment of outward-facing swaps condition should be limited to the specific circumstances described by ISDA & SIFMA. ii. Protection of Financial Markets In addition to preventing evasion, the Commission believes that the treatment of outward-facing swaps condition will help to limit the potential transfer of risks to U.S. companies and financial markets that may result from third-party swaps between affiliates and non-affiliated entities domiciled in jurisdictions that do not regulate swaps or where the regulation is not comparable to, or as comprehensive as, the CEA and Commission regulations. As described in the preceding sections of this adopting release, there are numerous benefits associated with central clearing of swaps. In particular, clearing mitigates counterparty credit risk, provides an organized mechanism for collateralizing the risk exposures posed by swaps, and when applied on a market-wide scale, clearing reduces systemic risk. The counterparty and systemic risk mitigation benefits of central clearing are also realized from clearing transactions between affiliates. The benefits of clearing notwithstanding, the Commission recognized in the NPRM, commenters' assertions that there is less counterparty risk associated with inter-affiliate swaps than with swaps between third parties to the extent that the affiliated counterparties that are members of the same corporate group internalize each other's counterparty credit risk. 65 While the Commission recognizes, generally, the benefits of inter-affiliate swaps and the incentives for inter-affiliates to fulfill their inter-affiliate swap obligations to each other, these swaps are not immune from some of the risks that are associated with swaps between non-affiliated parties. 65 See NPRM at 50427. In particular, the Commission is not persuaded that inter-affiliate swaps, and swaps between affiliate counterparties outside the U.S. and non-affiliated counterparties, pose no risks to the U.S financial markets or that central clearing would not mitigate the risks associated with such swaps. To the contrary, the counterparty and systemic risks associated with inter-affiliate swaps are heightened where, for example, the inter-affiliate transaction involves an uncleared swap with a foreign affiliate counterparty that is subsequently hedged with a third-party uncleared swap. Thus, the Commission disagrees with commenters that suggested that inter-affiliate swaps involving foreign affiliates do not have the potential to create systemic risk. As the Commission noted in the NPRM, systemic risk implications may be present where the foreign affiliate has large inter-affiliate swap positions and enters into related outward-facing swaps. If the foreign affiliate defaults on its obligations arising from the inter-affiliate swaps, it then increases the likelihood that the foreign affiliate could default on the outward-facing swaps, potentially jeopardizing the financial integrity of the third-party counterparty. Furthermore, to the extent that a foreign affiliate enters into both inter-affiliate swaps and related third-party swaps, any losses incurred by the foreign affiliate with respect to its inter-affiliate swaps may flow not only to the unaffiliated third-party counterparty, but conceivably, to the broader financial system. 66 66 In the Proposed Cross-Border Interpretive Guidance, the Commission specifically discussed the flow of risk to the U.S. by entities that facilitate a U.S. person's ability to execute swaps outside the Dodd-Frank Act regulatory regime. 77 FR 41228-29, 41234. Moreover, the Commission notes AFR's comment that inter-affiliate swaps can, in some circumstances, contribute to financial contagion across different groups within a complex financial institution, making it more difficult to contain risks in one part of an organization. As evidenced by the events surrounding the 2008 financial crisis, many large financial institutions are interconnected and highly inter-dependent, with affiliated legal entities that are inextricably linked to each other. 67 The interconnected nature of corporate groups, therefore, increases the potential that risk in any part of a corporate group may spread throughout the organization, jeopardizing the financial integrity of not only the U.S affiliate, but depending on the scope of a potential default, the broader financial system. 67 For a discussion of specific institutional risks leading up to the 2008 financial crisis, see Proposed Cross-Border Interpretive Guidance at 41215-16. For the aforementioned reasons, the Commission believes that the risk of evasion of U.S. laws and the potential systemic risk associated with uncleared inter-affiliate swaps involving foreign affiliates necessitates that the inter-affiliate exemption include the treatment of outward-facing swaps condition. The treatment of outward-facing swaps condition that is being adopted as part of the inter-affiliate clearing exemption in this final release is aimed at addressing the potential risks associated with an eligible foreign affiliate's swaps with non-affiliated counterparties. As modified, the final rule requires that, as a condition to the inter-affiliate exemption, each eligible affiliate counterparty must clear all swaps that it enters into with an unaffiliated counterparty to the extent that the swap is included in the Commission's clearing requirement, i.e., in a class of swaps identified in § 50.4. 