POLSINELLI FUNDS DIGEST | 1

APRIL 2020 | VOL. 2

Polsinelli Funds DigestThe Polsinelli Funds Digest highlights certain recent significant developments affecting advisers, broker-dealers, fund sponsors

and a diverse range of investment funds including private equity, mezzanine and credit funds, real estate and infrastructure funds, fund-of-funds, venture capital investments, secondary funds, co-investments, distressed investments and more.

SEC Censures Exempt Reporting Adviser for Failure to Form Advisory Committee

The Securities and Exchange Commission (SEC) issued an order on March 12, 2020, imposing fines and a cease-and-desist order on an exempt reporting adviser and its founders for, among other things, their failure to form a limited partner advisory committee authorized to approve certain transactions involving conflicts of interest.

Facts

Naya Ventures, LLC, a Texas exempt reporting adviser (“Naya Ventures”), and its wholly owned subsidiary, Naya Ventures Fund 1 GP, LLC (“Naya GP”), formed Naya Ventures Fund I, L.P. (the “Fund”) in October 2012. The

co-founders and managing members of Naya Ventures (the “Principals”) sought to raise up to $50 million in capital commitments to the Fund. As of December 2014, the Fund had received $13.5 million in commitments, of which $1 million came from Naya GP and the remainder from 53 limited partner investors, including the Principals.

By March 2016, the Fund had called 100% of capital commitments from its partners but had received only $7.8 million in capital contributions because each of the Principals and many of the limited partners defaulted on their obligations capital commitments to the Fund. While the Fund’s limited partnership agreement contemplated that Naya GP could impose a number of default remedies on defaulting partners, no such remedies were imposed and no partners, including the Principals, were deemed to be in default.

In addition, under the Fund’s limited partnership agreement, Naya GP was

required to establish an independent advisory committee (“IAC”) comprised of at least three limited partners. The Fund’s private placement memorandum provided that the IAC would be notified of any transactions entered into by Naya Ventures, Naya GP or any of their affiliates, on the one hand, and any portfolio companies of the Fund, on the other. However, the IAC was not formed until August 2018. In the interim, the Principals, directly and indirectly through one of their affiliates, contracted to provide services to a number of the Fund’s portfolio companies in exchange for compensation.

Finally, the Fund’s limited partnership agreement also required Naya GP to provide annual audited financial statements to the limited partners. However, no accounting firm was engaged to perform any such audits, and no audited financial statements were delivered to limited partners.

Todd W. BetkeShareholder Washington, D.C.

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SEC’s Determination

The SEC found that “[t]he decision concerning whether to deem [the Principals] in default presented a conflict of interest that required disclosure to the Fund, whether through the IAC or otherwise,” and that no such disclosure was made. The SEC also found that Naya Ventures had an obligation to notify the IAC about the compensation paid to the affiliate of the Principals by portfolio companies in exchange for services rendered, and that Naya GP had failed to comply with its obligation under the partnership agreement to provide audited financial statements to the limited partners.

As a result of the foregoing, the SEC determined that Naya Ventures had violated its obligations under the Advisers Act, and that the Principals were a cause of such violations. Specifically, the SEC found that Naya Ventures had failed to comply with Section 206(2) of the Advisers Act, which makes it “unlawful for any adviser … directly or indirectly to engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.” The SEC also found that Naya Ventures failed to comply with Section 206(4) of the Advisers Act (and Rule 206(4)-8 thereunder) which make it unlawful for an adviser to a pooled

investment vehicle to “[m]ake any untrue statement of a material fact or omit to state a material fact necessary to make the statements made ... not misleading, to any investor or prospective investor in the pooled investment vehicle,” or to “engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.”

The SEC ordered Naya Ventures to cease and desist from committing or causing any further violations of the sections of the Advisers Act referenced above, imposed civil money penalties of $40,000 on Naya Ventures and $20,000 on each of the Principals.

Suggested Takeaway

The SEC’s findings make it clear that private fund advisers should manage their funds in strict compliance with the terms of their respective partnership agreements or other applicable governing documents, including private placement memoranda, at all times. In addition, advisers should refrain from entering into any conflict of interest transactions unless previously disclosed in the fund’s offering documents or otherwise preapproved including by an independent committee. Special attention should be given to waivers to avoid conflicts of interest when not in the best interest of all investors.

C O N T I N U E D F R O M PA G E 1 Table of ContentsSEC Censures Exempt Reporting Adviser for Failure to Form Advisory Committee 1

Steps Private Equity Managers Should Take Now, Both For the Present and Post-Crisis 3

Proposed Changes to the Volcker Rule 5

Cayman Islands Private Funds Law, 2020and the Private Funds Regulations 2020 7

Risk Mitigation Techniques for Uncleared Security-Based Swaps 8

CFTC Proposes New Rules Regarding Cross-Border Swaps 10

ContactFor more information about any of the articles in this volume of the Polsinelli Funds Digest, please contact any of the following members of the Investment Funds team.

