October 26, 2017

SIDLEY UPDATE Federal Reserve Adopts Rule Requiring GSIBs to Amend QFC Transactions to Limit Termination Rights of Counterparties

On September 1, 2017, the Board of Governors of the Federal Reserve System (the Federal Reserve) adopted a rule (the Rule)1 that will require global systemically important U.S. bank holding companies (U.S. GSIBs)2 and most of their subsidiaries to amend a range of derivatives, short-term funding transactions, securities lending transactions and other qualifying financial contracts (QFCs). The required amendments will limit counterparty termination rights related to certain U.S. GSIB resolution and bankruptcy proceedings.

Banks and other depository institutions regulated by the Office of the Comptroller of the Currency (OCC) or the Federal Deposit Insurance Corporation (FDIC) are “excluded banks” under the Rule, but they will be subject to “substantively identical” rules adopted by those agencies.3

Overview of the Rule Entities subject to the Rule’s requirements are defined as “covered entities.” That term includes all U.S. GSIB parents and subsidiaries other than excluded banks and certain limited categories of other subsidiaries.4 It also includes the U.S. operations of global systemically important foreign banking organizations (non-U.S. GSIBs).5

The Rule will require covered entities, when entering into certain QFC transactions with buy-side counterparties (as well as with other covered entities and excluded banks), to include specific contract terms in related agreements. Those terms are intended to achieve two distinct regulatory goals: (i) ensure

1 See Federal Reserve, Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42882 (September 12, 2017) (the Adopting Release), available at https://www.gpo.gov/fdsys/pkg/FR-2017-09-12/pdf/2017-19053.pdf. 2 In this Sidley Update, “U.S. GSIB” means any U.S. bank holding company (BHC) that is identified as a global systemically important BHC pursuant to Federal Reserve rules. See Rule Section 252.82(b)(1). There are currently eight U.S. GSIBs: Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corporation and Wells Fargo & Company. See Adopting Release at 42892. 3 See Adopting Release at 42882. On September 27, 2017, the FDIC adopted its rule, which (as expected) is substantively identical to the Rule. See FDIC, Restrictions on Qualified Financial Contracts of Certain FDIC-Supervised Institutions; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions (Sept. 27, 2017), available at https://www.fdic.gov/news/news/press/2017/pr17072.html. The OCC is expected to adopt its rule shortly. 4 The Rule also excludes from its application (i) companies owned in satisfaction of a debt previously contacted, (ii) merchant banking and certain other portfolio companies and (iii) certain companies engaged in the business of making public welfare investments. See Rule Section 252.82(b)(2). 5 In this Sidley Update, “non-U.S. GSIB” means a global systemically important foreign banking organization meeting the criteria set forth in the Rule. See Rule Section 252.87.

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cross-border enforcement of the two U.S. special resolution regimes — the orderly liquidation authority under Title II of the Dodd-Frank Act (OLA) and the Federal Deposit Insurance Act (FDIA) — as they may apply to covered entities; and (ii) prohibit counterparties of a covered entity from exercising a range of cross- default rights that are related, directly or indirectly, to an affiliate of the covered entity becoming subject to insolvency proceedings, including under Chapter 11 of the Bankruptcy Code.

The Rule includes a safe harbor for QFCs that are amended by a covered entity and a given counterparty through their adherence to a qualifying protocol published (or to be published) by the International Swaps and Derivatives Association Inc. (ISDA). The safe harbor was provided even though the contract terms resulting from adherence to the qualifying ISDA protocols will differ in certain important respects from the contract terms that the Rule otherwise requires. Accordingly, the means by which a covered entity and a given counterparty choose to comply with the Rule will involve choosing not only between contracting mechanisms (protocol adherence versus bilateral documentation execution) but also between contractual terms that differ substantively.

Compliance with the Rule will be phased in over one year beginning January 1, 2019. However, as discussed toward the end of this Sidley Update, it is likely that covered entities will seek to ensure Rule compliance with all counterparties by January 1, 2019, including those counterparties for which the phase-in date is later.

In the balance of this Sidley Update, we will address the following topics:

• QFC Transactions Covered by the Rule

• Basic Operation of the Rule

• U.S. Special Resolution Regimes and Required Opt-In Provisions

• U.S. Bankruptcy Code and Restrictions on Cross-Defaults

• ISDA Protocols

• Differences Between the Rule’s Stated Requirements and the ISDA Protocols

• Other Issues

• Observations

QFC Transactions Covered by the Rule The Rule incorporates the Dodd-Frank Act’s definition of QFC. That definition includes “swaps, repo and reverse repo transactions, securities lending and borrowing transactions, commodity contracts, and forward agreements.”6 To narrow the breadth of the Rule’s application, the Rule applies only to “covered QFCs.” The definition of covered QFC narrows the Rule’s reach in two respects. The first considers the terms of a QFC to determine if it is “in scope” under the Rule. The second considers the date that the respective covered entity

6 See Adopting Release at 42894 (citing 12 U.S.C. 5390(c)(8)(D)). SIDLEY UPDATE Page 3

entered into the in-scope QFC (or certain related QFCs) to determine if it is a covered QFC (or, alternatively, whether the QFC, though in scope, is effectively grandfathered).7

A QFC is in scope if it either

• explicitly restricts transfer of the QFC (or any interest or obligation in or under, or any property securing, the QFC) from a covered entity (whether or not in connection with any default) or

• explicitly provides one or more “default rights” with respect to a QFC that may be exercised against a covered entity.

The Rule defines “default rights” very broadly. The definition encompasses not only typical termination and liquidation rights but also rights to demand additional collateral or margin (other than where the demand is based solely on mark-to-market requirements).8 Thus, for example, a typical credit rating downgrade provision would be covered.9

Because of the broad definition, most swap, repurchase and securities lending transactions that are subject to industry standard master agreements will be in scope. In contrast, spot foreign exchange transactions, though they are QFCs, will not be in scope if they are not subject to explicit terms restricting transfers or providing default rights. That may be true for many such transactions,10 but caution is warranted because trading relationships with covered entities may be subject to broadly worded master agreements or other umbrella trading documentation.

