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Daily Rules, Proposed Rules, and Notices of the Federal Government

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 39

RIN 3038-AD47

Clearing Exemption for Swaps Between Certain Affiliated Entities

AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rule.
SUMMARY: The Commodity Futures Trading Commission ("CFTC" or "Commission") is proposing a rule to exempt swaps between certain affiliated entities within a corporate group from the clearing requirement (the "inter-affiliate clearing exemption" or the "proposed exemption") under Section 2(h)(1)(A) of the Commodity Exchange Act ("CEA"). The Commission also is proposing rules that detail specific conditions counterparties must satisfy to elect the proposed inter-affiliate clearing exemption, as well as reporting requirements for affiliated entities that avail themselves of the proposed exemption. The Commission has finalized a rule that addresses swaps that are subject to the end-user exception. Counterparties to inter-affiliate swaps that qualify for the end-user exception would be able to elect to not clear swaps pursuant to the end-user exception or the proposed rule. The proposed rule does not address swaps that an affiliate enters into with a third party that are related to inter-affiliate swaps that are subject to the end-user exception. The Commission intends separately to propose a rule addressing swaps between an affiliate and a third party where the swaps are used to hedge or mitigate commercial risk arising from inter-affiliate swaps for which the end-user exception has been elected.
DATES: Comments must be received on or before September 20, 2012.
ADDRESSES: *The agency's Web site, at: http://comments.cftc.gov.Follow the instructions for submitting comments through the Web site.

*Mail:David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

*Hand Delivery/Courier:Same as mail above.

*Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.

Please submit your comments using only one method.

All comments must be submitted in English, or if not, accompanied by an English translation. "Inter-affiliate Clearing Exemption" must be in the subject field of responses submitted via email, and clearly indicated on written submissions. Comments will be posted as received tohttp://www.cftc.gov.You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the established procedures in CFTC regulation 145.9.1

117 CFR 145.9. Commission regulations may be accessed through the Commission's Web site,http://www.cftc.gov.

Throughout this proposed rulemaking, the Commission requests comment in response to specific questions. For convenience, the Commission has numbered each of these comment requests. The Commission asks that, in submitting responses to these requests, commenters identify the specific number of each request to which their comments are responsive.

The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse, or remove any or all of a submission from www.cftc.gov that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT: Gloria Clement, Assistant General Counsel, (202) 418-5122,gclement@cftc.gov,Office of General Counsel; Jonathan Lave, Associate Director, Exchange & Data Repository, (202) 418-5983,jlave@cftc.gov,and Alexis Hall-Bugg, Attorney-Advisor, (202) 418-6711,ahallbugg@cftc.gov,Division of Market Oversight; Warren Gorlick, Supervisory Attorney-Advisor, (202) 418-5195,wgorlick@cftc.gov,and Anuradha Banerjee, Attorney-Advisor, (202) 418-5661,abanerjee@cftc.gov,Office of International Affairs; Theodore Kneller, Attorney-Advisor, (202) 418-5727,tkneller@cftc.gov,Division of Enforcement; Elizabeth Miller, Attorney-Advisor, (202) 418-5985,emiller@cftc.gov,Division of Swap Dealer and Intermediary Oversight; Esen Onur, Research Economist, (202) 418-6146,eonur@cftc.gov,Office of the Chief Economist; and Jolanta Sterbenz, Counsel, (202) 418-6639,jsterbenz@cftc.gov,Office of General Counsel, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
I. Background A. Clearing Requirement for Swaps

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act" or "DFA").2 Title VII of the Dodd-Frank Act amended the CEA,3 and established a new regulatory framework for swaps. The legislation was enacted to reduce systemic risk, increase transparency, and promote market integrity within the financial system by, among other things: (1) Imposing clearing and trade execution requirements on standardized derivative products; (2) creating rigorous recordkeeping and data reporting regimes with respect to swaps, including real-time public reporting; and (3) enhancing the Commission's rulemaking and enforcement authorities over all registered entities, intermediaries, and swap counterparties subject to the Commission's oversight.

2 SeeDodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (July 21, 2010).

37 U.S.C. 1et seq.(2006).

Section 723 of the Dodd-Frank Act added section 2(h) to the CEA, which establishes a clearing requirement for swaps.4 The new section makes it unlawful for any person to engage in a swap, if the Commission determines such swap is required to be cleared, unless the person submits the swap for clearing to a registered derivatives clearing organization ("DCO") (or a DCO that is exempt from registration).5 TheCEA, however, permits exceptions and exemptions to the clearing requirement.

4CEA section 2(h)(1)(A), 7 U.S.C. 2(h)(1)(A).

5 SeeCEA section 2(h)(1)(A), 7 U.S.C. 2(h)(1)(A). The CEA's clearing requirement states that, "[i]t shall be unlawful for any person to engage in a swap unless that person submits such swap forclearing to a derivatives clearing organization that is registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the swap is required to be cleared."

A person may elect not to clear certain swaps if such person qualifies for an exception under CEA section 2(h)(7) and the Commission regulations issued in connection therewith (the "end-user exception").6 To summarize the principal components of the end-user exception, for a swap to qualify, a counterparty to the swap electing the exception must (i) not be a "financial entity," as defined in CEA section 2(h)(7)(C)(i) or qualify for an exemption from that defined term under section 2(h)(7)(D),7 or through a Commission-issued exemption under CEA sections 2(h)(7)(C)(ii)8 or 4(c)9 and (ii) be using the swap to hedge or mitigate commercial risk. The Commission has determined to exempt certain small banks, savings associations, farm credit institutions, and credit unions under section 2(h)(7)(C)(ii) of the CEA from the definition of "financial entity."10

6CEA section 2(h)(7)(A), 7 U.S.C. 2(h)(7)(A). CEA section 2(h)(7)(A) provides an elective exception to the clearing requirement to any counterparty to a swap that is not a financial entity, is using the swap to hedge or mitigate commercial risk, and notifies the Commission how it generally meets the financial conditions associated with entering into non-cleared swaps. The Commission issued the end-user exception in a rulemaking entitled, "End-User Exception to the Clearing Requirement for Swaps," 77 FR 42560, July 19, 2012 (final).