Todd W. Betke tbetke@polsinelli.com 202.626.8364

Brian A. Bullard bbullard@polsinelli.com 214.661.5531

Ruben K. Chuquimia rchuquimia@polsinelli.com 314.622.6636

Robert W. Dockery bdockery@polsinelli.com 214.661.5505

Philip G. Feigen pfeigen@polsinelli.com 202.626.8330

Daniel L. McAvoy dmcavoy@polsinelli.com 212.413.2844

Daniel A. Peterson dpeterson@polsinelli.com 314.622.6130

Pete Vincent pvincent@polsinelli.com 314.622.6610

Andrew L. Wool awool@polsinelli.com 312.463.624

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COVID-19 has already rocked the world of alternative investing. The two biggest private equity markets in the world – New York City and London – are now epicenters of the most recent wave of the outbreak and are under “stay at home” orders. Travel has been curtailed or outright banned in most of North America and Europe, making it much more difficult to analyze potential portfolio investments. A recession likely has begun. While there are many precautions that all employers and commercial firms currently should take – many of which we at Polsinelli discuss and will continue to update at our COVID-19 blog.

Look at your partnership agreements and side letters

Managers always are well served to analyze the terms of each fund’s partnership agreement and side letters whenever there is a major shift in the market. For example, it is advisable to assess the operating expenses provisions to understand how the costs of proposed methods of responding to the shift – such as accelerating investments in technology to facilitate virtual work environments during the current crisis – are to be allocated. Key person provisions should be assessed to determine if they might be triggered in case of a quarantine or extended period of limited mobility. Fund-level leverage provisions should also be reviewed to determine current compliance and the ability of the fund to obtain additional leverage to support portfolio companies or alleviate the need for capital calls during the anticipated downturn.

Determine what you can and can’t do with LP Advisory Committees (LPACs), particularly with respect to eliminating in-person meetings. Consider whether

interim claw-back provisions might be triggered due to an anomalous event. If an amendment to a fund’s partnership agreement may be necessary or desirable – such as to permit the fund to take additional actions due to extraordinary events, extend the final closing date or extend the investment period, among other things – it is often helpful to socialize possible amendment proposals with investors sooner rather than later. Take care to manage funds strictly in accordance with governing agreements and offering documents. In challenging economic times, defaults make occur that should not be waived unless permitted in these documents. Moreover, refrain from entering into any transactions with affiliated parties and portfolio companies that could create a conflict of interest unless previously disclosed in the offering documents or otherwise preapproved by investors or an independent committee.

Revise or supplement marketing materials

Managers that are out on the road should look at marketing materials to re-evaluate whether the statements therein are still true and whether risks are adequately disclosed. Managers have an obligation to provide investors in their managed funds with full and fair disclosure that is not misleading. In addition to including a COVID-19 risk factor specific to the fund’s asset class, risk factors and conflicts of interest should be re-evaluated from top to bottom, and updated and supplemented as necessary, to anticipate the effects and after-effects of the current crisis and

We believe that private equity managers should take a number of special steps, in response to the immediate crisis as well as to prepare for the post-outbreak environment.

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Steps Private Equity Managers Should Take Now, Both For the Present and Post-Crisis

Daniel L. McAvoyShareholder New York

Gabriel Yomi DabiriShareholder New York

Todd W. BetkeShareholder Washington, D.C.

Philip G. FeigenOffice Managing Partner Practice Chair Washington, D.C.

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the changes in social behavior resulting therefrom. Performance information should be revisited, particularly where unrealized portions of the portfolio are included. In addition, performance projections, if any, also should be revisited. Consider whether disclosures regarding business continuity plans should be elaborated upon. In some instances there may even need to be a slight pivot in the business thesis or value proposition of the fund, or a change in emphasis on aspects of your business model that you believe are countercyclical.

Keep an eye on standard provisions

Outside of certain industries, this appears to be the strongest buyer’s market in over a decade. In addition, the world is experiencing something unprecedented since the advent of private equity. Merger agreements, purchase agreements, loan agreements and other definitive agreements have been changing to account for the new world we are living in, both now and after the pandemic has passed. Regulatory approvals will certainly take longer than usual and the backlog may extend well into when operations normalize. This has put additional pressure on provisions governing how regulatory approvals are obtained, as well as how the business will be operated between signing and closing, what constitutes a force majeure and what will toll the drop dead date or outside date.

Representations, warranties and closing conditions regarding customers, suppliers and material adverse change have all materially shifted from where they were only months ago. Some of these changes likely are only going to remain relevant through the coronavirus crisis and until the valuation gap closes, but others are here to stay. In particular, don’t be surprised if processes of regulatory bodies and others change if it turns out that the same tasks can be accomplished in a more cost-efficient manner.

Consider valuations

Valuations of portfolio investments likely will be under a microscope. Carefully review policies and procedures that affect valuations. If existing investments will be marked down, consider how that could affect disclosure and reporting obligations and, if the fund is still in its marketing period, how this might affect limited partners’ required contributions at closing and the limited partners’ economic interest in existing investments, particularly if this might result in reopening side letter negotiations. Consider how valuations could be affected in a worst-case scenario, or if there is a recurrence of present events. In addition, prepare for LPs potentially to perform additional diligence in respect the valuation and performance of existing portfolio companies.

Adjust legal and business diligence

What was important when evaluating a business a month ago may not be as important now, and vice versa. Diligence that had already been completed may need to be reinstituted, even in areas where the effects of the virus and its economic effect are not obvious. Providers of rep and warranty insurance have honed in on matters relating to COVID-19 and, in many cases, are not willing to bear the risk of matters pertaining to the outbreak and its consequences.