An in-scope QFC will be a covered QFC if it is entered into11 by a covered entity after January 1, 2019 (irrespective of the type of QFC counterparty or related compliance phase-in date, as discussed below). In addition, if a covered entity and a given counterparty enter into a QFC (whether or not in scope) after January 1, 2019, then all in-scope QFCs between the two parties entered into prior to January 1, 2019 will become covered QFCs automatically. Moreover, the Rule includes a triggering mechanism for covered QFCs that is tied to affiliation: If a QFC (whether or not in scope) is executed on or after January 1, 2019 between (i) a covered entity or any affiliate that is either a covered entity or an excluded bank; and (ii) a counterparty or any of its consolidated affiliates, then all in-scope QFCs between the first covered entity and the counterparty or any of the counterparty’s consolidated affiliates will become covered QFCs automatically (regardless of when the in-scope QFCs were executed).12

7 In addition, the Rule excludes (i) covered QFCs to which a central counterparty clearinghouse (CCP) is a party or to which each party (other than the covered entity) is a financial market utility (FMU) and (ii) certain “types of contracts or agreements.” See Rule Sections 252.88(a) (referring to CCPs and FMUs) and 252.88(c) (referring to certain investment advisory contracts and warrants). 8 See Rule Section 252.81 (paragraph (1)(ii) of the definition of “default right,” which excludes “a right or operation of a contractual provision arising solely from a change in the value of collateral or margin or a change in the amount of an economic exposure”). 9 See Adopting Release at 42900 (describing permissible changes in margin due to changes in market price, not for “changes due to counterparty credit risk (e.g., credit rating downgrades)”). 10 See Adopting Release at 42894 (“[C]ommenters urged the Board to exclude QFCs that do not contain any transfer restrictions or default rights.... Commenters named several examples of contracts that fall into this category, including cash market securities transactions, certain spot FX transactions....”). 11 The Rule uses the phrase “Enters, executes, or otherwise becomes a party to....” See Rule Section 252.82(c). 12 Rule Section 252.82(c)(1) reads: [A] covered QFC is, ... [w]ith respect to a covered entity that is a covered entity on November 13, 2017, an in-scope QFC that the covered entity:

SIDLEY UPDATE Page 4

In other words, if, after January 1, 2019, any member of a given consolidated counterparty group trades with a covered entity or an excluded bank within a given covered entity group, all in-scope QFCs between the two groups become covered QFCs. The interplay between the “covered QFC” definition and the compliance phase-in schedule is discussed toward the end of this Sidley Update, as are the specifics of the affiliation triggers (see “Other Issues”).

Basic Operation of the Rule The Rule operates in two distinct ways:

• In order to ensure cross-border enforcement of the two U.S. special resolution regimes, the Rule requires covered entities to include terms, in certain covered QFCs, pursuant to which their counterparties “opt in” to the stay-and-transfer provisions of those regimes.

• In order to address perceived inadequacies of Chapter 11 of the Bankruptcy Code (and other insolvency regimes), the Rule prohibits certain covered QFCs from permitting counterparties to exercise a range of cross-default rights that are related, directly or indirectly, to an affiliate of the covered entity’s becoming subject to proceedings under the Bankruptcy Code or any other receivership, insolvency, liquidation, resolution or similar proceedings.13

Analogs for the first requirement (opt in) have been adopted or are under consideration by regulators in the United Kingdom, Germany, France, Switzerland and Japan. The second requirement (cross-default) is unique to the United States. The two requirements are separately discussed below.

U.S. Special Resolution Regimes and Required Opt-In Provisions The term “U.S. special resolution regimes” means the FDIA, which governs the resolution of FDIC-insured depository institutions, and OLA, which governs certain resolutions of systemically important financial institutions. The Federal Reserve explained that

The [U.S. special resolution regimes] create special resolution frameworks for failed financial firms that provide that the rights of a failed firm’s counterparties to terminate their QFCs are temporarily stayed when the firm enters a resolution proceeding to allow for the transfer of the relevant obligations under the QFC to a solvent party.

Such temporary stays generally last until the end of the business day following the appointment of the FDIC as receiver.

(i) Enters, executes, or otherwise becomes a party to on or after January 1, 2019; or (ii) Entered, executed, or otherwise became a party to before January 1, 2019, if the covered entity or any affiliate that is a covered entity or excluded bank also enters, executes, or otherwise becomes a party to a QFC with the same person or a consolidated affiliate of the same person on or after January 1, 2019. 13 The term “cross-default” often connotes default rights triggered by defaults under different agreements between the same two parties, and not only those right triggered by actions or circumstances of an affiliate of a contractual counterparty. However, the Adopting Release uses the term “cross-default” to refer to default rights triggered by the insolvency of an affiliate of a covered entity. Accordingly, we adopt a similar usage in this Sidley Update. SIDLEY UPDATE Page 5

Subject to certain exceptions (described below), the Rule requires that each covered QFC of a covered entity “explicitly” provide that in the event the covered entity becomes subject to a proceeding under a U.S. special resolution regime,

• the transfer of the covered QFC (and any interest and obligation in or under, and any property securing it) from the covered entity will be effective to the same extent as the transfer would be effective under the U.S. special resolution regime if the covered QFC (and any interest and obligation in or under, and any property securing it) were governed by the laws of the United States or a state of the United States, and

• default rights with respect to the covered QFC that may be exercised against the covered entity are permitted to be exercised to no greater extent than the default rights could be exercised under the U.S. special resolution regime if the covered QFC were governed by the laws of the United States or a state of the United States.14

The required provisions seek to ensure equivalent treatment, under the U.S. special resolution regimes, across all jurisdictions for all covered QFCs.15 Accordingly, the provisions are not required for a covered QFC if

• the covered QFC “[e]xplicitly provides that the Covered QFC is governed by the laws of the United States or a state of the United States” (and does not carve out application of the U.S. special resolution regimes), and

• each party to the covered QFC, other than the covered entity, is (i) an individual domiciled in the United States, (ii) a company either that is incorporated in or organized under U.S. law or that has its principal place of business in the United States or (iii) a U.S. government branch or U.S. agency.