7CEA section 2(h)(7)(D), 7 U.S.C. 2(h)(7)(D).

8CEA section 2(h)(7)(C)(ii), 7 U.S.C. 2(h)(7)(C)(ii) ("The Commission shall consider whether to exempt small banks, savings associations, farm credit system institutions, and credit unions * * * ").

9CEA section 4(c), 7 U.S.C. 6(c).

10"End-User Exception to the Clearing Requirement for Swaps," 77 FR 42560, July 19, 2012 (seeSS 39.6(d)).

Importantly, a counterparty to an inter-affiliate swap that qualifies for both the end-user exception and the inter-affiliate exemption may elect not to clear the inter-affiliate swap under either the end-user exception or the inter-affiliate exemption. As such, the Commission believes that the rule proposed in this rulemaking may not be necessary for the vast majority of inter-affiliate swaps involving a non-financial entity or a small financial institution because the end-user exception can be elected for those swaps. Accordingly, it is likely the proposed rule will be used for inter-affiliate swaps between two financial entities that do not qualify for the end-user exception or for swaps involving a non-financial entity that do not qualify for the end-user exception because the swaps do not hedge or mitigate commercial risk.

Finally, CEA section 4(c)(1), described in more detail below, grants the Commission general exemptive powers.11 Pursuant to that authority, the Commission has proposed a rule that would allow cooperatives meeting certain conditions to elect not to submit for clearing certain swaps subject to a clearing requirement.12

11Section 4(c)(1) of the CEA empowers the Commission to exempt any transaction or class of transactions, including swaps, from certain CEA provisions, such as the clearing requirement.

12"Clearing Exemption for Certain Swaps Entered into by Cooperatives," 77 FR 41940, July 17, 2012.

B. Swaps Between Affiliated Entities

Except as provided with respect to certain financing affiliates as noted above, CEA section 2(h) does not provide any specific exception to swaps entered into by affiliates that are subject to a clearing requirement ("inter-affiliate swaps").13 Inter-affiliate swaps that are hedged by back-to-back or matching book swaps entered into with third parties may pose risks to the financial system if the inter-affiliate swaps are not properly risk managed thereby raising the likelihood of default on the outward facing swaps. Furthermore, there could be systemic risk implications if an affiliate used by the corporate group to trade outward facing swaps (commonly referred as centralized treasury or conduit affiliates) has large positions and defaulted on obligations arising from inter-affiliate swaps if such swaps are hedged with third-party swaps.14 Such a default could harm third-party swap counterparties, and potentially, financial markets as a whole, if the treasury/conduit affiliate was unable to satisfy third-party obligations as a consequence of the default.

13For the purposes of this proposed rulemaking, "inter-affiliate swaps" refers to swaps between "affiliates," as that term is defined in proposed SS 39.6(g)(1): "[c]ounterparties to a swap * * * may elect not to clear a swap with an affiliate if one party directly or indirectly holds a majority ownership interest in the other, or if a third party directly or indirectly holds a majority interest in both, based on holding 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."See infrapt. II.B.1 for further discussion.

14There does not appear to be a common definition of a "treasury affiliate" or a "conduit affiliate." For purposes of this proposed rulemaking, a treasury/conduit affiliate (or structure) is an affiliate that enters into inter-affiliate swaps and enters into swaps with third parties that are related to such inter-affiliate swaps on a back-to-back or aggregate basis.

A number of commenters in a variety of Commission rulemakings have recommended that the Commission adopt an exemption to the clearing requirement for inter-affiliate swaps.15 Some commenters claimed that inter-affiliate swaps offer significant benefits with substantially less risk than swaps between unaffiliated entities. They contended that inter-affiliate swaps enable a corporate group to aggregate its risks on a global basis in one entity through risk transfers between affiliates. Commenters also described varying structures through which corporate groups entered into inter-affiliate swaps and manage risks.

15The Commission notes that comment letters to other proposed rulemakings under Title VII of the Dodd-Frank Act are not part of the administrative record for this rulemaking unless specifically cited herein.

Prudential Financial, Inc. ("PFI"), stated that it employs a "conduit" structure where separate legal entities are commonly owned by PFI.16 Under this structure, PFI uses one affiliate to directly face the market as a "conduit" to hedge the net commercial and financial risk of the various operating affiliates within PFI. PFI contended that the use of a conduit diminishes the demands on PFI's financial liquidity, operational assets, and management resources, because "affiliates within PFI avoid having to establish independent relationships and unique infrastructure to face the market." Moreover, PFI explained that its conduit facilitates the netting of its affiliates' trades (e.g.,where one affiliate hedges floating rates while another hedges fixed rates). PFI stated that this conduit structure effectively reduces the overall risk of PFI and its affiliates, and it allows PFI to manage fewer outstanding positions with external market participants.17

16Prudential Financial, Inc. comment letter to the proposed rulemaking, "Further Definition of `Swap Dealer,' `Security-Based Swap Dealer,' `Major Swap Participant,' `Major Security-Based Swap Participant' and `Eligible Contract Participant,' " 75 FR 80147, Dec. 21, 2010.

17J.P. Morgan commented that the most efficient way to manage risk is often at one entity and on a portfolio level. This way all the risk for the corporate group resides in one entity. J.P. Morgan maintained that this reduces market risk at each legal entity and can reduce risk on a group level because offsetting positions held by different members of the group can be aggregated to mitigate the overall risk of the portfolio. J.P. Morgan asserted that portfolio risk management enables regulators to more easily assess the net risk position on a group level rather than piecing together data from separate affiliates to reconstruct the actual risk profile of the group. J.P. Morgan comment letter to the proposed rulemaking, "Process for Review of Swaps for Mandatory Clearing," 75 FR 67277, Nov. 2, 2010.