Financial models may also need to be adjusted not only for the direct effect of COVID-19, but also for potential societal changes such as increased telecommuting, increased utilization of SaaS and lifestyle technologies, changes in governmental funding priorities and adjustments in interest rates and leverage ratios.

Make new friends

If there is a prolonged downturn or valuation gap, many managers may

need to turn to others to meet investor demands, adequately compensate employees, generate deal flow and keep portfolio companies afloat. Many investors are likely to want liquidity; building up relationships of those in the secondaries space can provide a means of giving a particular investor a liquidity opportunity or giving an entire fund a liquidity opportunity via GP-led restructuring. Far more secondary alternatives are available than there were in 2008 with there being significantly more dry powder and much more sophisticated transaction structures that can provide liquidity relief at any point in a fund’s or portfolio company’s life cycle. Without the ability for people to travel freely, intermediaries and investment bankers could become instrumental in generating deal flow.

Alternative debt providers now provide funding to more asset classes than ever, including venture debt and lending to GPs themselves, and refinancings might be key in being able to make distributions to investors and, when acceptable, boosting IRR. Private debt should become more important if it becomes more difficult for traditional commercial banks to meet their capital requirements or they simply refuse to lend in the post-crisis environment. In their absence, credit funds may reprise their role as “lender of last resort” as they did during the Great Recession of 2008. Many of the larger players in the private debt market have waited years for a correction in the market, although few would have hoped for one this severe, so expect more restrictions and fewer “cov-lite” loans.

Think about how you may want to reposition portfolio companies

Many portfolio companies will need to pivot their operations, exit strategies and possibly even business plans in response to the coronavirus crisis and any resulting change in the market environment. A number of steps that can be taken at the portfolio company level

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are described in another Polsinelli alert, Tips for Companies Facing Distress as a Result of COVID-19. That said, be careful that businesses don’t stray so far from their original business that they’re no longer within the fund’s investment mandate. Consider whether any of these changes might require LPAC approval.

Evaluate the nature of your investors

Funds with different investor bases will have different needs and different things that will keep them happy. Managers of “plan assets” could have far more restrictions as a fiduciary than those who are not, depending on a number of factors. State investors might be subject to changes in law or changes in internal policy that are binding as a matter of chain-of-command but not necessarily transparent to the outside world. Family offices may have a longer liquidity horizon and might better be able to withstand a years-long recession, should that happen. While many managers have a lot of experience with their investors,

they haven’t necessarily dealt with those investors in a time of financial instability. Knowing the needs of those investors can help a manager better anticipate their needs and to which changes they might provide more or less resistance.

Consider whether new financing alternatives might be available

The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) expands existing eligibility requirements and provides greater funding opportunities for businesses under two Small Business Administration Loan programs. Under the SBA 7(a) program, eligible portfolio companies may borrow up to $10 million with significant loan forgiveness if the funds are used for payroll, lease payments and other general expenses. Under the disaster assistance program, your portfolio companies may be eligible to borrow up to $2 million. This chart compares the salient aspects of both the SBA 7(a) loan program and the disaster assistance

program. Eligibility has been extended or expanded under a number of other federal programs, including the qualified opportunity zone fund program.

Don’t Panic

Remember the lessons we learned from 2008. While this downturn has come much faster, the circumstances are also very different. There are more sources of unregulated debt financing. There are more sources of LP and tail-end fund liquidity. There are more available capital commitments across the board. Capital markets have taken a significant tumble, but they have not frozen. While the market decline was faster, most analysts predict that the recovery will also be faster. And coming out of the Great Recession, private equity was one of the best performing asset classes. This definitely is not business as usual, but we know a lot more now, and have a lot more knowledge, than we did 12 years ago.

COVID-19: What Your Business Needs To Know

Join our mailing list to receive new blog posts, event information and COVID-19 legal updates direct to your email inbox.

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On January 30, 2020, the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency, Treasury (OCC), the Board of Governors of the Federal Reserve System (“Fed”), the Federal Deposit Insurance Corporation (FDIC) and the Commodity Futures Trading Commission (CFTC) (the “agencies”) issued a proposal to amend certain regulations under the “Volcker Rule.” The Volcker Rule under section 13 of the Bank Holding Company Act (BHC Act) prohibits banks and certain other financial institutions from engaging

in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring or having certain other relationships with a “covered fund.” The agencies’ proposal would add exclusions to the definition of “covered fund” and provide clarity on various pre-existing exclusions.

Presently, “covered fund” is defined as a company that is an investment company under the Investment Company Act of 1940, as amended (1940 Act) but for the exceptions contained in

Daniel L. McAvoyShareholder New York

Caroline C. SteckAssociate St. Louis

Proposed Changes to the Volcker Rule

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Sections 3(c)(1) or 3(c)(7) of the 1940 Act. Section 3(c)(1) excepts companies with fewer than 100 beneficial owners from being investment companies, with a number of complicated look-through rules for funds-of-funds. Section 3(c)(7) excepts companies owned only by “qualified purchasers,” typically entities with greater than $25 million invested, individuals with greater than $5 million invested, qualified institutional buyers and certain knowledgeable employees. While this was originally intended to prevent banks from circumventing the prohibition on proprietary trading by indirectly doing so through hedge funds and other investment vehicles, this captured a much wider swathe than intended. As a result, banks no longer can have exposure to a number of asset classes seen as low-risk, such as venture capital, real estate funds and certain collateralized loan obligations.