The Federal Reserve explained the two conditions of the exemption as follows:

It has long been clear that the laws of the United States and the laws of a state of the United States both include U.S. federal law, such as the U.S. Special Resolution Regimes. Therefore, [the governing law condition] ensures that contracts that meet this exemption also contain language that helps ensure that foreign courts will enforce the stay-and-transfer provisions of the U.S. Special Resolution Regimes.... [The domicile/place-of-business condition] helps ensure that the FDIC will be able to quickly and easily enforce the stay-and-transfer provisions of the U.S. Special Resolution Regimes.16

14 This provision must also apply in circumstances in which an affiliate of the covered entity becomes subject to a proceeding under a U.S. special resolution regime. 15 The Rule “requires the QFCs of Covered Entities to contain contractual provisions that opt into the stay-and-transfer treatment of the [U.S. special resolution regimes] to reduce the risk that the stay-and-transfer treatment would be challenged by a QFC counterparty or a court in a foreign jurisdiction.” Adopting Release at 42889. 16Adopting Release at 42901. SIDLEY UPDATE Page 6

U.S. Bankruptcy Code and Restrictions on Cross-Defaults The U.S. special resolution regimes do not include Chapter 11 of the U.S. Bankruptcy Code, any other chapter of the Bankruptcy Code or any other U.S. or non-U.S. insolvency regime. For QFCs, the Bankruptcy Code provides a safe harbor exemption from the automatic stay that otherwise generally applies when a debtor files for relief. Thus, the Bankruptcy Code does not have the kinds of short-term stay mechanisms applicable to QFCs that are found in the FDIA and OLA.

The Rule addresses that difference, in part, by requiring covered QFCs to limit the exercise of default rights (and certain restrictions on transfer) that relate to an affiliate of a direct party to the QFC becoming subject to a receivership, insolvency, liquidation, resolution or similar proceeding (referred to below as an affiliate insolvency). Of particular relevance are QFCs entered into by covered entities that are subsidiaries of bank holding companies (BHCs), particularly where a BHC guarantees the covered entity’s QFC obligations.17 QFC agreements for such trading relationships often include cross-default rights, permitting a counterparty of a covered entity to terminate the QFCs where the covered entity’s BHC parent files for protection under the Bankruptcy Code. Such QFCs permitted counterparties of Lehman’s subsidiaries to terminate their transactions when Lehman’s parent filed for Chapter 11 protection.18

In explaining the Rule’s restrictions on cross-defaults, the Federal Reserve contrasted OLA and the Bankruptcy Code as follows:

[OLA]’s stay-and-transfer provisions ... address both direct default rights and cross-default rights. But, as explained above, no similar statutory provisions would apply to a resolution under the U.S. Bankruptcy Code. The final rule attempts to address these obstacles to orderly resolution by extending the stay- and-transfer provisions to any type of resolution of a Covered Entity. Similarly, the final rule would facilitate a transfer of the GSIB parent’s interests in its subsidiaries, along with any credit enhancements it provides for those subsidiaries, to a solvent financial company by prohibiting Covered Entities from having QFCs that would allow the QFC counterparty to prevent such a transfer or to use it as a ground for exercising default rights.

Thus, subject to a number of exceptions (discussed below), a covered QFC

• may not permit the exercise of any default right with respect to the covered QFC that is related, directly or indirectly, to an affiliate insolvency and

• may not prohibit the transfer of a covered affiliate credit enhancement (described below) or certain related rights and obligations to a transferee upon or following an affiliate insolvency.19

17 The Federal Reserve emphasized that the cross-default limitations were important in the context of a resolution or insolvency proceeding that is part of a “single point of entry” strategy as applied to a BHC. See Adopting Release at 42885. 18 See Adopting Release at 42883. 19 The Rule includes a carve out from the transfer limitation where “the transfer would result in the supported party being the beneficiary of the credit enhancement in violation of any law applicable to the supported party.” Rule Section 252.84(b)(2). SIDLEY UPDATE Page 7

The Federal Reserve confirmed that a QFC does not become subject to the Rule’s restrictions on cross- default because a counterparty has the right

to terminate the contract on demand or at its option at a specified time, or from time to time, without the need to show cause.... Therefore, [the cross-default section of the Rule] does not restrict the ability of QFCs, including overnight repos, to terminate at the end of the term of the contract.20

In formulating its restrictions on cross-default rights, the Rule distinguishes between (i) covered entities that are “direct parties” to QFCs and thus enter into “covered direct QFCs” and (ii) covered entities that are credit support providers for their affiliates’ QFCs (defined as “covered affiliate support providers”) and thus provide “covered affiliate credit enhancements.”

The Rule provides certain exceptions to the mandated contractual restrictions described above; it refers to the exceptions as “creditor protections.” The creditor protections allow covered QFCs to have default provisions that permit counterparties to terminate a covered QFC due to the insolvency of the direct party or its failure to satisfy payment or delivery obligations pursuant either to the covered QFC or to another contract between the direct party and the counterparty; they also allow the exercise of default rights due to the failure of the covered affiliate support provider to satisfy a payment or delivery obligation pursuant to a covered affiliate credit enhancement.21 Accordingly, in the Adopting Release, the Federal Reserve emphasized that “the QFC counterparty would retain its ability under the U.S. Bankruptcy Code’s safe harbors to exercise direct default rights.”22

Creditor protections also permit cross-default terminations after a short “stay period” following the commencement of affiliate insolvency proceedings — one business day or 48 hours, whichever is longer — if one of four conditions is met.23 If none of those conditions is met, then the restriction on the exercise of

20 Adopting Release at 42895 note 110; see also Rule Section 252.81 (paragraph (2) of the definition of “default right”). 21 See Rule 252.84(d) (“General Creditor Protections” permitting “the exercise of a default right that arises as a result of” (1) the direct party becoming subject to an insolvency proceeding; (2) the direct party not satisfying a payment or delivery obligation pursuant to the covered QFC or another contract between the same parties that gives rise to a default right in the covered QFC; or (3) the covered affiliate support provider or transferee not satisfying a payment or delivery obligation pursuant to a covered affiliate credit enhancement that supports the covered direct QFC). 22 Adopting Release at 42905. 23 Termination is permitted after the stay period if • the covered affiliate support provider that remains obligated under the covered affiliate credit enhancement becomes subject to a receivership, insolvency, liquidation, resolution or similar proceeding, other than a Chapter 11 proceeding, • the transferee, if any, becomes subject to a receivership, insolvency, liquidation, resolution or similar proceeding (subject to certain exceptions related to resolution under the FDIA), • the covered affiliate support provider does not remain, and a transferee does not become, obligated to the same, or substantially similar, extent as the covered affiliate support provider was obligated immediately prior to entering the insolvency proceeding with respect to (i) the covered affiliate credit enhancement; (ii) all other covered affiliate credit enhancements provided by the covered affiliate support provider in support of other covered direct QFCs between the direct party and the supported party under such covered affiliate credit enhancement; and (iii) all covered affiliate credit enhancements provided by the covered affiliate support provider in support of covered direct QFCs between the direct party and affiliates of such supported party, or • in the case of a transfer of the covered affiliate credit enhancement to a transferee, (i) all of the ownership interests of the direct party directly or indirectly held by the covered affiliate support provider are not transferred to the transferee, or (ii) reasonable assurance has not been provided that all or substantially all of the assets of the covered affiliate support provider (or net proceeds therefrom) will be, with limited exceptions, transferred or sold to the transferee in a timely manner. See Rule Section 252.84(f). SIDLEY UPDATE Page 8

cross-default rights will last longer than the short stay period. For example, if the covered affiliate credit enhancement is not transferred in connection with a Chapter 11 proceeding, the restriction will continue beyond the short stay period if the covered affiliate support provider