In a letter to Congress, the Coalition for Derivatives End-Users ("CDEU") asserted that inter-affiliate swaps do not create external counterparty exposure and, therefore, pose none of the systemic or other risks that the clearing requirement is designed to protect against.18 Thus, in CDEU's view, theimposition of required clearing on inter-affiliate swaps would not reduce systemic risk. CDEU also commented that a conduit or treasury structure is beneficial because it centralizes trade expertise and execution in a single or limited number of entities. Finally, CDEU claimed that a treasury or conduit structure benefits affiliates because they can enjoy their parents' corporate credit ratings and associated pricing benefits.

18Coalition for Derivatives End-Users comment letter for H.R. 2682, H.R. 2779, and H.R. 2586 (Mar. 23, 2012).

These comments suggest that swaps entered into between corporate affiliates, if properly risk-managed, may be beneficial to the operation of the corporate group as a whole. They indicate that inter-affiliate swaps may improve a corporate group's risk management internally and allow the corporate group to use the most efficient means to effectuate swaps with third parties. While the Commission recognizes these potential benefits of inter-affiliate swaps, the Commission is also taking into account the systemic risk repercussions of inter-affiliate swaps as it considers and proposes an exemption to the CEA's clearing requirement applicable to those inter-affiliate swaps.

II. Inter-Affiliate Clearing Exemption Under CEA Section 4(c)(1) A. The Commission's Section 4(c)(1) Authority

Section 4(c)(1) of the CEA empowers the Commission to "promote responsible economic or financial innovation and fair competition" by exempting any transaction or class of transactions, including swaps, from any of the provisions of the CEA (subject to exceptions not relevant here).19 In enacting CEA section 4(c)(1), Congress noted that the goal 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."20 Observant of that objective, the Commission has determined preliminarily that it would be appropriate to exempt inter-affiliate swaps from the clearing requirement in CEA section 2(h) under certain terms and conditions. The proposed exemption, however, would not extend to swaps that affiliates entered into with third parties.

19Section 4(c)(1) of the CEA, 7 U.S.C. 6(c)(1), provides, in pertinent part, that:

In order to promote responsible economic or financial innovation and fair competition, the Commission by rule, regulation, or order, after notice and opportunity for hearing, may (on its own initiative or on application of any person * * * ) exempt any agreement, contract, or transaction (or class thereof) that is otherwise subject to subsection (a) of this section * * * either unconditionally or on stated terms or conditions or for stated periods and either retroactively or prospectively, or both, from any of the requirements of subsection (a) of this section, or from any other provision of this Act.

By issuing a proposed exemptive rule, the Commission also is exercising its general rulemaking authority under CEA section 8a(5), 7 U.S.C. 12a(5).

20House Conf. Report No. 102-978, 1992 U.S.C.C.A.N. 3179, 3213 ("4(c) Conf. Report").

The primary benefit of clearing is the reduction of counterparty risk. The Commission notes commenters' assertions that there is less counterparty risk associated with inter-affiliate swaps than swaps with third parties to the extent that affiliated counterparties internalize each other's counterparty risk because they are members of the same corporate group. This internalization can be demonstrated by the example of a swap entered into between affiliates A and B that are majority owned by the same person.21 If affiliate A fails to perform, then affiliate B would be harmed. However, affiliate A also may be harmed if (1) B's harm adversely impacts the profits of A and B's corporate group22 or (2) A's failure to perform drives the group into bankruptcy, because, for instance, B has entered into a swap with a third party and B is unable to perform as a consequence of A's failure to perform. The potential harm to A for failing to perform is greater than the harm A would experience if B was not a majority-owned affiliate. Accordingly, A internalizes B's counterparty risk and A has a greater economic incentive to perform than if B were a third party.

21The meaning of "majority-owned" is set forth and discussed in part B1.

22A's corporate group is the group that contains the person with a majority ownership interest of A. Similarly, B's corporate group is the group that contains the person with a majority ownership interest of B.

The Commission does not believe there is significantly reduced counterparty risk with respect to swaps between affiliates that are not majority-owned by the same person because there is less economic feedback. If A is a majority-owned affiliate and B is a minority-owned affiliate, then any harm that B experiences as a consequence of A's failure to perform is likely to have a less adverse impact on the profits of A's corporate group than if B was a majority-owned affiliate. In addition, the Commission believes that B's failure to perform would be significantly less likely to drive A's corporate group into bankruptcy than if B were majority-owned.

On the basis of reduced counterparty risk, the Commission has determined preliminarily that inter-affiliate swap risk may not need to be mitigated through clearing, but can be reduced through other means. The Commission also believes at the proposal stage that exempting inter-affiliate swaps would enable corporations to structure their groups so that corporate risk is concentrated in one entity--whether it be at a treasury- or conduit-type affiliate, or at the parent company.23 The Commission recognizes there may be advantages for the corporate group and regulators if risk is appropriately managed and controlled on a consolidated basis and at a single affiliate. Based upon the comments received, the Commission understands that some corporate groups use this type of structure.

23Treasury/conduit affiliates, for example, often enter into swaps with third parties that hedge aggregate inter-affiliate swap risk. The aggregation is based on risk correlations. If those correlations break down, then the treasury/conduit affiliate may no longer be able to satisfy its third-party swap obligations.

The Commission, nevertheless, believes that uncleared inter-affiliate swaps could pose risk to corporate groups and market participants, generally. Uncleared inter-affiliate swaps also may pose risk to other market participants, and therefore the financial system, if the treasury/conduit affiliate enters into swaps with third parties that are related on a back-to-back or matched book basis with inter-affiliate swaps. To continue the above example, if A's failure to perform (for whatever reason) makes it impossible for B to meet its third-party swap obligations, then those third parties would be harmed and risk could spread into the marketplace. However, A's risk of nonperformance is less than it would be if B were a third party to the extent A internalizes B's counterparty risk.

