Substituted Compliance Framework

Substituted compliance is an alternative method by which the SEC can determine which participants in US security-based swap markets may satisfy certain conditions under the Exchange Act and its rules and regulations by complying with similar non-US requirements.

Exchange Act rule 3a71-6 provisionally provides that non-US security-based swap dealers and major security-based swap participants may meet certain conditions under Section 15F of the Exchange Act by instead complying with foreign requirements the SEC has deemed comparable. Rule 3a71-6 further conditions substituted compliance on the SEC and the foreign financial regulatory authority entering into an enforcement and supervisory memorandum of understanding and/or other arrangement addressing enforcement and supervisory cooperation and other concerns related to substituted compliance. The SEC and BaFin are currently negotiating a memorandum of understanding to address cooperation issues related to substituted compliance.

BaFin’s Substituted Compliance Application

BaFin is requesting that the SEC grants substituted compliance concerning requirements under the Exchange Act regarding:

• counterparty protection – requirements related to: (a) fair and balanced communications; (b) disclosure of risks, characteristics, incentives, or conflicts of interest; (c) daily mark disclosure; (d) “know your counterparty”; (e) suitability; and (f) clearing rights disclosure
• internal supervision and compliance – requirements related to supervision, conflicts of interest, and chief compliance officers and certain related matters
• recordkeeping and reporting – requirements related to: (a) record creation; (b) record maintenance; (c) reporting; and (d) notices
• risk control – requirements related to: (a) risk management systems; (b) trade acknowledgment and verification; (c) portfolio reconciliation; (d) portfolio compression; and (e) trading relationship documentation

The application is available here.

Proposed Order

The SEC is publishing a proposed order and welcomes public remarks regarding BaFin’s application. The proposed order is designed to reflect the SEC’s initial evaluation of the comparability of German and EU requirements and incorporates requirements meant to help promote comparability in practice. The proposed order also reflects the SEC’s preliminary assessments regarding the effectiveness of the German financial supervisory and enforcement frameworks. The proposed order incorporates certain conditions or other limits including:

• Portfolio reconciliation and dispute reporting – Based on EU timing requirements, firms will report counterparty valuation disputes directly to the SEC.
• Notification – The firm would need to: (a) simultaneously transmit to the SEC a copy of any notice required to be sent by comparable German and EU laws and include the contact data of someone who can provide further information about the notice; and (b) comply with the requirement in the SEC’s rule to provide notice of failure to make a required deposit into the reserve account required by the segregation rule for security-based swap dealers.
• Compliance reports – Firms must provide compliance reports directly to the SEC.
• Trading relationship documentation – Firms would not be permitted to apply the MiFID “eligible counterparty” exception regarding applicable German and EU requirements and would not receive substituted compliance in connection with certain disclosure-related provisions.
• Recordmaking – The firm would need to: (a) preserve the data elements to create certain records required by the SEC’s rule and provide the record in the format as required by said rule; (b) make certain records related to the security-based swap dealer segregation rule if the firm is not exempt from that rule; and (c) make certain records related to business conduct requirements for which substituted compliance is not available.
• Internal supervision and chief compliance officer requirements – Firms’ internal supervision and chief compliance officer frameworks must also promote compliance with certain residual US requirements and the conditions to the order.
• Suitability – The firm’s counterparty must be treated as a “per se professional client” under German and EU requirements. The counterparty must not be a “special entity”, which is defined in Exchange Act section 15F(h)(2)(C) and Exchange Act rule 15Fh-2(d).
• Daily mark disclosure – The firm must reconcile the portfolio containing the relevant security-based swap on each business day.
• Record preservation – The firm would need to: (a) maintain records concerning the security-based swap dealer segregation rule if the firm is not exempt from that rule; and (b) maintain records related to Regulation SBSR and business conduct requirements for which substituted compliance is not available.
• Financial and operational reporting – The firm would need to report financial and operational information in the manner and format specified by SEC order or rule.

Lastly, firms would continue to be subject to Exchange Act requirements to keep books and records open to inspection by the SEC. They will also need to provide for the SEC prompt, legible, true, complete, and current copies of those records of the firm that are required to be preserved.

Though the SEC welcomes applications that address margin and capital requirements under the Exchange Act, BaFin’s application does not seek substituted compliance with regard to margin and capital requirements. BaFin’s application is available on the SEC’s website, while additional information about substituted compliance applications is available here.

The SEC will seek public comments on the notice of application and proposed order for 25 days following publication in the Federal Register. Interested parties may send comments electronically via the SEC’s internet submission form or email submissions to: rule-comments@sec.gov. Paper submissions may be mailed to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. Submissions should refer to File Number S7-16-20, and if email is used, the file number should appear on the subject line. Information that is submitted will become part of the meeting’s public record and posted on the SEC’s website at sec.gov.

Sources:

SEC Publishes Notice of German Substituted Compliance Application and Proposed Order (sec.gov)

Notice of Substituted Compliance Application Submitted by the Bundesanstalt für Finanzdienstleistungsaufsicht in Connection with Certain Requirements Applicable to Security-Based Swap Entities Subject to Regulation in the Federal Republic of Germany; Proposed Order (sec.gov)

Substituted compliance application pursuant to Rules 0-13 and 3a71-6 under the Securities Exchange Act of 1934 “Exchange Act”) (sec.gov)