• does not become subject to alternative insolvency proceedings (e.g., Chapter 7 liquidation proceedings) and

• remains obligated to at least a “substantially similar” extent under (i) the covered affiliate credit enhancement and (ii) each other covered affiliate credit enhancement in respect of other covered direct QFCs with the supported party and its affiliates — and thus does not engage in “cherry picking.”24

In that circumstance, a counterparty would retain its right to terminate covered QFCs for subsequent payment or delivery defaults (or other direct defaults, as described above); for example, termination would be permitted if the direct party covered entity failed to meet a collateral call. But the counterparty would not otherwise be able to terminate the covered QFC even if, for example, Chapter 11 proceedings were continuing with respect to a covered affiliate support provider that is a BHC parent guarantor. Moreover, the counterparty would remain obligated to perform its obligations under the covered QFCs, including posting additional collateral as and when contractually required.

If the covered affiliate credit enhancement is transferred to, for example, a court-approved transferee, the restriction on the exercise of cross-default rights will remain in effect if (in addition to the conditions described above, as they apply to the transferee) either (i) all of the ownership interests in the direct party are transferred to the transferee or (ii) “reasonable assurance” is provided that all or substantially all of the assets of the covered affiliate support provider (or net proceeds therefrom) will be, with limited exceptions, transferred or sold to the transferee in a timely manner.25

As discussed below, the creditor protections described above are not as protective as those that are included in analogous provisions of the International Swaps and Derivatives Association (ISDA) 2015 Universal Resolution Stay Protocol (the Universal Protocol). The Universal Protocol takes greater advantage of the kinds of protections available to creditors in U.S. bankruptcy proceedings (e.g., by conditioning continued restrictions on cross-default rights by reference to various kinds of court orders).

ISDA Protocols The Rule provides a safe harbor for certain ISDA protocols as a means of compliance with the Rule, despite differences between the kinds of QFC amendments effected by those protocols and the Rule’s requirements. This section provides a brief overview of those protocols; related differences between the protocols and the requirements of the Rule are discussed in the next section.

24 The Federal Reserve explained that the “substantially similar” requirement was intended “to prevent the support provider or the transferee from ‘cherry picking’ by assuming only those QFCs of a given counterparty that are favorable to the support provider or transferee. [OLA and the FDIA] contain similar provisions to prevent cherry picking.” Adopting Release at 42905. 25 See Rule Section 252.84(f)(4). SIDLEY UPDATE Page 9

The Rule permits compliance through QFC amendments that result from adherence to the Universal Protocol, which ISDA published in November 2015.26 Like the Rule requirements, the Universal Protocol addresses two distinct goals: (i) reinforcing cross-border enforcement of special resolution regimes and (ii) limiting cross-defaults in the context of certain U.S. insolvency proceedings.27 Thus, adherents to the Universal Protocol achieve contractual ends for their QFCs that are similar to, though not the same as, those mandated by the Rule.

The Universal Protocol was developed and published to enable U.S. and non-U.S. GSIBs to comply with regulatory requirements in several FSB jurisdictions, including the United States. The GSIBs have already adhered to the Universal Protocol, and thus they will satisfy, with respect to covered QFCs between them, both the opt-in and the cross-default requirements of the Rule.

However, the Universal Protocol was not intended for adherence by buy-side counterparties of the GSIBs,28 and thus it is not expected to be a means by which covered entities comply with the Rule with respect to covered QFCs with their buy-side counterparties. Accordingly, the Rule also permits compliance with its requirements via adherence to a yet-to-be published ISDA protocol — defined in the Rule as a U.S. Protocol. To qualify as a U.S. Protocol for purposes of the Rule, a new protocol must be “the same as” the Universal Protocol, except in certain limited respects (described below).29

In May 2016, ISDA published the ISDA Resolution Stay Jurisdictional Modular Protocol (the JMP) as a complement to the Universal Protocol.30 The JMP was designed with the expectation that a separate JMP “module” would be created for each jurisdiction that required its banking organizations to amend contracts with buy-side counterparties. Thus, unlike the Universal Protocol, which amends QFCs to comply with the requirements of multiple jurisdictions, the JMP provides for adherence on a jurisdiction-by-jurisdiction basis — that is, on a module-by-module basis. For example, in 2015, ISDA published a UK module to the JMP (the JMP UK Module)31 to permit banking organizations subject to the UK bank resolution regime to amend their contracts with buy-side counterparties in the manner required by UK regulations that were also

26 The Universal Protocol is available at http://assets.isda.org/media/ac6b533f-3/5a7c32f8.pdf/. 27 A previous Sidley Update described the Universal Protocol and its background. See Sidley Update, New ISDA Resolution Stay Protocols: Challenges for Buy-side and Sell-side Firms Alike (Nov. 19, 2015), available at http://www.sidley.com/news/11-19-2015-derivatives-update. 28 When the Universal Protocol was published, ISDA stated: “While ISDA 2015 Universal Protocol is open to any entity to voluntarily adhere, it was not developed with the expectation of being used by broader market participants, including buy-side institutions, as a means of complying with regulations applicable to their dealer counterparties.” ISDA 2015 Universal Resolution Stay Protocol FAQs, available at http://www2.isda.org/functional-areas/protocol-management/faq/22. In the general FAQs published with the JMP, ISDA continued in a similar vein: “It is expected that market participants will utilize ISDA Jurisdictional Modular Protocol, rather than ISDA 2014 Protocol or the [2015] Protocol, to comply with Stay Regulations.” However, the general FAQs later state: “Section 1 and Section 2 of the [2015] Protocol will not form a part of ISDA Jurisdictional Modular Protocol unless those amendments are specifically required for compliance with Stay Regulations.” ISDA Resolution Stay Jurisdictional Modular Protocol FAQ, available at http://assets.isda.org/media/f253b540-125/93347b32- pdf/. 29 See Rule Section 252.85(a)(3)(ii). 30 The JMP is available at http://assets.isda.org/media/f253b540-95/83d17e3d-pdf/. 31 ISDA published the “UK (PRA Rule) Jurisdictional Module” at the same time as the JMP. The JMP UK Module and related “Module FAQs” are available on ISDA’s website: http://www2.isda.org/functional-areas/protocol-management/protocol/25. SIDLEY UPDATE Page 10

published in 2015.32 A previous Sidley Update describes and compares the Universal Protocol and the JMP and describes the JMP UK Module.33

It is now expected that a U.S. module to the JMP will be published in a form that will qualify the module as a U.S. Protocol under the Rule. We refer to the expected module (together with related terms of the JMP) as the JMP U.S. Module.