68 In order to satisfy this requirement, eligible affiliate counterparties must clear their third-party swaps pursuant to the Commission's clearing requirement or comply with the requirements for clearing the swap under a foreign jurisdiction's clearing mandate that is comparable, and comprehensive but not necessarily identical, to the clearing requirement of section 2(h) of the Act and part 50 of the Commission's regulations, as determined by the Commission. In addition, the Commission is modifying the inter-affiliate exemption to allow for recognition of clearing exceptions and exemptions under the CEA and an exception or exemption under a foreign clearing mandate provided that the foreign jurisdiction's clearing mandate is comparable, and comprehensive but not necessarily identical, to the clearing requirement of section 2(h) of the Act and part 50 and the foreign jurisdiction's exception or exemption is comparable to an exception or exemption under the CEA or part 50, in each instance as determined by the Commission. 68 Currently, the scope of the Commission's clearing requirement is limited to four classes of interest rate swaps and two classes of CDS. For eligible affiliate counterparties that are not located in the U.S. or in a comparable foreign jurisdiction, as determined by the Commission, the rule permits such eligible affiliates to clear any outward-facing swap that is required to be cleared under § 50.4 through a registered DCO or a clearing organization that is subject to supervision by appropriate government authorities in the home country of the clearing organization and has been assessed to be in compliance with the Principles for Financial Market Infrastructures (PFMIs). 69 69 See Principles for Financial Market Infrastructures, April 2012, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf. The Commission believes that this modified formulation of the treatment of outward-facing swaps condition being adopted as part of the final rule will more clearly establish the conditions to the exemption and alternative methods by which eligible affiliates may satisfy the requirements. Moreover, in finalizing the requirement that eligible affiliate counterparties clear their swaps with unaffiliated counterparties, the Commission considered the approach adopted in EMIR. Articles 3, 4, and 13 of EMIR generally exempt from clearing OTC derivatives transactions between intragroup counterparties, where one counterparty is located in the European Union and the other counterparty is located outside the European Union, provided that, among other things, the European Commission determines that the foreign counterparty is established in a country with “equivalent” requirements to EMIR. 70 By requiring that a foreign counterparty to an intragroup transaction be located in a country with equivalent requirements to EMIR, including clearing, any third-party swaps entered into by either the European Union counterparty or the non-European Union counterparty would be subject to a clearing requirement under EMIR or one that is equivalent to that required under EMIR, respectively. 70 See EMIR Article 13(1)-(3). The European Union has yet to make determinations as to whether third countries have equivalent requirements to EMIR. The European Commission (EC) has instructed the European Securities and Markets Authority (ESMA) to prepare possible implementing acts concerning the equivalence between the legal and supervisory frameworks of certain third countries and EMIR. Pursuant to the EC's instructions, ESMA must make its determination regarding the United States' clearing requirement by March 15, 2013. “Formal Request to ESMA for Technical Advice on Possible Implementing Acts Concerning Regulation 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories (EMIR)” available at http://www.esma.europa.eu/system/files/formal_request_for_technical_advice_on_equivalence.pdf. In addition to the modifications to the treatment of outward-facing swaps condition described above, the Commission also is providing a transition period with alternative compliance frameworks, in response to concerns raised by commenters pertaining to the timing and sequencing of the implementation of the inter-affiliate exemption, which are discussed below. 