The SEC's Cross Border Regulatory Creep

Last week, the Securities and Exchange Commission proposed its cross-border security-based swaps rule under Dodd-Frank with great fanfare and a unanimous commission vote. Many outside the SEC have deemed the proposal a success, presumably because it is not as bad as the approach taken by the Commodity Futures Trading Commission that has angered regulators the world over. Exceeding the CFTC's low bar is a pretty poor metric for assessing regulatory success.

Dodd-Frank prohibits the SEC from applying its rules to security-based swaps businesses conducted "without the jurisdiction of the United States," except to the extent the firm violates SEC rules designed to prevent evasion of Dodd-Frank provisions. The SEC's proposed approach strays from the statute's territorial limitations and instead employs a nebulous approach based on conjecture about whether particular activities will be "conduits of risk into the U.S. financial system." As a consequence, the proposal departs from SEC precedent in selecting which market participants and transactions to regulate. Although the SEC's desire to safeguard the U.S. financial system from risks of foreign origin is understandable, its proposal is impractical and not respectful of other countries' very rigorous ongoing regulatory efforts.

The proposal, which offers detailed consideration of numerous, complicated cross-border implementation questions, is lengthy-the Web version is 650 pages, almost as long as Dodd-Frank itself. It proposes a framework governing the application of U.S. security-based swaps markets rules to international swaps transactions and foreign market participants. The proposal tells firms how to figure out if they need to register and which transaction-level and entity-level requirements apply once they are registered.

The proposal allows firms to apply for permission to bypass certain requirements on the basis of so-called substituted compliance, the centerpiece of the proposal. If the SEC signs off on substituted compliance for one firm in a foreign jurisdiction, all firms in the same jurisdiction will be permitted to comply with their home country rules instead of the SEC's rules. The catch is that firms have to obtain separate approval for each of four categories of regulations, and the proposal leaves the SEC the option of ignoring these categories and applying substituted compliance on a rule-by-rule basis. Moreover, the proposal tells one category of foreign market participants-major security-based swap participants-not to even bother applying for substituted compliance because the SEC doesn't know enough about them.

Substituted compliance will impose tremendous initial burdens on the SEC staff as they try to assess requests from firms eager to avoid having to comply with duplicative, and perhaps conflicting, regulatory regimes. Firms will also incur great costs to figure out which requirements apply to which transactions. If other countries follow suit, the costs and complexities will be even greater. Until a firm succeeds in obtaining a substituted compliance approval from each country with any potential tie to its security-based swap transactions, it would be forced to comply with every one of those countries' rules-rules that may be incompatible with one another. The SEC considered and rejected an approach that would have been easier to administer and easier for market participants to comply with, namely allowing "substituted compliance across the entire set of security-based swap requirements with respect to regimes that have implemented regulations consistent with the overall objectives of the G20 commitments."

The SEC's creep across the border is less dramatic than the CFTC's leap, and its proposal reflects a greater respect for important procedural issues such as economic analysis, meaningful opportunity for public comment, and thoughtful consideration of alternative approaches. Nevertheless, the SEC has avoided criticism of its security-based swaps rulemaking so far by being not quite as unreasonable as the CFTC. It's time to start applying a tougher standard to the SEC's efforts.