Proposed Additional Covered Fund Exclusions

The proposal to the Volcker Rule would add several new exclusions to the definition of “covered fund”:

Venture capital funds and credit funds

Entities created and used to facilitate a customer’s exposures to a transaction, investment strategy or other service (i.e., special purpose vehicles or SPVs)

Wealth management vehicles that manage the investment portfolio of a family and certain other persons (i.e., single family offices)

The proposal calls on the definition of “venture capital fund” from the exemption under the Investment Advisers Act of 1940, as amended (Advisers Act), with a number of additional requirements including that the fund must not engage in any activity that would constitute proprietary trading and financial institutions seeking to rely on this exclusion may not guarantee,

assume or otherwise insure the obligations or performance of the issuer. If the financial institution wishes to sponsor a venture capital fund, it must also ensure that the fund’s activities are in line with safety and soundness standards applicable to banking entities generally. Notably, while the bank may not guarantee obligations of the fund itself, there is no such restriction with respect to portfolio companies.

The proposal would exclude credit funds that make loans, invest in debt or otherwise extend the type of credit that banking entities may provide directly under applicable banking law. As used in the proposed exclusion, a credit fund is an issue whose assets consist solely of loans, debt instruments, related rights and other assets that are related to or incidental to acquiring, holding, servicing or selling loans, or debt instruments, and certain interest rate or foreign exchange derivatives. To use the exclusion, however, the credit fund must not engage in activities that would constitute proprietary trading and must not issue asset-backed securities. As proposed, this is a hair trigger test without any de minimis exceptions for other assets. Further, since this does not include warrants, it would still preclude banking entities from investing in or sponsoring venture debt funds.

The proposal would also exclude family wealth management vehicles from the definition of “covered fund” if it is (a) organized as a trust, the grantors of the entity are all family customers and (b) not organized as a trust, a majority of the voting interests in the entity are owned by family customers and the entity is owned only by family customers and, in each case, up to three closely related persons of the family customers. The entity also must not hold itself out as an entity that raises capital from third parties for investment purposes. This too borrows the definition of “family customer” from the Advisers Act, using the same definition as “family client” thereunder.

Finally, the proposal would exclude any issuer that acts as a customer facilitation vehicle from the definition. For the purpose of the proposal, a “customer facilitation vehicle” is any issuer that is formed by or at the request of a customer of the banking entity for the purpose of providing such customer with exposure to a transaction, investment strategy or other service provided by the banking entity. This proposed exclusion recognizes the reality that certain investments need to be structured as entities, even when it is a fund-of-one.

As a general matter, for a banking entity to rely on any of these exemptions, it must provide the investor with certain disclosures that normally would be made with respect to covered funds. Further, the family office and customer facilitation vehicle exclusions require that the bank not guarantee, assume or insure the obligations of the issuer, that the banking entity not retain, as principal, an ownership interest in the issuer other than an interest of up to 0.5% for certain legal purposes.

Loan Securitizations

The Volcker Rule permits banking entities to securitize loans through covered funds that hold only a limited set of assets and financial instruments. While most mortgage loan securitizations are completely outside the definition of “covered fund” because they rely on other exemptions under the Investment Company Act, many asset-backed securities include assets outside of all of the exclusions. This has limited the ability of banking entities to participate in certain types of securitizations and hampered their ability to structure complex instruments. In 2018, the agencies released a Loan Securitization Servicing FAQ to clarify the scope of what constitutes a “loan” and servicing rights. The proposed amendment would codify that FAQ.

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Modifications to Existing Public Welfare Exclusions

The BHC Act permits banking entities to make and retain investments that are designed primarily to promote the public welfare, such as investments in affordable housing vehicles, but whether an investment qualifies as promoting the public welfare varies depending on the agency issuing the implementing regulation. Further, there are many investments that arguably could be for public welfare, but there is insufficient specificity in the rules to make an appropriate determination.

The agencies are seeking comments on whether any change should be made to clarify that all permissible public welfare investments, under any agency’s regulation, are excluded from the covered fund restrictions. Specifically, the agencies are seeking comment on

whether qualified opportunity funds or QOFs and rural business investment companies should be expressly excluded from the definition of covered funds, rather than relying on the general public welfare exclusion to exclude such funds.

Additional Changes to the Volcker Rule

In addition to those mentioned above, the proposal would make the following changes to the Volcker Rule:

� Clarify that small business investment companies (“SBICs”) continue to stay outside of the definition of covered fund if the SBIC voluntarily surrenders its license to operate as an SBIC, so long as no new investments were made after the voluntary surrender;

� Excluding qualifying foreign excluded funds – in general terms

an entirely foreign fund that is deemed sponsored by a bank solely due to common control with a US bank under the BHC Act – from the definition of “covered funds;”

� Permit a banking entity to engage in a limited set of covered transactions with a covered fund the banking entity sponsors or advises or with which the banking entity has certain other relationships; and

� Clarify certain aspects of the definition of “ownership interest,” including specifically exempting bona fide senior loans or senior debt instruments from that definition.