To address these concerns, the Commission is proposing rules that would exempt inter-affiliate swaps from clearing if certain conditions are satisfied. First, the proposed exemption would be limited to swaps between majority-owned affiliates whose financial statements are reported on a consolidated basis. Second, the proposed rules would require the following: Centralized risk management, documentation of the swap agreement, variation margin payments (for financial entities), and satisfaction of reporting requirements. In addition, the exemption would be limited to swaps between U.S. affiliates, and swaps between a U.S. affiliate and a foreign affiliate located in a jurisdiction with a comparable and comprehensive clearing regime or the non-United States counterparty is otherwise required to clear the swaps it enters into with thirdparties in compliance with United States law or does not enter into swaps with third parties. Additionally, the Commission notes that the proposed exemption does not limit the applicability of any CEA provision or Commission regulation to any person or transaction except as provided in the proposed rulemaking. These conditions will be discussed in further detail below.

Request for Comments

Q1. The Commission requests comment on whether it should exercise its authority under CEA section 4(c).

Q2. Do inter-affiliate swaps pose risk to the corporate group? If so, what risk is posed? In particular, do inter-affiliate swaps pose less risk to a corporate group than swaps with third parties? If so, why is that the case?

Q3. Do inter-affiliate swaps pose risk to the third parties that have entered into swaps that are related to the inter-affiliate swaps? If so, what risk is posed?

Q4. Would the proposed exemption promote responsible economic or financial innovation and fair competition?

Q5. Would the proposed exemption promote the public interest?

Q6. Inter-affiliate swaps that do not meet the conditions to the proposed exemption would be subject to the clearing requirement under CEA section 2(h)(1)(A) and, potentially, the trade execution requirement under CEA section 2(h)(8) as well. What would be the costs and benefits of imposing the trade execution requirement on these inter-affiliate swaps? Should the Commission exempt some or all inter-affiliate swaps from the trade execution requirement regardless of whether the conditions to the proposed inter-affiliate clearing exemption are met?

B. Proposed Regulations 1. Proposed SS 39.6(g)(1): Definition of Affiliate Relationship

Under proposed SS 39.6(g)(1), the inter-affiliate clearing exemption would only be available for swaps between majority-owned affiliates. As explained above, the Commission believes there is reduced counterparty risk with respect to such swaps. Under the proposed rule, affiliates would be majority-owned if one affiliate directly or indirectly holds a majority ownership interest in the other affiliate, or if a third party directly or indirectly holds a majority ownership interest in both affiliates and the financial statements of both affiliates are reported on a consolidated basis. A majority-ownership interest would be based on holding 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.24

24The affiliate status required by proposed SS 39.6(g)(1) to elect the proposed exemption is based on and functionally equivalent to the definition of majority-owned affiliates in recently adopted CFTC regulation 1.3(ggg)(6)(i).

The Commission is not proposing to extend the exemption to affiliates that are related on a minority-owned basis. As explained above, the Commission does not believe there is significantly reduced counterparty risk with respect to swaps between such affiliates. The Commission also believes it is important for the proposed 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.25 For example, the European Parliament and Council of the European Union have adopted the European Market Infrastructure Regulation ("EMIR").26 Subject to the relevant provisions, technical standards, and regulations under EMIR, certain derivatives transactions between parent and subsidiary entities, could be exempt from its general clearing requirement.

25In 2009, the G20 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." G20 Leaders' Final Statement at Pittsburgh Summit: Framework for Strong, Sustainable and Balanced Growth (Sept. 29, 2009).

26 SeeRegulation (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) available athttp://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.

Request for Comments

Q7. The Commission requests comments on all aspects of the Commission's proposed requirement that the inter-affiliate clearing exemption be available to majority-owned affiliates.

Q8a. Should the Commission consider requiring a percentage of ownership greater than majority ownership to qualify for the inter-affiliate clearing exemption?

Q8b. If so, what percentage should be used and what are the benefits and burdens of such ownership requirements?

Q8b. Should the Commission require a 100% ownership threshold for the inter-affiliate clearing exemption? Would a 100% ownership threshold reduce counterparty risk and protect minority owners better than the proposed threshold. Are there other means to lessen risk to minority owners, such as consent?

Q9. Should the Commission consider an 80% ownership threshold based on section 1504 of the Internal Revenue Code, which establishes an 80% voting and value test for an affiliate group.27 In light of the potential benefits from centralized risk management in an affiliated group, would an 80% threshold sufficiently reduce overall risk to financial system

27The Internal Revenue Service allows a business conglomerate to file consolidated tax returns if the parent company and its subsidiaries meet a relationship test that is outlined in 26 U.S.C. 1504(a)(2):

(a) Affiliated group defined for purposes of this subtitle--

(1) In general. The term "affiliated group" means--

(A) 1 or more chains of corporations connected through stock ownership with a common parent corporation which is a corporation, but only if--

(B) (i) the common parent owns directly stock meeting the requirements of paragraph (2) in at least 1 of the other corporations, and

(ii) stock meeting the requirements of paragraph (2) in each of the includible corporations (except the common parent) is owned directly by 1 or more of the other includible corporations.

(2) 80-percent voting and value test The ownership of stock of any corporation meets the requirements of this paragraph if it--

(A) possesses at least 80 percent of the total voting power of the stock of such corporation, and

(B) has a value equal to at least 80 percent of the total value of the stock of such corporation.

(3) Stock not to include certain preferred stock

For purposes of this subsection, the term "stock" does not include any stock which--(A) is not entitled to vote,

(B) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent,

(C) has redemption and liquidation rights which do not exceed the issue price of such stock (except for a reasonable redemption or liquidation premium), and

(D) is not convertible into another class of stock.

2. Proposed SS 39.6(g)(2)(i): Both Counterparties Must Elect the Inter-Affiliate Clearing Exemption

The Commission believes that affiliates within a corporate group may make independent determinations on whether to submit an inter-affiliate swap for clearing. Ostensibly, each affiliate may reach different conclusions regarding the appropriateness of clearing. Given this possibility, proposed SS 39.6(g)(2)(i) would require that both counterparties elect the proposed inter-affiliate clearing exemption (each, an "electing counterparty").