Differences Between the Rule’s Stated Requirements and the ISDA Protocols As indicated above, neither the Universal Module nor a U.S. Protocol will result in QFC amendments that are strictly in accordance with the Rule’s requirements for (i) opt-in provisions related to the U.S. special resolution regimes or (ii) limits on cross-default (and transfer) rights with respect to other insolvency regimes, including Chapter 11 of the Bankruptcy Code. We refer to those Rule requirements, collectively, as the stated requirements.

Accordingly, there will be relative advantages and disadvantages, from the perspective of counterparties to covered entities, to amending covered QFCs via protocol adherence rather than amending covered QFCs in accordance with the stated requirements. That is particularly true for buy-side counterparties.

In this section, we first discuss the limited differences that the Rule permits between a U.S. Protocol and the Universal Protocol. We then discuss the key disadvantage and the key advantage, from a buy-side perspective, of amending QFCs through a U.S. Protocol (such as the expected JMP U.S. Module) rather than amending QFCs in accordance with the stated requirements.

Differences Between a U.S. Protocol and the Universal Protocol

A U.S. Protocol may vary from the Universal Protocol in only very limited respects. The two principal permitted variations may be described as follows:34

32 The JMP UK Module relates to final rules published by the UK Prudential Regulation Authority (PRA). See UK PRA Rulebook: CRR Firms and Non-Authorised Persons: Stay in Resolution Instrument 2015 (PRA 2015/82), available at http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515app1.pdf. 33 See Sidley Update, New ISDA Resolution Stay Protocol and UK Module; Federal Reserve Rule Proposal (May 13, 2016), available at https://www.sidley.com/en/insights/newsupdates/2016/05/isda-resolution-stay-jurisdictional-modular. 34 In addition, notwithstanding the terms of the Universal Protocol, a U.S. Protocol • must apply to the client-facing leg of a cleared transaction for which the clearing member of the central counterparty acts as principal, and the clearing mechanism thus involves two back-to-back principal-to-principal transactions (as contrasted with cleared transactions for which clearing members act as agent, as in the case of cleared futures and derivatives in the United States), • may permit certain “opt outs” in respect of covered QFCs only to the extent those covered QFCs would, by other means, continue to meet the requirements of the Rule, • must not include the sunset provision that would have applied under the Universal Protocol if U.S. regulations like the Rule had not come into effect by January 1, 2018, and • may include “minor and technical differences from the Universal Protocol and differences necessary to conform the U.S. protocol to the differences” permitted under the Rule. See Rule Section 252.85(a)(3)(ii). SIDLEY UPDATE Page 11

• The Universal Protocol restricts rights in a two-way manner between all adherents (that is, between all U.S. and non-U.S. GSIBs). However, the U.S. Protocol may restrict rights in a one-way manner: As between a covered entity and a buy-side counterparty that adhere to a U.S. Protocol, the U.S. Protocol may limit the rights of the counterparty under the amended covered QFC (related to the resolution or insolvency of the covered entity) without limiting the rights of the covered entity (in connection with any insolvency of the buy-side counterparty). As a corollary, the U.S. Protocol will not amend agreements between two adherents (in either direction) if neither adherent is a covered entity (or an excluded bank).

• The opt-in provisions of the Universal Protocol apply with respect to a broad range of national resolution regimes: (i) six “Identified Regimes” specified in the Universal Protocol; and (ii) “Protocol-Eligible Regimes,” which the Universal Protocol does not specify but may subsequently qualify as such under the Universal Protocol (including via publication of new “Country Annexes”). However, the U.S. Protocol may limit its application to the six Identified Regimes.

Thus, despite market expectations that buy-side counterparties of GSIBs would not adhere to the Universal Protocol, the Federal Reserve appears to expect that buy-side participants will adhere to a JMP U.S. Module that includes terms that are, from a U.S. perspective, largely identical to those in Universal Protocol.

Differences Between a U.S. Protocol and the Stated Requirements

The principal disadvantage to a counterparty that adheres to a U.S. Protocol (such as the expected JMP U.S. Protocol), rather than amending QFCs in accordance with the stated requirements, is that adherence is not permitted on a “dealer-by-dealer” or “static” basis, but is “universal” and “dynamic.” As discussed below, once a buy-side market participant adheres to a U.S. Protocol, it amends its covered QFCs with all adhering covered entities, including entities that adhere to the U.S. Protocol as covered entities in the future. 35

The principal advantage to a counterparty that adheres to a U.S. Protocol (such as the expected JMP U.S. Protocol), rather than amending QFCs in accordance with the stated requirements, is that the amendments that result from adherence, like those that result from the Universal Protocol, will provide greater creditor protections to a counterparty than those permitted by the stated requirements.

Adherence. The JMP is formulated to permit dealer-by-dealer adherence through jurisdiction-specific modules. For example, the JMP UK Module took advantage of that JMP feature and permitted buy-side market participants to choose those JMP UK banking organizations with which they would amend QFCs through adherence. However, any JMP U.S. Module that qualifies as a U.S. Protocol will not permit that flexibility, but will require adherence on an all-or-none — or universal — basis.

