Sullivan & Cromwell discusses Foreign Banks and the Swap-Push Out Rule

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Federal Reserve Issues Rule to Classify Uninsured U.S. Branches and Agencies of Foreign Banks as Insured Depository Institutions for Purposes of the Swaps Push-out Provision of the Dodd-Frank Act and Explain the Process for Obtaining Transition Period Relief

On June 5, 2013, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued an interim final rule (the “Interim Final Rule”) that places U.S. branches and agencies of foreign banks on an equal footing with U.S. banks with respect to the so-called “swaps push-out” provision of Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Interim Final Rule, which is effective immediately, reflects the widely expressed intent of Congress, avoids a discriminatory impact on foreign banks, and ameliorates the disruption and other negative consequences that will be experienced by the U.S. branches and agencies of foreign banks and the swap markets.

Section 716 of the Dodd-Frank Act, which will become effective on July 16, 2013, generally prohibits providing Federal assistance1 (including advances from the Federal Reserve’s discount window and Federal Deposit Insurance Corporation insurance or guarantees) to “swaps entities,” including registered swap dealers, security-based swap dealers, major swap participants and major security-based swap participants. This general prohibition is subject to several important exceptions for insured depository institutions.

First, Section 716(b)(2)(B) provides that an insured depository institution is not a “swaps entity” if it is a major swap participant or major security-based swap participant.2 Second, Section 716(d) provides that the general prohibition does not apply to an insured depository institution that limits its swaps activities to hedging and other similar risk-mitigating activities directly related to the insured depository institution’s activities or acting as a swaps entity for swaps or security-based swaps involving rates or reference assets that are permissible for investment by a national bank under the National Bank Act.3 In addition, Section 716(f) provides that the appropriate Federal banking agency “shall permit” a transition period for insured depository institution swap entities to divest or cease non-conforming swap activities.4 The initial transition period can be up to 24 months, which can be extended for an additional one year. Section 716(e) provides that the general prohibition shall only apply to swaps or security-based swaps entered into by an insured depository institution after the end of the transition period.5

The term “insured depository institutions,” which is not defined in Title VII of the Dodd-Frank Act, and the related exceptions, have been read by some as excluding uninsured U.S. branches and agencies of foreign banks. This discriminatory approach, however, was disavowed by former Senator Blanche Lincoln, the principal sponsor of Section 716, and former Senate Banking Committee Chairman Christopher Dodd, who maintained that uninsured U.S. branches and agencies of foreign banks should be “treated the same as insured depository institutions under the provisions of section 716, including the safe harbor language.”6

The Interim Final Rule adopts this non-discriminatory approach and provides that for purposes of the swaps push-out provision and the Interim Final Rule itself, the term “insured depository institution” includes both any insured depository institution, as defined in section 3 of the Federal Deposit Insurance Act (“FDIA”), and any uninsured U.S. branch or agency of a foreign bank.7 As a result of the Interim Final Rule, uninsured branches or agencies of foreign banks can rely on the exclusions, grandfather and transition period provisions of Section 716 to the same extent as U.S. banks. The Interim Final Rule became effective on June 5, 2013, although the Federal Reserve has requested comments and the Rule could therefore be subject to further change. Comments must be submitted by August 4, 2013.

In addition, the Interim Final Rule also explains the process for state member banks and uninsured state branches or agencies of foreign banks to apply to the Federal Reserve for the transition period. The Federal Reserve has already received applications from state member banks requesting transition period relief.

We note the Office of the Comptroller of the Currency (“OCC”) issued guidance (the “OCC Guidance”) on December 31, 2012 regarding the transition periods for insured Federal depository institutions. The OCC Guidance does not apply to uninsured federally licensed U.S. branches and agencies of foreign banks. Because the Federal Reserve has now clarified that the term “insured depository institution” includes uninsured U.S. branches or agencies of foreign banks (in addition to U.S. banks) for purposes of Section 716, we expect that the OCC would provide further guidance regarding the transition periods for uninsured federally licensed U.S. branches and agencies of foreign banks.

Endnotes:

1. See 15 U.S.C. 8305(a).
2. See 15 U.S.C. 8305(b)(2)(B).
3. See 15 U.S.C. 8305(d). Acting as a swaps entity for credit default swaps, including swaps or security-based swaps referencing the credit risk of asset-backed securities are not considered a bank permissible activity for purposes of this section unless such swaps or security-based swaps are cleared by a derivatives clearing organization or a clearing agency that is registered, or exempt from registration, as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act, respectively.
4. See 15 U.S.C. 8305(f).
5. See 15 U.S.C. 8305(e).
6. See 156 Cong. Rec. S5903-S5904 (daily ed. July 15, 2010) (colloquy between Senator Christopher Dodd, Chairman of the Senate Banking Committee, and Senator Blanche Lincoln, Chairman of the Senate Agriculture Committee and sponsor of the swaps push-out provision).
7. Insured branches of foreign banks are also included in the definition of “insured depository institution” under section 3 of the FDIA.

The original memo published by Sullivan & Cromwell LLP was published here on June 6, 2013.