Request for Comments

Q10. Would this requirement create any operational issues?

3. Proposed SS 39.6(g)(2)(ii): Swap Documentation

The Commission understands that affiliates may enter into swaps witheach other with little documentation about the terms and conditions of the swaps. The Commission is concerned that without proper documentation affiliates would be unable to effectively track and manage risks arising from inter-affiliate swaps or offer sufficient proof of claim in the event of bankruptcy. This could create challenges and uncertainty that could adversely affect affiliates, third party creditors, and potentially the financial system. The Commission also is concerned about transparency should there be a need for an audit or enforcement proceeding.

Proposed SS 39.6(g)(2)(iii) would address these concerns by requiring affiliates to enter into swaps with a swap trading relationship document.28 The proposed rule would require the document to be in writing and to include all terms governing the trading relationship between the affiliates, including, without limitation, terms addressing payment obligations, netting of payments, events of default or other termination events, calculation and netting of obligations upon termination, transfer of rights and obligations, governing law, valuation, and dispute resolution procedures.29 The Commission believes this requirement would not be onerous because affiliates should be able to use a master agreement to document most of the terms of their inter-affiliate swaps.

28For swap dealers and major swap participants, these issues are addressed in the swap trading relationship documentation rules proposed by the Commission in SS 23.504.See"Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants," 76 FR 6715, Feb. 8, 2011. The proposed rule requires that if one or more of the parties to the swap for which the inter-affiliate exemption is elected is a swap dealer or major swap participant, then that party shall comply with SS 23.504 for that swap. Swap dealers and major swap participants that comply with that provision would also satisfy the proposed requirements.

29The requirements of the swap trading relationship document are informed by proposed CFTC regulation 23.504(b)(1).See"Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants," 76 FR 6715, Feb. 8, 2011.

Request for Comments

Q11. The Commission requests comment as to the burden or cost of the proposed rule requiring documentation of inter-affiliate swaps.

Q12. The Commission also requests comment as to whether its risk tracking and management and proof-of-claim concerns could be addressed by other means of documentation.

Q13. The Commission requests comment as to whether the Commission should create a specific document template. Should the industry do so?

4. Proposed SS 39.6(g)(2)(iii): Centralized Risk Management

Proposed SS 39.6(g)(2)(iii) would require inter-affiliate swaps to be subject to a centralized risk management program reasonably designed to monitor and manage the risks associated with the inter-affiliate swaps. As noted in Part I.B. above, inter-affiliate swaps may pose risk to third parties if risks are not properly managed. Accordingly, to encourage prudent risk management, the proposed inter-affiliate clearing exemption would be conditioned on a corporate group's evaluation, measurement and control of such risks. The Commission anticipates that the program would be implemented and run by the parent company or the treasury/conduit affiliate, but the rule provides flexibility to determine how best to satisfy this requirement.30

30The Commission has adopted risk management rules for swap dealers and major swap participants in SS 23.600.See"Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants," 77 FR 20128, 20173-75, April 3, 2012 (final rule). The rule requires that if one or more of the parties to the swap for which the inter-affiliate exemption is elected is a swap dealer or major swap participant, then that party shall comply with SS 23.600 for that swap. Swap dealers and major swap participants that comply with that provision will also satisfy the proposed requirements.

The Commission understands that some groups that use inter-affiliate swaps, particularly large financial entities, already have a centralized risk management program.31 Indeed, several commenters--e.g.,SIFMA and ISDA--supported centralized risk management and claimed that centralized risk management for inter-affiliate swaps "would be compromised" by a clearing requirement.32 CDEU also commented that inter-affiliate swaps are beneficial because they allow swaps with third parties to be traded at a treasury-type structure which contains risk management expertise.33 Based on comments received, the Commission believes that the proposed rule is in line with industry practice. Proposed SS 39.6(g)(2)(iii) also is in harmony with similar requirements under EMIR, which would require under certain circumstances for both counterparties to intra-group transactions to be "subject to an appropriate centrali[z]ed risk evaluation, measurement and control procedures. * * *"34

31 See, e.g.,Letter from SIFMA and ISDA submitted to the Commission on their own initiative (May 14, 2012).

32 Id.

33 See3/23/23 Letter from CDEU.

34 SeeEMIR Article 3, paragraphs 1 and 2. EMIR identifies factors necessary to establish a transaction as an intra-group transaction.

Request for Comments

Q14. The Commission requests comments that explain how current centralized risk management programs operate.

Q15. The Commission requests comment on whether it should promulgate additional regulations that set forth minimum standards for a centralized risk management program. If so, what should those standards be? Is there a consistent industry practice which could be observed?

Q16. Is the proposed rule in line with industry practice?

5. Proposed SS 39.6(g)(2)(iv): Variation Margin

Proposed SS 39.6(g)(2)(iv) would require that variation margin be collected for swaps between affiliates that are financial entities, as defined in CEA section 2(h)(7)(C), in compliance with the proposed variation margin requirements set forth in proposed SS 39.6(g)(3).35 Variation margin is an essential risk-management tool. A well-designed variation margin system protects both parties to a trade. It serves both as a check on risk-taking that might exceed a party's financial capacity and as a limitation on losses when there is a failure. Variation margin entails marking open positions to their current market value each day and transferring funds between the parties to reflect any change in value since the previous time the positions were marked.36 This process prevents uncollateralized exposures from accumulating over time and thereby reduces the size of any loss resulting from a default should one occur. Required margining also might cause parties to more carefully consider the risks involved with swaps and manage those risks more closely over time. The Commission believes, at this stage, that inter-affiliate swap risk may be mitigated through variation margin and notes that requiring variation margin for inter-affiliate swaps is being discussed by international regulators working on harmonizing regulations governing swap clearing.

35Discussed in pt. II.B.8., below.

36Variation margin is distinguished from initial margin, which is intended to serve as a performance bond against potential future losses. If a party defaults, the other party may use initial margin to cover most or all of any loss that may result between the time the default occurs and when the non-defaulting party replaces the open position.