The comment period for the proposal is scheduled to end on May 1, 2020.

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On February 7, 2020, the Cayman Islands Government passed the Private Funds Law, 2020 and the Private Funds (Savings and Transitional Provisions) Regulations 2020 (the “Funds Law”) that require registration of certain closed-ended funds with the Cayman Islands Monetary Authority (“CIMA”).

Under the Funds Law, a “private fund” is defined as an entity whose principal business is the offering and issuing of its investment interests, in order to pool

investor funds and spread investment risks allowing investors to receive profits or gains from fund investments provided that the investors are not involved in the acquisition, holding or management of the investments, and the investments are managed by or on behalf of the operator of the fund for a reward based on the assets, profits or gains of the entity. The Funds Law does not apply to securitization SPVs, joint ventures, proprietary vehicles or holding vehicles, preferred equity vehicles, sovereign wealth funds, structured finance vehicles, and single-family offices.

Regulatory requirements for registered private funds include auditing, submission of year-end financial statements, appropriate procedures for asset valuations, safekeeping of fund

assets, title verification, cash monitoring, and records of the identification codes of the securities that the private fund trades. Failure to register will result in a fine of CI$100,000 (approximately $122,000) fine; failure to comply with other requirements may result in fines to the operator of CI$20,000 (approximately $24,400).

Key Takeaway

The Funds Law includes a six-month transitional period until August 7, 2020, the date by which all private funds must be registered. Following the transitional period, private funds must file with the CIMA within 21 days after the acceptance of capital commitments from investors.

Sara C. AinsworthAssociate Washington, D.C.

Cayman Islands Private Funds Law, 2020 and the Private Funds Regulations 2020

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Effective on April 6, 2020 are new Securities and Exchange Commission (“SEC”) risk mitigation tools pursuant to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act applicable to portfolios of uncleared security-based swaps. The SEC’s new rules involve (i) risk mitigation techniques to portfolios of uncleared security-based swaps; (ii) amendments to existing cross-border rule to provide a means to request substituted compliance with respect to the portfolio reconciliation, compression, and trading relationship documentation requirements; and (iii) changes to recently-adopted recordkeeping, reporting, and notification rules to incorporate records relating to the new risk mitigation requirements. The compliance date for the final rules, other than the amendments to Rule 3a71-6 (as discussed below), will be the same as the compliance date for the registration of security-based swap dealer or major security-based swap participants (each, an “SBS Entity”) on October 6, 2021.

The SEC’s new rules (15Fi-3, 15Fi-4, and 15Fi-5) establish requirements for each registered SBS Entity with respect to (i) reconciling outstanding security-based swaps with applicable counterparties on a periodic basis, (ii) engaging in certain forms of portfolio compression exercises and (iii) executing written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap transaction.

Rule 15Fi-3: Portfolio Reconciliation

For purposes of the new requirements, the term “portfolio reconciliation” will be defined to mean the process by which the two parties to one or more security-based swaps:

� Exchange the terms of all security-based swaps in the security-based swap portfolio between the counterparties; 

� Exchange each counterparty’s valuation of all outstanding security-based swaps entered into between the counterparties as of the close of business on the immediately preceding business day; and

� Resolve any discrepancy in valuations or material terms.

The term “material terms” includes each term of a security-based swap that is required to be reported to a registered swap data repository or the SEC pursuant to Regulation SBSR, other than a term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap. Rule 15Fi-3(a) applies to security-based swap portfolios between two SBS Entities, as follows:

� Each business day for each portfolio that includes 500 or more security-based swaps;

� Weekly for each portfolio that includes more than 50 but fewer than 500 security-based swaps on the business day during any week; and

� Quarterly for each portfolio that includes no more than 50 security-based swaps at any time during the calendar quarter.

Any discrepancy in a material term other than with respect to valuation must be resolved immediately. Valuation discrepancies of ten percent or greater of the higher valuation must be resolved as soon as possible, but in any event within five business days of identifying the discrepancy.

Rule 15Fi-3(b) applies to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity requiring the former to establish, maintain and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation no less frequently than: (i) quarterly for each portfolio that includes more than 100 security-based swaps at any time during the calendar quarter; and (ii) annually for each portfolio that includes no more than 100 security-based swaps at any time during the calendar year. The policies and procedures also must provide that any discrepancy in the valuation or in a material term must be resolved in a “timely fashion.”

Rule 15Fi-3(c) establishes a reporting obligation in the event of certain unresolved security-based swap valuation disputes involving prompt notification to the SEC of any security-based swap valuation dispute in excess of $20,000,000, at either the transaction or portfolio level, if not resolved within: three business days, if the dispute is with a counterparty that is an SBS Entity; or five business days, if the dispute is with a counterparty that is not an SBS Entity. 

Matthew C. CooperAssociate Washington, D.C.

Risk Mitigation Techniques for Uncleared Security-Based Swaps

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Rule 15Fi-4: Portfolio Compression

Rule 15Fi-4(a) applies to security-based swap portfolios between two SBS Entities, and requires each SBS Entity to establish, maintain, and follow written policies and procedures to:

� Evaluate bilateral and multilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party;

� Engage periodically in bilateral portfolio compression exercises and multilateral portfolio compression exercises, in each case when appropriate, with its SBS Entity counterparties; and

� Terminating each fully offsetting security-based swap with its SBS Entity counterparties in a timely fashion, when appropriate.