Moreover, the Rule does not permit “static” adherence via a U.S. Protocol. In other words, once a buy-side market participant adheres to a U.S. Protocol, it adheres in respect of all counterparties that are covered entities that adhere to the U.S. Protocol, whether they are covered entities on the date of adherence or

35 In addition, the stated requirements with respect to “opt in” (as contrasted to cross-defaults) are limited to OLA and the FDIA, whereas adherence to a U.S. Protocol (as noted above) would effect an opt-in with respect to each of the six Identified Regimes. However, it is not clear how significant a consequence that would be because (i) Identified Regimes other that OLA and the FDIA may have limited application with respect to many covered entities (e.g., U.S.-domiciled entities within U.S. GSIB groups), and (ii) where they do apply (e.g., where the covered entity is non-U.S. subsidiary of a U.S. GSIB or is a U.S. subsidiary of non-U.S. GSIB), a non-U.S. Identified Regime may be enforceable against the counterparty whether or not the counterparty has opted in through adherence to a U.S. Protocol. SIDLEY UPDATE Page 12

become covered entities in the future. In effect, adherence will be dynamic. Thus, even though the U.S. Protocol would not initially apply to QFCs between a buy-side adherent and a banking organization that is a non-covered entity, if that non-covered entity were to become a covered entity — for example, because it was acquired by a U.S. GSIB or because the Federal Reserve designated it as such — and were to adhere to the U.S. Protocol, the buy-side adherent’s existing QFCs with the new covered entity would be amended automatically by the U.S. Protocol.36

The Federal Reserve’s approach with respect to universal adherence was deliberate; indeed, it was central to the Federal Reserve’s consideration of the ISDA protocols. In the Federal Reserve’s proposal of the Rule,37 and in the Adopting Release, the Federal Reserve emphasized that it was permitting compliance through use of the Universal Protocol and a U.S. Protocol — despite their inconsistencies with the general requirements of the Rule — because such compliance would ensure universal application:

[W]hile the scope of the stay-and-transfer provisions of the Universal Protocol are narrower than the stay-and-transfer provisions that would have been required under the proposal and the Universal Protocol provides a number of creditor protection provisions that would not otherwise have been available under the proposal, the Universal Protocol includes a number of desirable features that the proposal lacked. The proposal explained that “when an entity (whether or not it is a Covered Entity) adheres to the [Universal] Protocol, it necessarily adheres to the [Universal] Protocol with respect to all Covered Entities that have also adhered to the Protocol rather than one or a subset of Covered Entities (as the proposal may otherwise permit).... This feature appears to allow the [Universal] Protocol to address impediments to resolution on an industry-wide basis and increase market certainty, transparency, and equitable treatment with respect to default rights of non-defaulting parties.38

Creditor Protections. Like the Universal Protocol, a U.S. Protocol will provide greater creditor protections related to cross-defaults than the creditor protections permitted by the stated requirements. Annex A to this Sidley Update provides a summary comparison of certain key differences between creditor protections under a U.S. Protocol and those permitted by the stated requirements. As the comparison table indicates:

• A U.S. Protocol will limit cross-default rights principally in connection with affiliate insolvencies under Chapter 11 of the Bankruptcy Code and the FDIA.39 In contrast, the stated requirements

36 The Adopting Release states: [T]he final rule does not permit adherence to a ‘‘static list’’ of all current Covered Entities, which other commenters requested.... The final rule, however, does not prohibit the creation of a dynamic list identifying of all current ‘‘Covered Parties,’’ as would be defined in the U.S. Protocol, to facilitate due diligence and provide additional clarity to the market. See final rule § 252.85(a)(2)(ii)(E) (allowing minor and technical differences from the Universal Protocol). Adopting Release at 42910 (including footnote 224). 37 See Federal Reserve, Notice of Proposed Rulemaking, Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 81 Fed. Reg. 29169 (May 11, 2016) (NPR), available at https://www.gpo.gov/fdsys/pkg/FR-2016-05-11/pdf/2016-11209.pdf. 38 Adopting Release at 42908-09 (quoting NPR at 29182-83). 39 If the affiliate is not a credit enhancement provider (as defined in the Universal Protocol), the restrictions also apply (and are not subject to creditor protection exceptions) under Chapter 7 of the Bankruptcy Code and proceedings under the Securities Investor Protection Act (SIPA). SIDLEY UPDATE Page 13

limit cross-defaults in respect of a broad category of generically defined types of affiliate insolvencies.

• A U.S. Protocol will condition any continued suspension of cross-default rights (beyond a one- business day/48-hour stay period) on bankruptcy court involvement for the benefit of creditors. Under the stated requirements, in contrast, the related creditor protections are neither as specific nor as robust as those that will be provided for in a U.S. Protocol.

• A U.S. Protocol’s creditor protections will be available whether or not the affiliate support provider is itself a covered entity. In contrast, creditor protections under the stated requirements are limited to “covered affiliate support providers” (that is, affiliates that are themselves covered entities). Thus, for example, if the covered entity is a U.S. subsidiary of a non-U.S. GSIB, and the parent of the non-U.S. GSIB (which is not a covered entity) provides a guarantee supporting the U.S. subsidiary’s QFCs, certain creditor protections will not be available.40

Other Issues Practical Considerations Related to QFC Amendments

Adherence to a U.S. Protocol may be administratively simpler than entering into bilateral amendment agreements with each covered entity. For buy-side market participants, that will be particularly true for those that have trading relationships with multiple covered entities. All covered entities, given the likely breadth of their trading relationships with buy-side counterparties, are likely to prefer to amend covered QFCs through adherence to a U.S. Protocol.

Compliance Phase-in Period

As noted above, compliance with the Rule will be phased in during 2019. A covered entity’s compliance date for a given covered QFC will be determined by the regulatory status of the counterparty to the covered QFC, as follows:

Counterparty Compliance Date

Other covered entity or excluded bank January 1, 2019

Financial counterparty41 July 1, 2019

Other counterparties January 1, 2020

40 See Adopting Release at 42906 (discussing the unavailability of creditor protections with respect to “non-U.S. affiliate credit supporter providers”). 41 The definition of “financial counterparty” in the Rule is similar to the definition of “financial end user” in the Federal Reserve’s margin rules for noncleared swaps. The Rule definition includes (i) bank holding companies or an affiliate thereof; (ii) savings and loan holding companies; (iii) certain U.S. intermediate holding companies; (iv)nonbank financial companies supervised by the Federal Reserve; (v) certain depository institutions; (vi) certain banking organizations that are organized under the laws of a foreign country; (vii) certain institutions that function solely in a trust or fiduciary capacity; (viii) certain credit or lending entities; (ix) certain swap dealers and major swap participants; (x) certain securities holding companies; (xi) certain securities brokers or dealers; (xii) certain investment advisers; (xiii) certain investment companies and entities that would be investment companies but for certain exemptions; (xiv) certain private funds; (xv) certain commodity pools, commodity pool operators and commodity trading advisors; (xvi) certain futures commission merchants and other commodities market professionals; (xvii) certain employee benefit plans; and (xviii) certain insurance companies. See Rule Section 252.81. The definition expressly excludes sovereign entities, multilateral development banks and the Bank for International Settlements. SIDLEY UPDATE Page 14

However, as noted above (see “QFC Transactions Covered by the Rule”), an in-scope QFC becomes a covered QFC (and is not grandfathered) if it is executed after January 1, 2019 (notwithstanding a later compliance phase-in date for the relevant counterparty). Moreover, in-scope QFCs executed by a covered entity and a counterparty before January 1, 2019, will become covered QFCs if they trade any QFC (whether or not in scope) after January 1, 2019 (even if the counterparty has a compliance phase-in date that is later than the trade date). And, as discussed above, there are knock-on consequences for the affiliates of a covered entity and a counterparty if they trade a QFC after January 1, 2019.