2. Time-limited Alternative Compliance Frameworks A number of commenters expressed concern with respect to the “comparable and comprehensive” requirement of the proposed rule. Several commenters expressed concern with respect to the timing and sequencing of the Commission's comparability determination in relation to the expected compliance date for the initial clearing requirement under section 2(h) of the Act. 71 These commenters noted that the comparability requirement is dependent upon the adoption of clearing regimes by other jurisdictions, and that because the U.S. clearing requirement is likely to take effect in advance of other jurisdictions adopting or finalizing their clearing regimes, non-U.S. affiliates effectively will not be able to rely on the inter-affiliate exemption from clearing when the Commission's initial clearing requirement takes effect. Significantly, ISDA & SIFMA commented that the cross-border condition may prove to be unnecessary because it is expected that the major financial jurisdictions will implement their own clearing regimes. However, ISDA & SIFMA and CDEU noted that questions of timing and criteria for comparability render the proposed treatment of outward-facing swaps condition problematic, and that unless the condition is satisfactorily resolved, the condition could hamper the ability of U.S.-based groups to compete in foreign markets. ISDA & SIFMA further commented that if the Commission retains the cross-border requirements, the Commission should provide an appropriate transition period in order to allow foreign jurisdictions to implement their own G-20 mandates. 71 See Clearing Requirement at 74319-21 (discussing the compliance dates for the first clearing requirement determination). The Working Group commented that because no other jurisdiction has a comparable clearing requirement, 72 the proposed rule would impose an obligation on almost all non-U.S. persons to comply with the U.S. clearing requirement in the event such entities wanted to engage in a non-hedge swap that was subject to mandatory clearing with a U.S. person affiliate. The Working Group claimed that this limitation would render the exemption unusable and questioned the public policy benefit of extending the clearing requirement in such instances. The Working Group further commented that the proposed rule represents a broad extension of U.S. law by, in effect, imposing the clearing requirement under section 2(h)(1)(A) on non-U.S. persons that enter into swaps with U.S. person affiliates in order to satisfy the conditions of the inter-affiliate exemption. AFR supported the comparability condition and suggested that the Commission should grant the inter-affiliate exemption only with respect to foreign affiliate swaps once foreign jurisdictions finalize and implement their own clearing requirements. 72 This assertion is no longer accurate. As discussed below, Japan has adopted a clearing mandate for certain interest rate swaps and CDS. The Commission recognizes commenters' concerns pertaining to the timing and sequencing of the inter-affiliate exemption in light of the Commission's clearing requirement, and in view of the ongoing progress of other jurisdictions to adopt and implement their respective clearing regimes. Accordingly, the Commission has determined to modify the proposed rule, as described in this release. As an initial matter, and informed in large part by the reports of relevant international organizations and ongoing dialogue with international regulators, the Commission believes that many jurisdictions have made significant progress in implementing their clearing regimes. It is the Commission's understanding that the G-20 Leaders reaffirmed their commitment that all standardized OTC derivatives should be cleared through central counterparties by end-2012. 73 Importantly, the majority of G-20 members with major financial markets have been preparing for mandatory clearing, and significant steps towards further implementation have been taken by the United States, Japan, Singapore, and the European Union. In Japan, for example, the Japanese Financial Services Authority (JFSA) cabinet office ordinance regarding central counterparties and trade repositories which, among other things, subjects certain transactions to mandatory central clearing, became effective on November 1, 2012. The JFSA initially requires certain financial institutions to clear yen-denominated interest rate swaps that reference Yen-LIBOR, and CDS based on the Japanese iTraxx indices at a licensed CCP. 73 “G20 Leaders Declaration Los Cabos Mexico” (June 18-19, 2012) at paragraph 39. According to the October 2012 Report of the Financial Stability Board (FSB), 10 out of the 19 members of the G-20 group have either proposed or adopted legislation and/or regulations to implement their clearing framework, as of the date of that release. FSB, OTC Derivatives Market Reforms: Fourth Progress Report on Implementation, Oct. 31, 2012 at 74-77, available at https://www.financialstabilityboard.org/publications/r_121031a.pdf. On November 15, 2012, the Singapore Parliament passed the Securities