Rule 15Fi-4(b) applies to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity, and require the SBS Entity to establish, maintain, and follow written policies and procedures for periodically terminating fully offsetting security-based swaps and for engaging in bilateral or multilateral portfolio compression exercises with the applicable counterparty, when appropriate and to the extent requested by any such counterparty.

Rule 15Fi-5: Trading Relationship Documentation

Rule 15Fi-5(a)(2) requires each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties (regardless of whether the counterparty is an SBS Entity) prior to, or contemporaneously with, executing a security-based swap with such counterparty. Pursuant to Rules 15Fi-5(b)(1) and (3), the applicable policies and procedures

should require security-based swap trading documentation in writing with all terms governing the trading relationship including 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. The rules should require that the security-based swap trading relationship documentation include credit support arrangements addressing certain margin-related matters identified in the rule.

Rule 15Fi-5(b)(4) requires that the applicable policies and procedures provide that the relevant swap trading relationship documentation between certain specified types of financial counterparties include written documentation about procedures, rules, and inputs, for determining the value of each security-based swap at any time from execution to the termination, maturity, or expiration of such security-based swap. 

Rules 15Fi-5(b)(5) and (6) requires that the policies and procedures governing the applicable trading relationship documentation require SBS Entities to disclose certain information to their counterparties regarding both their legal status and the status of the security-based swap. Finally, Rule 15Fi-5(c) will require each SBS Entity to have an independent auditor conduct periodic audits sufficient to identify any material weakness in its documentation policies and procedures required by the rule.

Amendments to Recordkeeping Rules

The SEC amended Rule 3a71-6 to address the potential availability of substituted compliance in connection with Rules 15Fi-3 through 15Fi-5. The SEC also amended the recordkeeping, reporting, and notification requirements applicable to SBS Entities to require SBS Entities to make and keep records regarding portfolio reconciliation,

bilateral offsets, bilateral or multilateral portfolio compression, valuation disputes, and written trading relationship documentation.

Cross-Border Application of Rules 15Fi-3, 15Fi-4 and 15Fi-5

Finally, the SEC also put forward a final cross-border interpretation to treat new Rules 15Fi-3 through 15Fi-5 as entity-level requirements that apply to an SBS Entity’s entire security-based swap business without exception, including in connection with any security-based swap business it conducts with foreign counterparties.

Key Takeaways

The SEC’s rules represent significant changes to the security-based swap industry. The adoption of Rules 15Fi-3, 15Fi-4 and 15Fi-5 under Title VII of the Dodd-Frank Act establish requirements for SBS Entities to reconcile outstanding security-based swaps with counterparties, engage in portfolio compression exercises, as needed, and execute written trading relationship documentation with counterparties before or while executing a security-based swap transaction. The compliance date for these rules will be October 6, 2021.

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CFTC Proposes New Rules Regarding Cross-Border Swaps

1 Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants, 85 Fed Reg. 952.2 Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292 (July 26, 2013).

The Commodity Futures Trading Commission (“CFTC”) published proposed rules regarding the cross-border application of registration thresholds and certain requirements applicable to swap dealers (the “Proposal”).1 CFTC Chairman Heath Tarbert has publicly stated that he intends to finalize the Proposal by summer 2020. The Proposal revises certain CFTC’s positions including redefining or establishing certain key terms, re-categorizing entity-level and transaction-level requirements and codifying how to count cross-border swaps towards the swap dealer (“SD”) registration threshold and exceptions for certain foreign-based swaps and the CFTC’s approach to substituted compliance and comparability determinations and treat arranged, negotiated, or executed (“ANE”) transactions as any other swap between Non-U.S. Persons.

Background

Section 2(i) of the Commodity Exchange Act (the “Act”) imposes a regulatory framework for swaps, including certain swap transactions and related activities that take place outside of the United States that have a direct and significant connection with activities in or effect on U.S. commerce. The CFTC first formally issued interpretive guidance and a policy statement on Section 2(i) in 2013 (the “Cross-Border Guidance”) under the

Act, which was not codified.2 In 2016, the CFTC proposed regulations codifying its cross-border application of swap rules under the Act, after it had adopted cross-border margin rules for uncleared swaps in the Cross-Border Margin Rule. The Proposal would withdraw the Cross-Border Margin Rule and codify the CFTC’s new framework to implement a more deliberate and territorial approach to the regulation of cross-border swaps and the counterparties involved.

The Proposal’s New and Amended Definitions

The Proposal contains new and amended definitions of important terms, including U.S. Person, guarantee, significant risk subsidiary (“SRS”), and related terms to assess whether a direct and significant connection exists such that certain swaps should be counted toward the SD or major swap participant (“MSP”) de minimis threshold and subject to the cross-border application of certain Dodd-Frank Act requirements.