Thus, for example: If a covered entity and a financial counterparty execute a QFC on February 1, 2019, neither that QFC nor any existing QFC between the two parties must comply with the Rule on that date, because it is before July 1, 2019 (the phase-in compliance date for financial counterparties). But if that QFC is an in-scope QFC, it will be a covered QFC when it is executed (regardless of the compliance phase-in date). Moreover, whether or not it is an in-scope QFC, the execution of that QFC on February 1 will result in all in- scope QFCs between the covered entity and the financial counterparty becoming covered QFCs automatically (and, as noted above, there are knock-on affects for affiliates). Thus, when July 1, 2019, arrives, each of those covered QFCs will be required to comply with the Rule (e.g., by being amended pursuant to a U.S. Protocol).

Accordingly, a covered entity will have an incentive, before trading any QFC (whether or not in-scope) with any counterparty after January 1, 2019, to know how the covered entity (and its excluded bank affiliates) will comply with the Rule when the compliance phase-in date arrives for the respective counterparty (and its consolidated affiliates). As a consequence, covered entities may seek to have revised trading documentation (whether via a U.S. Protocol or otherwise) in place with each of its QFC counterparties by the beginning of 2019 even if that documentation does not take effect until the respective phase-in date.

“Affiliates”

As noted above (see “QFC Transactions Covered by the Rule”), an existing in-scope QFC between a covered entity and a buy-side counterparty becomes a covered QFC only if a new QFC is traded between the covered entity or certain of its affiliates, on the one hand, and the buy-side counterparty or certain of its affiliates, on the other. For each side of that trading relationship, affiliate status is determined differently. On the covered entity side, “affiliate” is defined by reference to the “control” definition in the Bank Holding Company Act of 1956 (the BHCA).42 On the counterparty side, only “consolidated affiliates,” as defined in the Rule, must be considered.43 The BHCA definition of “control” results in there being affiliates of a covered entity beyond those entities that are consolidated with the covered entity under generally accepted accounting principles (GAAP). In contrast, the Rule’s definition of “consolidated affiliate” is limited to those entities that are consolidated with one another on financial statements prepared in accordance with GAAP (or that would have been so consolidated if GAAP had applied).

42 See Adopting Release at 42892 (“‘Subsidiary’ in the final rule continues to be defined by reference to BHC Act control, as does the definition of ‘affiliate’”, citing 12 CFR 252.2). Commenters had raised concerns about whether all affiliates of a covered entity would be subject to operational control, given that the BHCA definition of control may result in affiliates that are minority owned. See Adopting Release at 42891. 43 See Rule Section 252.81. SIDLEY UPDATE Page 15

Compliance Alternatives

The Rule includes a provision stating,

A covered entity may request that the Board approve as compliant with the [stated requirements] proposed provisions of one or more forms of covered QFCs, or proposed amendments to one or more forms of covered QFCs, with enhanced creditor protection conditions.44

However, the provision itself suggests potential limitations on the practical availability of “enhanced creditor protection conditions.” The provision includes detailed “considerations” by which any request is likely to be evaluated.45 The considerations include whether the request would permit adherence “with respect to only one or a subset of covered entities” — that is, whether dealer-by-dealer adherence is permitted — and whether adherence would apply to “existing and future transactions.”46 Only covered entities are permitted to submit requests to the Federal Reserve under the provision, even though commenters had requested “that counterparties and trade groups, in addition to covered entities, should be permitted to make such requests.”47 Moreover, the provision would require a covered entity to provide “a written legal opinion verifying that proposed provisions or amendments would be valid and enforceable under applicable law of the relevant jurisdictions, including, in the case of proposed amendments, the validity and enforceability of the proposal to amend the covered QFC.”48 Thus there may be meaningful hurdles to overcome with respect to taking advantage of any approach to amending covered QFCs that is not achieved through adherence to a U.S. Protocol or compliance with the stated requirements.

Covered Entities Acting as Agents

The Rule states that

(1) A covered entity does not become a party to a QFC solely by acting as agent with respect to the QFC; and (2) The exercise of a default right with respect to a covered QFC includes the automatic or deemed exercise of the default right pursuant to the terms of the QFC or other arrangement.49

However, the Federal Reserve cautioned that where covered entities, acting as agent, also take on obligations as principal, a different outcome will be warranted. It stated in the Adopting Release,

[T]he final rule does not exempt a QFC with respect to which an agent also acts in another capacity, such as guarantor. Continuing the example regarding the covered entity acting as agent with respect to a master securities lending agreement, if the covered entity also provided a [securities lending authorization agreement] that included the typical indemnification provision discussed above,

44 See Rule Section 252.85(b)(1). 45 See Rule Section 252.85(d). 46 Rule Section 252.85(d), paragraphs (6) and (4). 47 Adopting Release at 42911. 48 See Rule Section 252.85(b)(3)(ii). 49 Rule Section 252.82(e). SIDLEY UPDATE Page 16

the agency exemption of the final rule would not exclude [that agreement] but would still exclude the master securities lending agreement.50

Burden of Proof

The Rule’s cross-default provisions include a requirement related to the burden of proof and the standard of proof associated with any exercise of default rights. It states,

A covered QFC must require, after an affiliate of the direct party has become subject to a receivership, insolvency, liquidation, resolution, or similar proceeding: (1) The party seeking to exercise a default right to bear the burden of proof that the exercise is permitted under the covered QFC; and (2) Clear and convincing evidence or a similar or higher burden of proof to exercise a default right.51

The Federal Reserve explained,

The purpose of [burden/standard of proof] requirement is to deter the QFC counterparty of a covered entity from thwarting the purpose of the final rule by exercising a default right because of an affiliate’s entry into resolution under the guise of other default rights that are unrelated to the affiliate’s entry into resolution.... The requirement [makes] clear that a party that exercises a default right when an affiliate of its direct party enters receivership of [sic] insolvency proceedings is unlikely to prevail in court unless there is clear and convincing evidence that the exercise of the default right against a covered entity is not related to the insolvency or resolution proceeding.52

Similar features are found in the Universal Protocol53 and thus would be elements of any U.S. Protocol qualifying for safe harbor treatment under the Rule.

