The Commodity Futures Trading Commission (CFTC) may have tempered its ambition to regulate cross-border swaps, but whistleblowers abroad still will play an important role in preventing regulatory evasion.
In June 2012, the CFTC proposed sweeping regulation of swaps that cross U.S. borders. The proposal would have regulated all U.S.-facing swaps, and more than a few foreign firms would be subject to entity-level requirements. However, pushback from the industry and foreign regulators caused the CFTC to reassess.
The agency then offered a diluted proposal and took public comments, but the CFTC has yet to revisit the issue. Instead, in early December the CFTC issued a joint statement on global swap regulation with other G-20 regulators. The statement announced a consensus-based approach to cross-borders regulation.
The CFTC’s authority and commitment to prosecute those who evade regulation appear unwavering and unquestioned — even when the evasion comes abroad.
We can expect such regulation to be like the IRS’ enforcement focus on offshore financial centers. Regulatory arbitrage causes violators to engage in numerous complex schemes to park funds in favorable jurisdictions to evade U.S. tax liability.
Similarly, jurisdictions with lax oversight could draw firms seeking to avoid swap regulation. For example, firms may organize foreign subsidiaries, as opposed to branches, to avoid entity-level capitalization and management requirements.
For the time being, substantive cross-border regulation seems to have stalled.
To be sure, the CFTC may insist that individual swaps involving U.S. citizens meet new requirements, like mandatory clearing. Some entity-level requirements, like reporting, also may survive. This is because the CFTC has expressed the view that these requirements further critical oversight objectives.
But three things signal that the agency will adopt a position that is much more modest than the June 2012 proposal.
First, in addition to the diluted July proposal that the CFTC eventually offered, the CFTC’s joint statement with G-20 regulators signals that the CFTC is now committed to a consensus-based approach that will guarantee a retreat from the CFTC’s original, internationally unpopular proposal. Second, the agency has declined to issue final guidance despite closing the public comment period four months ago. The agency said it plans to issue the guidance, but it has declined to do so in several final rules that the agency has issued since the comment period. Finally, the long-awaited final rule on mandatory swap clearance made substantial concessions to the industry, signaling that the agency may do so again in the cross-border context.
Even if the CFTC takes an aggressive position on cross-border regulation, only the very largest foreign firms will be covered. This is because the mandatory swap clearance regulation exempts any participant whose annual swaps have a notional value of less than $8 billion (a threshold that will drop to $3 billion after a phase-in period) from the definition of “swap dealer” and “major swap participant.” As such, only the largest firms will incur extensive regulation as swap dealers or major participants.
Under the proposed rule, the CFTC estimated that more than 300 firms would register as swap dealers. The agency now expects only about 125 firms to register under the final rule. The CFTC did not specify whether this figure is based on the phase-in or final threshold, or whether the figure includes foreign firms. The law gives the CFTC stronger authority to prosecute those who intentionally evade regulation.
This type of violation is particularly amenable to oversight by insiders because the CFTC has declined to apply a technical definition to “evasion.” Rather, the agency will examine the totality of circumstances around a firm’s conduct to determine whether the firm was evading regulation.
Whistleblowers will have an important role because the evasion inquiry focuses on the firm’s intent. Whistleblowers will be in a position to provide the type of direct evidence rarely available to outside regulators. Because defendants may argue that they mistakenly violated the new, technical provisions, being able to provide evidence of scienter will be especially important during the regulations’ early days.
Further, whistleblowers need not have technical knowledge to identify evasive transactions. But insiders’ technical knowledge will help identify new frauds because the CFTC’s various exemptions leave room for fraudsters to game legal loopholes. Some of those exemptions, like the hedge exemption, focus not only on the transaction, but also on the purpose behind it.
The Dodd Frank Act’s whistleblower rewards programs provide ample incentive to disclose violations. Though evasion cases could be worthwhile alone, these cases could reveal much larger frauds. Because evasive transactions are treated as swaps, they count toward the aggregate annual notional value of a firm’s swaps. Therefore, repeat offenses may trigger a firm’s duty to register as a swap dealer or major swap participant. Through its evasion, the firm also will have then failed to meet entity-level obligations. Further, each evasive transaction may violate transaction-level requirements concomitantly, like mandatory clearing.
Finally, two points from the agency’s requested FY 2013 budget suggest that this is a particularly good time to bring a CFTC whistleblower rewards claim.
First, the CFTC has sought to nearly double its swap and intermediary oversight budget, adding roughly 70% to the activity’s work force. This suggests that the CFTC believes that the new swap regulations will require substantial oversight to ensure compliance.
Second, the Commission is seeking to add almost fifty employees to its enforcement division.
Coupled with a whistleblower’s office that has a light workload compared to the Securities and Exchange Commission, this situation presents substantial potential for whistleblowers to bring successful rewards actions.
In sum, although cross-borders swap regulation appears much farther away than it did last summer, whistleblowers can help at least ensure that firms are not committing regulatory arbitrage by moving transactions to less-regulated jurisdictions.