U.S. Person, Non-U.S. Person, and United States. The focal point of the Proposal is the addition of a formal definition for the term “U.S. Person” with a definition identical to the definition of the same term adopted by the SEC in relation to security-based swaps. The Proposal would define a “U.S. Person” as a natural person resident in the United States; a partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States; and an account of a U.S. Person; or the estate of a decedent who was a resident of the United States at the time of death. This definition aligns

with the SEC’s Cross-Border Rule, which contains a definition consistent with the Proposal’s definition.

Under the Proposal, the CFTC would no longer consider a fund that is majority owned by one or more U.S. Persons as a U.S. Person, despite acknowledging that this approach may present a challenge under certain arrangements, such as for fund of funds. The Proposal explicitly excludes international financial institutions, such as the International Monetary Fund (among others).

Guarantee. Under the Act, additional rules and obligations can apply to counterparties when entering into a swap with a Non-U.S. Person that has a guarantee from a U.S. Person, than if the Non-U.S. Person did not have guarantee issued by a U.S. Person. Moreover, Non-U.S. counterparties with a guarantee from a U.S. Person must count all of their swaps towards the de minimis threshold for registration as an SD, and Non-U.S. Persons must count all swap dealing activity with a Non-U.S. Person with a U.S. Person guarantee towards the same threshold. Thus, recourse would exists if the party has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from the guarantor with respect to its counterparty’s obligations under the swap. Further, a “guarantee” does not necessarily need to be included within the swap documentation.

Significant Risk Subsidiary. In another substantial change, the Proposal eliminates the Cross-Border Guidance concept of a “Conduit Affiliate,” and adds in its place a new category of non-U.S. entity called an SRS, which must be treated like a U.S. Person for regulatory

Pete VincentAssociate St. Louis

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purposes due to the risks posed to an ultimate and significant U.S. parent of the SRS. The Proposal would consider a Non-U.S. Person a SRS if the Non-U.S. Person is a significant subsidiary of an ultimate U.S. parent entity, as defined in the Proposal.

Significant Subsidiaries. The Proposal would adopt a definition of “significant subsidiary” that is similar but not identical to the definitions in SEC Regulation S-X and the Federal Reserve Board’s financial statement filing requirements for foreign subsidiaries of U.S. banking organizations. The Proposal would define “significant subsidiary,” as a subsidiary that meets one of the following three quantitative tests determined in accordance with GAAP at the end of the most recently completed fiscal year:

� Equity Capital Significance Test: The three-year rolling average of the subsidiary’s equity capital is equal to or greater than 5% of the three-year rolling average of its ultimate U.S. parent entity’s consolidated equity capital; or

� Revenue Significance Test: The three-year rolling average of the subsidiary’s revenue is equal to or greater than 10% of the three-year rolling average of its ultimate U.S. parent entity’s consolidated revenue; or

� Asset Significance Test: The three-year rolling average of the subsidiary’s assets are equal to or greater than 10% of the three-year rolling average of its ultimate U.S. parent entity’s consolidated assets.

Non-U.S. Persons with U.S. Parent Entities. Non-U.S. subsidiaries that are consolidated in the financial statements of U.S. parent entities may require greater regulatory supervision than Other Non-U.S. Persons, as consolidation may permit U.S. Persons to accrue risk through the swap activities of their non-U.S. subsidiaries, which in turn could have a significant effect on the

U.S. financial system. The Proposal contemplates a risk-based approach to determine which SRSs must comply with CFTC swap requirements as reflected in the definition of SRS.

Exclusions from the Definition of SRS. A Non-U.S. Person would not be an SRS to the extent the entity is subject to regulation as a subsidiary of a U.S. bank holding company (“BHC”), or is subject to comparable capital and margin standards such as Basel Committee on Banking Supervision’s International Regulatory Framework for Banks or if CFTC has issued a margin determination.

Swaps Conducted Through a Foreign Branch and Foreign-Based Swaps

Foreign Branch. Under the Proposal, a “foreign branch” is an office of a bank that is a U.S. Person, where such office is located outside the United States, operates for valid business reasons, maintains accounts independently of the home office and of the accounts of other foreign branches, with the profit or loss accrued at each branch determined as a separate item for each foreign branch and is engaged in the business of banking or finance and is subject to substantive regulation in banking or financing in the jurisdiction where it is located. The term “foreign branch” does not include an affiliate of a U.S. bank that is incorporated or organized as a separate legal entity, and the Proposal does not consider foreign branches of U.S. Persons to be separate from their U.S. principal for registration purposes.

Swaps Conducted Through a Foreign Branch. The Proposal defines a swap conducted through a foreign branch refers to a swap entered into by a foreign branch where the foreign branch is the office through which the U.S. Person makes and receives payments and deliveries under the swap pursuant to a master netting or similar trading agreement, and the documentation of the swap specifies that the office

for the U.S. Person is such foreign branch; the swap is entered into by such foreign branch in its normal course of business; and the swap is reflected in the local accounts of the foreign branch. This definition serves as an anti-evasion measure to prevent a U.S. bank from routing swaps for booking through a foreign branch for purposes of the SD and MSP registration thresholds or to avoid certain applicable regulatory requirements.

Foreign-Based Swaps. The Proposal defines “foreign-based swap” as a swap by a non-U.S. swap entity, except for a swap conducted through a U.S. branch or a swap conducted through a foreign branch. Foreign-based swaps generally consist of swaps by non-U.S. swap entities, except for swaps conducted through a U.S. branches, and swaps conducted through a foreign branch such that it would satisfy the definition of a foreign-based swap. Certain foreign-based swaps are eligible for newly proposed exceptions, described further below.