and Futures (Amendment) Bill 2012 to amend the Singapore Securities and Futures Act (SFA). This bill puts in place the regulatory regime for OTC derivatives in Singapore. This legislation institutes mandatory reporting and clearing requirements for financial entities and large non-financial entities. The Monetary Authority of Singapore is deliberating how to implement these legislative requirements and is expected to issue further consultation in 2013. In the European Union, EMIR entered into force on August 16, 2012, and requires the clearing of all OTC derivatives subject to the clearing obligation. Clearing determinations are made at the initiative of the national authorities or the European Securities and Markets Authority (ESMA). Within six months of ESMA receiving notification by a national authority that a central counterparty has been authorized to clear a class of OTC derivatives, ESMA must determine whether that the class of OTC derivatives should be subject to the clearing obligation. At its own initiative, ESMA can also identify classes of OTC derivatives that should be subject to the clearing obligation. Additional details regarding the specific manner in which clearing determinations will be made have been set forth in implementing regulations adopted by the European Commission on December 19, 2012. 74 74 See http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm. As evidenced by the progress of these jurisdictions, and others that host major financial markets across the world in implementing their clearing frameworks, the Commission agrees with ISDA & SIFMA that the comparability requirement of the inter-affiliate exemption is unlikely to pose a significant impediment to the use of the inter-affiliate exemption by most foreign affiliates because it is expected that the major financial jurisdictions will implement their own mandatory clearing regimes. Notwithstanding the progress of other jurisdictions to implement their clearing regimes, as discussed above, the Commission is mindful of commenters' concerns that the compliance timeframe for the clearing requirement in the U.S. is likely to precede the adoption and/or implementation of the clearing regimes of most other jurisdictions. Accordingly, the Commission believes that it is important to provide for a transition period for foreign regimes to implement their clearing mandates to bring swaps into clearing. For certain eligible affiliate counterparties located in jurisdictions that have adopted swap clearing regimes and are currently in the process of implementation, namely Japan, the European Union, and Singapore, the Commission is modifying the proposed rule to allow for a transition period of one year from the first compliance date of the U.S. clearing mandate, until March 11, 2014, for those foreign jurisdictions that are working to implement their mandatory clearing regimes. 75 The Commission believes that a transition period of 12 months after required clearing began in the U.S. is appropriate given its understanding of the progress being made on mandatory clearing in the specified foreign jurisdictions. Regulation 50.52(b)(4)(ii)(A) provides that during that one-year period, affiliates domiciled in such foreign jurisdictions can satisfy the requirements of § 50.52(b)(4)(i) through the following: (i) Each eligible affiliate counterparty, or a majority-interest holder on behalf of both eligible affiliate counterparties, pays and collects full variation margin daily on all its swaps with unaffiliated counterparties; or (ii) each eligible affiliate counterparty, or a majority-interest holder on behalf of both eligible affiliate counterparties, pays and collects full variation margin daily on all its swaps with other eligible affiliate counterparties. 75 While the time-limited alternative compliance framework of § 50.52(b)(4)(ii) is limited to jurisdictions that currently have the legal authority to adopt mandatory clearing regimes, any jurisdiction that later adopts a mandatory clearing regime will be eligible for a comparability determination for purposes of this rule. Moreover, the Commission has determined to provide further time-limited relief for certain eligible affiliated counterparties located in the European Union, Japan, or Singapore from complying with the requirements of § 50.52(b)(4)(i) (or (b)(4)(ii)(A)) as a condition of electing the inter-affiliate exemption. In particular, § 50.52(b)(4)(ii)(B) provides that if one of the eligible affiliate counterparties is located in the European Union, Japan, or Singapore, the requirements of paragraph (b)(4)(i) will not apply to such eligible affiliate counterparty until March 11, 2014, provided that two conditions are met. The first condition provides that the one counterparty that directly or indirectly holds a majority ownership interest in the other counterparty or the third party that directly or indirectly holds a majority ownership interest