The Commission understands that a number of financial entities currentlypost variation margin for their inter-affiliate swaps. According to SIFMA and ISDA, "[t]he posting of variation margin limiting the impact of market movements upon the respective positions of the affiliated parties now occurs routinely in financial groups and its imposition on affiliates who transact directly with affiliated swap dealers (SDs) or major swap participants (MSPs) should not be unduly disruptive."37 The Commission has proposed rules requiring certain financial entities to pay and collect variation and initial margin for uncleared swaps entered into with other financial entities.38

37 See, e.g.,5/14/12 Letter from SIFMA and ISDA.

38The Commission does not propose that variation margin posted in respect of inter-affiliate swaps be required to be held in a segregated account or be otherwise unavailable for use and rehypothecation by the counterparty holding such variation margin.

The proposed requirement would not apply to 100% commonly-owned and commonly-guaranteed affiliates, provided that the common guarantor is also under 100% common ownership. As discussed above, the risk of an inter-affiliate swap may be mitigated through the posting of variation margin. The Commission believes that when the economic interests of two affiliates are both (i) fully aligned and (ii) a common guarantor bears the ultimate risk associated swaps entered into with a third party, non-affiliated counterparty, the posting of variation margin does not substantially mitigate the risk of an inter-affiliate swap. This exception is intended to apply to swaps between two wholly-owned subsidiaries of a common parent or in instances where one affiliate is wholly owned by the other.

The first of the conditions required to claim the exception to the requirement under proposed regulation 39.6(g)(2)(iv) to post variation margin relates to complete common ownership. When two affiliates are owned by the same owner or one is wholly owned by the other, the underlying owners are the same and the economic interests of the two affiliates are aligned.39 In such circumstances, the two affiliates are subject to the control of a common owner or common set of owners.40

39In contrast, if two affiliates do not have the same owners, the potential exists that the two affiliates may have differing economic interests.SeealsoCopperweldv.Independence Tube--467 U.S. 752 (1984) at 771 ("The coordinated activity of a parent and its wholly owned subsidiary must be viewed as that of a single enterprise for purposes of SS 1 of the Sherman Act. A parent and its wholly owned subsidiary have a complete unity of interest. Their objectives are common, not disparate, and their general corporate objectives are guided or determined not by two separate corporate consciousnesses, but one.").

40Under such circumstances, the two affiliates are subject to common control, in actuality or potentially--i.e., the common owner could assert full control when one or both affiliates cease to act in the common owner's best interest.

A person would not be able to claim 100 percent ownership for the purposes of this provision based on a contingent right or obligation, by contract or otherwise, to take ownership of the equity interest in the affiliate by purchase or otherwise.41 Conversely, structures in which a person owns 100 percent of the equity but has an obligation or right, by contract or otherwise, to give up, by sale or otherwise, all or a portion of that equity interest would not meet the 100 percent ownership test. Such contingent or residual rights evidence a less than complete responsibility for the affiliate, including its swap obligations, that the 100 percent ownership and guaranty provision is intended to require. Under such circumstances, the interests of the owner and the affiliate are not fully aligned. The second condition requires the existence of a common guarantor. When two affiliates share a common guarantor that is under the same common ownership, the Commission believes that the risk created by a swap with a non-affiliated third party is ultimately borne by the enterprise (which is defined by an alignment of economic interests). To provide an example, assume that A and B are guaranteed wholly-owned subsidiaries of X. B enters into a swap with non-affiliated third party T. B then enters into a back-to-back swap (mirroring the risk created in the swap with T) with A (i.e., an inter-affiliate swap). In this scenario, the risk associated with the swap with T is effectively borne by X and therefore ultimately borne by the enterprise. In such circumstances therefore the inter-affiliate swap does not create new risks for the enterprise, rather, it allocates the risk from one wholly-owned subsidiary to another. The posting of variation margin here would not substantially mitigate the risk of the inter-affiliate swap because the inter-affiliate swap itself does not create new risks for the enterprise.

41For example, if a financial entity established a trust, partnership, corporation or other type of entity, and sells the equity interests therein to investors, but retains the right to call, repurchase, or otherwise take control of the equity interest, or has a contingent obligation to call, repurchase or otherwise take control of the equity interest, such right or obligation would not be sufficient to constitute ownership of the affiliate for purposes of this provision.

Request for Comments

Q17a. The Commission requests comment as to whether it should promulgate regulations that set forth minimum standards for variation margin. If so, what should those standards be?

Q17b. The Commission requests comment as to whether it should promulgate regulations that set forth minimum standards for initial margin. If so, what should those standards be?

Q17c. The Commission requests comment as to whether it should promulgate regulations that set forth minimum standards for both initial and variation margin for inter-affiliate swaps. If so, what should those standards be?

Q17d. The Commission's proposed rule "Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants"--17 CFR Part 23--would require initial and variation margin for certain swaps that are not cleared by a registered designated clearing organization. Should inter-affiliate swaps that are not subject to the clearing requirement of CEA section 2(h)(1)(A) be subject to the margin requirements as set out in proposed Part 23 or otherwise?

Q18. The Commission requests comment on the costs and benefits of requiring variation margin for inter-affiliate swaps, both in general and specifically, regarding corporate groups that do not currently transfer variation margin in respect of inter-affiliate swaps.

Q19. The Commission requests comment on whether 100% commonly-owned affiliates sharing a common guarantor--that is, a guarantor that is also 100% commonly owned--should be exempt from the requirement to transfer variation margin. Please explain the impact on the corporate group, if any, if the described affiliates are required to transfer variation margin.

Q20a. Should any other categories of entities or corporate groups, such as non-swap dealers and non-major swap participants, be exempt from the variation margin requirement for their inter-affiliate swaps? If so, which categories and why?

Q20b. Should the Commission limit the variation margin requirements to those inter-affiliate swaps for which at least one counterparty is a swap dealer, major swap participant, or financial entity, as defined in paragraph (g)(6) of the proposed rule text, that is subject to prudential regulation?