Cross-Border Swap Dealer Registration Thresholds

An SD who enters into swaps with an aggregate gross notional amount of over $8 billion (or $25 million if the counterparty is a “special entity”), over the course of the immediately preceding 12 months, is required to register as an SD. The Proposal addresses the application of a de minimis threshold to the cross-border swap dealing transactions of U.S. and Non-U.S. Persons in connection with SD and MSP registration. Whether a swap is counted toward the de minimis threshold depends in large part on the status of the counterparty. Swaps that are anonymously entered into on a registered designated contract market, any swap execution facility or registered foreign board of trade are not applied towards the threshold for registration as an SD as long as the swap is cleared by a derivatives clearing organization.

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Counting Swaps toward the Swap Dealer De Minimis Threshold. The CFTC intends to treat an SRS the same as a U.S. Person to prevent the creation of a “substantial regulatory loophole” that might incentivize U.S. Persons to avoid any relevant Dodd-Frank Act requirements by conducting their dealing business with Non-U.S. Persons through an SRS. Accordingly, under the Proposal, an SRS would include all of its dealing swaps in its de minimis threshold calculation without exception, including swap dealing activities of an SRS’s branches and require a Non-U.S. Person to include all dealing swaps with a U.S. Person toward the de minimis threshold for registration as an SD (except for swaps with a counterparty that is a foreign branch of a U.S. SD unless it is a Guaranteed Entity or SRS).

Counting Swaps Toward the MSP Thresholds. The Proposal would apply the “attribution requirement” to the analysis whether a person must register as an MSP because its swap positions exceed one of several thresholds. An entity’s swaps would be attributed to a parent, other affiliate, or guarantor to the extent that the counterparties have recourse to the parent, other affiliate, or guarantor with respect to the swap position, if the parent, other affiliate, or guarantor is not subject to capital regulation by the CFTC, SEC or other regulator. U.S. Person, Guaranteed Entity or SRS would be required to count all of its swap positions toward the MSP threshold and Other Non-U.S. Person would count all swaps with a U.S. Person, except those conducted through a foreign branch of a registered SD and Guaranteed Entity, with certain exceptions, toward the MSP thresholds.

Aggregation Requirement. The Proposal would require a person to aggregate all of its dealing swaps with those of persons controlling, controlled by, or under common control

with the person as long as such other persons are required to include the relevant swaps in their de minimis calculations (unless the affiliated person is a registered SD), which is consistent with the Cross-Border Guidance. When an affiliated group meets the de minimis threshold, at least one member of such group must register as an SD, with the other affiliates’ swap dealing activities remaining below the de minimis threshold.

Revised Approach to Substituted Compliance

Due largely to the development of the global swaps supervisory landscape, the Proposal represents a more limited U.S. approach to the cross-border reach of the Act and would allow market participants increased opportunities to take advantage of substituted compliance with foreign regulatory regimes. The Proposal would eliminate the Cross-Border Guidance classifications of Entity-Level Requirements and Transaction-Level Requirements, creating new categories of requirements, classified as “Groups A, B, and C Requirements” and introduce several exemptions for qualifying SDs when transacting in foreign-based swaps. The Proposal allows non-U.S. SDs and non-U.S. regulatory agencies as well as trade associations to request the CFTC to issue a comparability determination to allow substituted compliance with swap-related requirements. Existing comparability determinations would remain effective if the CFTC adopts the Proposal.

New Classification Scheme. The Cross-Border Guidance established a taxonomy of SD compliance obligations distinguishing between “entity-level” and “transaction-level” requirements that were further sub-divided, as follows, entity-level requirements were allocated between “first” and “second” categories,

and transaction-level requirements were split between “Category A” and “Category B” requirements. The Proposal would reclassify SD compliance obligations into Groups A, B and C. The Proposal would provide four exceptions with respect to foreign-based swaps (1) exchange-traded exception, (2) foreign swap Group C exception, (3) non-U.S. swap entity Group B exception, and (4) foreign branch Group B exception. The Proposal is silent as to whether a foreign regulator must take action or issue a finding of noncompliance against a non-U.S. swap entity before the CFTC could take enforcement action under these circumstances.

Arranged, Negotiated, or Executed Transactions

The Proposal would treat all foreign-based swaps entered into between a non-U.S. SD and a Non-U.S. Person the same regardless of whether the swap was an ANE transaction, thus superseding the Division of Swap Dealer and Intermediary Oversight requirements with respect to the application of the new categories of SD requirements (i.e., “Groups B and C” requirements) as described above. This proposed treatment of ANE transactions contrasts with the SEC’s, which has taken an expansive approach under which ANE transactions count toward the security-based SD de minimis registration threshold and are generally subject to the SEC Cross-Border Rule.

The CFTC supports the new position in the Proposal based on policy considerations, including undue market distortions and international comity. The CFTC also points to commenters’ concerns that the DSIO advisory’s requirements could cause non-U.S. SDs to relocate personnel to other countries. The CFTC would continue to have anti-fraud and anti-manipulation authority over ANE transactions.

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