in both counterparties is not a “financial entity” as defined in section 2(h)(7)(C)(i) of the Act. 76 The second condition requires that neither eligible affiliate counterparty is affiliated with an entity that is an SD or MSP, as defined in § 1.3. This condition essentially requires that the eligible affiliate counterparties are not part of a corporate group with a member affiliate that is an SD or MSP. Accordingly, eligible affiliate counterparties that are located in European Union, Japan, or Singapore and meet these two conditions, are exempt from the requirements of § 50.52(b)(4)(i) until March 11, 2014. The Commission believes that providing the time-limited exemption in § 50.52(b)(4)(ii)(B) to the specific entities described above is consistent with comments requesting that the exchange of variation margin requirement, to the extent retained, be limited to SDs and MSPs. Specifically, ISDA & SIFMA noted in their comments that the scope of the Commission's regulatory concern should be limited to SDs and MSPs, and that the regulatory regime applicable to SDs already contained applicable safeguards, including variation margin requirements. Similarly, CDEU commented that any variation margin requirements be limited to SDs and MSPs. 76 For purposes of meeting the requirements of § 50.52(b)(4)(ii)(B)(1) until March 11, 2014, the holding company ( i.e., the ultimate parent of the corporate group) may not be considered to be a “financial entity,” as defined in section 2(h)(7)(C)(i) of the CEA, under certain circumstances. The holding company must be able to identify all affiliates that meet the requirements of § 50.52(a). Of those identified affiliates, a predominant number must qualify for the end-user exception under § 50.50. If a predominant number of the affiliates meeting the requirements of § 50.52(a) qualify for the end-user exception under § 50.50, then the holding company may treat the activities of all of its affiliates meeting the requirements of § 50.52(a) as if the holding company was engaged directly in such activities and consider such affiliates' activities on a cumulative basis with the holding company's other activities when assessing whether the holding company is “predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956” under section 2(h)(7)(C)(i)(VIII) of the CEA. In effect, the holding company may “look through” its investment in affiliates to all of the activities of the affiliates meeting the requirements of § 50.52(a). Accordingly, the activities of affiliates meeting the requirements of § 50.52(a) that are not in the business of banking or financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956, would be attributed to the holding company. Conversely, if the affiliates meeting the requirements of § 50.52(a) are engaged in activities that are in the business of banking or of a financial nature, then those activities would be attributed to the holding company for purposes of determining whether the holding company is a financial entity for purposes of meeting the requirements of § 50.52(b)(4)(ii)(B)(1). For eligible affiliate counterparties that are located in jurisdictions other than the European Union, Japan or Singapore, the Commission also is providing another time-limited alternative compliance framework for meeting the requirements of § 50.52(b)(4)(i). Specifically, § 50.52(b)(4)(iii) provides that if an eligible affiliate counterparty located in the United States enters into swaps (that are included in a class of swaps identified in § 50.4), with eligible affiliate counterparties located in jurisdictions other than the United States, the European Union, Japan, and Singapore, and the aggregate notional value of such swaps, which are included in a class of swaps identified in § 50.4 does not exceed five percent of the aggregate notional value of all swaps, which are included in a class of swaps identified in § 50.4, in each instance the notional value as measured in U.S. dollar equivalents and calculated for each calendar quarter, held by the eligible affiliate counterparty located in the United States, then such swaps shall be deemed to satisfy the requirements of paragraph (b)(4)(i) until March 11, 2014, provided that: (A) Each eligible affiliate counterparty, or a third party that directly or indirectly holds a majority interest in both eligible affiliate counterparties, pays and collects full variation margin daily on all swaps entered into between the eligible affiliate counterparties located in jurisdictions other than the United States, the European Union, Japan, and Singapore and an unaffiliated counterparty; or (B) each eligible affiliate counterparty, or a third party that directly or indirectly holds a majority interest in both eligible affiliate counterparties, pays and collects full variation margin daily on all of the eligible affi [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2013-07970. Public record. Not legal advice.