Q21. The Commission requests comment as to whether it should eliminate the proposed exemption's variation margin condition for swaps between 100% owned affiliates.

Q22. The Commission requests comment as to whether it should eliminate the proposed exemption'svariation margin condition for swaps between 80% owned affiliates.

Q23. The Commission requests comment on whether all types of financial entities identified in CEA section 2(h)(7)(C) should be subject to the variation margin requirement. Should entities that are part of a commercial corporate group and are financial entities solely because of CEA section 2(h)(7)(C)(i)(VIII) be excluded from such requirement? Why?

6. Proposed SS 39.6(g)(2)(v): Both Affiliates Must Be Located in the United States or in a Country With a Comparable and Comprehensive Clearing Regime or the Non-United States Counterparty Is Otherwise Required To Clear Swaps With Third Parties in Compliance With United States Law or Does Not Enter Into Swaps With Third Parties

The Commission is proposing to limit the inter-affiliate clearing exemption to inter-affiliate swaps between two U.S.-based affiliates or swaps where one affiliate is located abroad in a jurisdiction with a comparable and comprehensive clearing regime or the non-United States counterparty is otherwise required to clear swaps with third parties in compliance with United States law or does not enter into swaps with third parties. The limitation in SS 39.6(g)(2)(v) is designed to address the Commission's concerns about risk and to deter evasion as directed by CEA section 2(h)(4)(A).

Under section 2(h)(4)(A), the Commission must prescribe rules necessary to prevent evasion of the clearing requirement.42 The Commission is concerned that an inter-affiliate clearing exemption could enable entities to evade the clearing requirement through trades, for example, with affiliates that are located in foreign jurisdictions that do not have a comparable and comprehensive clearing regime. Informed in part by certain relevant intra-group transactions provisions under EMIR,43 proposed SS 39.6(g)(2)(v) would require that both affiliates be U.S. persons or one of the affiliates is a U.S. person and the other affiliate is domiciled in a non-U.S. jurisdiction with a comparable and comprehensive regulatory regime for swap clearing or the non-United States counterparty is otherwise required to clear swaps with third parties in compliance with United States Law or does not enter into swaps with third parties.44

42 SeeCEA section 2(h)(4)(A), 7 U.S.C. 2(h)(4)(A). Additionally, CEA section 6(e)(4)-(5) states that any DCO, SD, or MSP may be subject to double civil monetary penalties should they evade the clearing requirement, among other things. The relevant CEA sections state, "that knowingly or recklessly evades or participates in or facilitates an evasion of the requirements of section 2(h) shall be liable for a civil monetary penalty twice the amount otherwise available for a violation of section 2(h)."SeeCEA section 6(e)(4)-(5), 7 U.S.C. 9a(4)-(5).

43 See, generally,EMIR Articles 3, 4, 11, 13.

44For example, a counterparty located in a country that does not have a comparable clearing regime may be required to clear swaps with third parties in compliance with United States law if it meets the definition of a "conduit" as described in the Commission's proposed interpretive guidance and policy statement entitled, "Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act," 77 FR 41214, July 12, 2012.

The Commission recognizes that there may be a legitimate reason for an inter-affiliate swap where one affiliate is located in a country that does not have a comparable clearing regime. However, the Commission believes that financial markets may be at risk if the foreign affiliate enters into a related third-party swap that would be subject to clearing were it entered into in the United States, but is not cleared. On balance, the Commission believes that the risk of evasion and the systemic risk associated with uncleared swaps necessitates that the exemption be limited to swaps between affiliates located in the United States or in foreign countries with comparable clearing regimes or the non-United States counterparty is otherwise required to clear swaps with third parties in compliance with United States law or does not enter into swaps with third parties.

Request for Comments

Q24a. The Commission requests comment on proposed SS 39.6(g)(2)(v). Is the proposed condition that both affiliates must be located in the United States or in a country with a comparable and comprehensive clearing jurisdiction or the non-United States counterparty is otherwise required to clear swaps with third parties or does not enter into swaps with third parties a necessary and appropriate means of reducing risk and evasion concerns related to inter-affiliate swaps? If not, how should these concerns be addressed?

Q24b. Should the Commission limit the inter-affiliate clearing exemption to foreign affiliates that only enter into inter-affiliate swaps if such foreign affiliates are not located in a jurisdiction with a comparable and comprehensive clearing requirement or are otherwise required to clear swaps with third parties in compliance with United States?

Q24c. Should the Commission limit the inter-affiliate clearing exemption to foreign affiliates that enter into swaps with third parties on an occasional basis if such foreign affiliates are not located in a jurisdiction with a comparable and comprehensive clearing requirement or are otherwise required to clear swaps with third parties in compliance with United States. What would constitute an occasional basis? For example, would once a year be an appropriate time frame?

Q25. The Commission requests comment on (1) the prevalence of cross-border inter-affiliate swaps and the mechanics of moving swap-related risks between U.S. and non-U.S. affiliates for risk management and other purposes (including an identification of such purposes); (2) the risk implications of cross-border inter-affiliate swaps for the U.S. markets; and (3) specific means to address the risk issues potentially presented by cross-border inter-affiliate swaps.

Q26. The Commission recently adopted anti-evasion provisions relating to cross-border swap activities in its new rule 1.6.45 To what extent are the risk issues potentially presented by cross-border inter-affiliate swaps addressed by the anti-evasion provisions in rule 1.6?

45Rule 1.6 was included in the Commission's "Product Definitions" rulemaking, which was adopted jointly with the SEC.See"Further Definition of `Swap,' `Security-Based Swap,' and `Security-Based Swap Agreement;' Mixed Swaps; Security-Based Swap Agreement Recordkeeping,"77 FR 39626 (July 23, 2012).

