Big Blow to Banks as CFTC Policy Change Is Upheld

     (CN) – A federal judge dealt a blow to big-banking interests by upholding a policy extending regulatory reach to the overseas subsidiaries of U.S. financial firms involved in derivative swaps.
     The Commodity Futures Trading Commission (CFTC) announced a new policy regarding cross-border derivative swaps in July 2013, trying to address a problem made clear by the 2008 financial crisis: that the investment decisions of foreign offices had major ramifications for U.S. financial firms.
     American International Group nearly failed because of the risks incurred by swaps made by its London-based subsidiary, AIG Financial Products – but the U.S. government bore the burden of bailing the company out.
     And Lehman Brothers, which did not benefit from a government bailout, similarly guaranteed nearly 130,000 derivative contracts held by one of its London-based subsidiaries when it filed for bankruptcy in 2008.
     The derivatives market has since rebounded from the crisis, and financial firms have an estimated $700 trillion derivatives exposure worldwide.
     In a “Cross-Border Action,” which the CFTC described as a policy rather than a binding rule, the agency said major swap dealers must register with the CFTC to clear swaps involving a foreign party through a derivative clearing organization. Such registration aims to reduce the risk of default and imposes reporting obligations on swap participants, the CFTC said.
     The policy states that “where the conduit is located outside the United States, but is owned and controlled by a U.S. person … to recognize the economic reality of the situation, the conduit’s swaps should be attributed to the U.S. affiliate(s).”
     Three trade organizations representing the financial industry, headed by the Securities Industry and Financial Markets Association (SIFMA), challenged the cross-border action with a federal complaint, alleging that the CFTC exceeded its authority in applying its regulatory powers overseas.
     SIFMA also challenged the policy for not including a cost-benefit analysis and failing to follow the formal rulemaking requirements.
     Handing a major victory to the CFTC on Tuesday, U.S. District Judge Paul Friedman in Washington upheld the agency’s effort to regulate overseas trading.
     “The majority of plaintiffs’ claims fail because Congress has clearly indicated that the swaps provisions within Title VII of the Dodd-Frank Act – including any rules or regulations prescribed by the CFTC – apply extraterritorially whenever the jurisdictional nexus in 7 U.S.C. §2(i) is satisfied,” he wrote. “In this regard, plaintiffs’ challenges to the extraterritorial application of the Title VII Rules merely seek to delay the inevitable. The court will not question the CFTC’s decision to proceed in interpreting and applying Section 2(i) on a case-by-case basis through adjudication; nor will it set aside the CFTC’s decision to promulgate the cross-border action to announce its non-binding policies regarding the Title VII Rules’ extraterritorial applications.”
     The judge agreed with the agency that the cross-border action is not a legislative rule, and is therefore not bound by the formal rule-making process.
     “The court embraces the wisdom of the now-infamous ‘duck test,'” Friedman said.
     “Because the majority of the cross-border action looks, walks, and quacks like a policy statement, the court holds that the majority of the cross-border action is a policy statement.”
     The 92-page opinion emphasizes that the cross-border action adopts a flexible, case-by-case approach throughout, and encourages market participants to consult agency staff about their individual circumstances.
     “The court therefore is satisfied that no CFTC staff member or market participant could, after consulting the cross-border action in its entirety, reasonably construe it as setting forth binding norms,” Friedman wrote.
     Friedman did agreed with SIFMA, however, that the CFTC failed to adequately consider the costs and benefits of the Title VII rules by excluding the costs and benefits of their extraterritorial applications.
     “Consideration of only the costs and benefits of the domestic application of a given Title VII Rule, while ignoring the costs and benefits of its statutorily mandated application abroad, provides an incomplete accounting of the Rule’s total costs and benefits,” Friedman said.
     The rules shall remain in effect while the CFTC makes its cost analysis on remand.
     SIFMA did not back down after the rulings, saying in an email that it continues “to believe that the CFTC engaged in rulemaking and should have followed more formal procedures.”
     “The decision affirms that the CFTC had failed to consider the costs that would result from the rules’ application to non-U.S. parties and transactions, and must now meet its legal requirement to appropriately consider the cost and benefits of a significant number of its Title VII regulations,” the statement said.
     CFTC Chairman Tim Massad applauded Friedman’s decision.
     “I am pleased the court upheld the Commission’s July 2013 policy statement on the cross-border application of Title VII swaps provisions, and rejected a sweeping injunction of the rules that are at the heart of Dodd-Frank’s overhaul of the swaps markets,” Massad said in a statement. “I am committed to continuing our efforts to reform the swaps markets, including addressing Congress’s concerns that risks undertaken abroad might threaten the health of the U.S. economy.”

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