Q27. The Commission also is considering an alternative condition to address evasion. That condition would require non-U.S. affiliates to clear all swap transactions with non-U.S. persons, provided that such transactions are related to inter-affiliate swaps which would be subject to a clearing requirement if entered into by two U.S. persons.46 Should the Commission adopt such a condition? Would such a condition help enable the Commission to ensure that the proposed inter-affiliate clearing exemption is not abused or used to evade the clearing requirement? Are there any other means to prevent evasion of the clearing requirement or abuse of the proposed inter-affiliate clearing exemption that the Commission should adopt?

46The Commission has proposed separately interpretative guidance on certain entity-level and transaction-level requirements imposed by Title VII of Dodd-Frank for cross-border swaps.SeeProposed Interpretive Guidance and Policy Statement entitled, "Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act," 77 FR 41214 (July 12, 2012).

7. Proposed SS 39.6(g)(2)(vi): Notification to the Commission

As explained in more detail below, the Commission has preliminarily determined that it must receive certaininformation to effectively regulate inter-affiliate swaps. Proposed SS 39.6(g)(2)(vi) would require one of the counterparties to an inter-affiliate swap to comply with the reporting requirements set forth in SS 39.6(g)(4.).

8. Proposed SS 39.6(g)(3): Variation Margin Requirements

Proposed SS 39.6(g)(3) would set forth the requirements for transferring variation margin. Proposed SS 39.6(g)(3)(i) would require that if both counterparties to the swap are financial entities, each counterparty shall pay and collect variation margin for each inter-affiliate swap for which the proposed exemption is elected. Proposed SS 39.6(g)(3)(ii) would require that the swap trading relationship document set forth and describe the methodology to be used to calculate variation margin with sufficient specificity to allow the counterparties, the Commission, and any appropriate prudential regulator to calculate the margin requirement independently. The Commission believes that the proposed rule would help ensure that affiliates have a written methodology. The proposed rule also would allow affiliates to manage their risks more effectively throughout the life of the swap and to avoid disputes regarding issues such as valuation.47

47For further discussion on the concept of variation margin for uncleared swaps,seeproposed rulemaking, "Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants," 76 FR 27621, Feb. 12, 2011.

9. Proposed SS 39.6(g)(4): Reporting Requirements

Pursuant to CEA section 4r,48 uncleared swaps must be reported to a Swap Data Repository ("SDR"), or to the Commission if no repository will accept such information, by one of the counterparties (the "reporting counterparty").49 In addition to any general reporting requirements applicable under other applicable rules to a particular type of entity that is an affiliate or to the inter-affiliate swap, proposed SS 39.6(g)(4) would implement reporting requirements specifically for uncleared inter-affiliate swaps.50 Proposed SS 39.6(g)(4)(i) would require the reporting counterparty to affirm that both counterparties to the inter-affiliate swap are electing not to clear the swap and that both counterparties meet the requirements in proposed SS 39.6(g)(1)-(2). Besides alerting the Commission of the election, the information would help ensure that each counterparty is aware of, and satisfies the definitions and conditions set forth in proposed SS 39.6(g)(1)-(2).

48CEA section 4r; 7 U.S.C. 6r.

49 SeeCEA sections 2(a)(13) (reporting of swaps to SDRs) and 4r (reporting alternatives for uncleared swaps); 7 U.S.C. 2(a)(13) and 7 U.S.C. 6r.

50 See"Swap Data Recordkeeping and Reporting Requirements," 77 FR 2136, Jan. 13, 2012 ("Swap Data Recordkeeping and Reporting"). Regulation 45.11 contemplates that this information may be delivered to the Commission directly in limited circumstances when a SDR is not available. 77 FR at 2168. When permitted, such delivery would also meet the proposed inter-affiliate clearing exemption reporting requirement.

Proposed SS 39.6(g)(4)(ii)-(iii) would require the reporting counterparty to provide certain information, unless such information had been provided in a current annual filing pursuant to proposed SS 39.6(g)(5). Proposed SS 39.6(g)(4)(ii) would require the reporting counterparty to submit information regarding how the financial obligations of both counterparties are generally satisfied with respect to uncleared swaps. The information is valuable because it would provide the Commission a more complete view of the risk characteristics of uncleared swaps. The information also would enhance the Commission's efforts to identify and reduce potential systemic risk.

Proposed SS 39.6(g)(4)(iii) would implement CEA section 2(j) for purposes of the inter-affiliate exemption.51 That CEA section places a prerequisite on issuers of securities registered under section 12 of the Securities Exchange Act of 1934 ("Exchange Act")52 or required to file reports under Exchange Act section 15(g)53 ("electing SEC Filer") that elect exemptions from the CEA's clearing requirement under section 2(h)(1)(A). CEA section 2(j) requires that an appropriate committee of the electing SEC Filer's board or governing body review and approve its decision to enter into swaps subject to the clearing exemption.

517 U.S.C. 2(j), in pertinent part:

Exemptions from the requirements of subsection (h)(1) to clear a swap and subsection (h)(8) to execute a swap through a board of trade or swap execution facility shall be available to a counterparty that is an issuer of securities that are registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that is required to file reports pursuant to section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o) only if an appropriate committee of the issuer's board or governing body has reviewed and approved its decision to enter into swaps that are subject to such exemptions.

5215 U.S.C. 78l.

5315 U.S.C. 78o.

Proposed SS 39.6(g)(4)(iii)(A) would require an electing SEC Filer to notify the Commission of its SEC Filer status by submitting its SEC Central Index Key number. This information would enable the Commission to cross-reference materials filed with the relevant SDR with information in periodic reports and other materials filed by the electing SEC Filer with the U.S. Securities and Exchange Commission ("SEC"). In addition, proposed SS 39.6(g)(4)(iii)(B) would require the counterparty to report whether an appropriate committee of its board of directors (or equivalent governing body) has reviewed and approved the decision to enter into the inter-affiliate swaps that are exempt from clearing.54 If both affiliates/counterparties are electing SEC Filers, both counterparties would have to report the additional information in proposed SS 39.6(g)(4)(iii).

54For example, a board resolution or an amendment to a board committee's charter could express