Observations The Federal Reserve is not mandating, by rule, that large U.S. GSIBs trade with buy-side counterparties only if those counterparties agree to amendments that are consistent with the Universal Protocol, including universal adherence. However, the Federal Reserve has ensured that in the absence of such an agreement, the alternative for U.S. GSIBs and their counterparties — that is, compliance with the Rule’s stated requirements — will be less attractive from a counterparty creditor protection perspective. The only alternative to compliance with the stated requirements or through adherence to a U.S. Protocol requires a covered entity to petition the Federal Reserve itself, in accordance with the Rule provisions governing

50 Adopting Release at 42908. 51 Rule Section 252.84(i). 52 Adopting Release at 42907. 53 See Universal Protocol Attachment Section 2(i) (“Burden of Proof”) and Section 6 (definition of “Unrelated Default Right” incorporating a “clear and convincing evidence” standard). SIDLEY UPDATE Page 17

“enhanced creditor protection conditions.” As suggested above, it may be difficult to take advantage of that alternative.

For investment advisers and asset managers representing buy-side clients, there will now be the challenge of communicating the terms and consequences of the Rule and, perhaps, a U.S. Protocol, to their clients, investors and accounts. Investment advisers and asset managers will face additional challenges because (as discussed above) triggers for compliance with the Rule are applied between a covered entity and each counterparty (and the counterparty’s consolidated affiliates) without regard to whether the counterparty (or an affiliate) trades through multiple advisers and/or managers. Thus, for example, if an investment adviser trades a QFC with a given covered entity, the consequences may be manifold. Of course, one consequence will be that all covered QFCs the adviser trades (or has traded) on behalf of the respective client with that covered entity will become subject to the Rule. In addition, however, compliance will be required for covered QFCs that the client has executed with the covered entity away from the adviser (e.g., either directly or through another investment adviser). Moreover, as discussed above, the adviser’s trade on behalf of the client may trigger requirements for the QFCs of the client’s affiliates.

On the sell side, covered entities will need to monitor for themselves, and disclose to buy-side counterparties as necessary, the covered entities’ “affiliates” as determined by reference to the broad BHCA concept of “control.” More generally, there will be the challenge of educating counterparties and encouraging them to act before regulatory deadlines take effect. In some circumstances, the challenges may arise as counterparties request alternative (e.g., nonprotocol) approaches — that is, ad hoc documentation amendments that meet regulatory requirements but do not do so solely via a U.S. Protocol such as the expected JMP U.S. Module and that may, therefore, attract regulatory attention.

SIDLEY UPDATE Page 18

If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or

Kenneth A. Kopelman Michele Navazio Ellen P. Pesch Partner Partner Partner [email protected] [email protected] [email protected] +1 212 839 5834 +1 212 839 5310 +1 212 839 5569

William Shirley Counsel [email protected] +1 212 839 5965

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SIDLEY UPDATE Page 19

Annex A

Comparison of Certain Key Differences Between the Creditor Protections Under a U.S. Protocol and the Rule’s Stated Requirements The table below compares the Universal Protocol and the Rule’s stated requirements with respect to their treatment of cross-default restrictions. More specifically, it compares (i) certain creditor protections under (and related aspects of) Section 2 of the Attachment to Universal Protocol, which would be incorporated in substance in any U.S. Protocol and (ii) certain creditor protections under (and related aspects of) Section 252.84 of the Rule.

As discussed in this Sidley Update, a U.S. Protocol and the stated requirements will restrict the cross-default rights of a counterparty under a covered QFC with a covered entity — that is, those rights that are triggered by an affiliate of the covered entity’s becoming subject to certain insolvency proceedings. The creditor protections permit certain exceptions to the otherwise mandated restrictions.

U.S. Protocol54 Section 252.8455

Restricts the exercise of cross-default rights where the affiliate is subject to: . if the affiliate is an affiliate support provider with . any receivership, insolvency, liquidation, respect to the QFC,56 then resolution, or similar proceeding, whether U.S. or foreign, whether U.S. state or federal, whether • proceedings under Chapter 11 of the under an insolvency regime of general or of Bankruptcy Code or specific nature. • proceedings under the FDIA; Section 252.84(a) Sections 2(b) and 2(d) . if the affiliate is not an affiliate support provider with respect to the QFC, then • proceedings under Chapter 7 or Chapter 11 of the Bankruptcy Code or • proceedings under the FDIA or SIPA. Section 2(a) (and definition of “U.S. Insolvency Proceedings” in Section 6)

Creditor protections are available with respect to: . any affiliate support provider. . only affiliate support providers that are themselves covered entities (i.e., “covered affiliate support Section 2(a) (defining “Party in U.S. providers”). Proceedings” as an “Affiliate”, which, under Section 6, is not limited to Covered Entities) Rule Section 252.84(f)

In connection with an affiliate’s Chapter 11 proceeding, for the short-term stay to be extended where the covered affiliate credit support is not transferred:

54 Citations are to Section 2 of the Attachment to the Universal Protocol. 55Assumes no reliance on the safe harbor provision in Section 252.85(a). 56 The Universal Protocol uses the defined term “credit enhancement provider.” SIDLEY UPDATE Page 20

. The bankruptcy court must issue an order by the . No additional protection. end of the stay period providing supported parties with increased creditor priority in bankruptcy. Section 2(b)(iii) (and definitions of “DIP stay conditions” and “creditor protection order” in Section 6)

In connection with an affiliate’s Chapter 11 proceeding, for the short-term stay to be extended where the covered affiliate credit support is transferred: . The bankruptcy court order must confirm that the . There is only a generic “reasonable assurance” affiliate support provider’s assets (or net proceeds requirement regarding the related transfer of the therefrom) are transferred to the transferee. covered affiliate support provider’s assets (or net proceeds therefrom). Section 2(b)(ii)(B)(I) Section 252.84(f)(4)(ii) . The transferee must • satisfy all material payment and delivery obligations to each of its creditors during the stay period, Section 2(b)(ii)(A)(II) • in certain circumstances, continue to satisfy all financial covenants and other terms applicable to the credit enhancement provider under the agreement after the stay period, and Section 2(b)(ii)(C)(II) • continue to satisfy all provisions and covenants regarding the attachment, enforceability, perfection or priority of property securing the obligations of the credit enhancement after the stay period. Section 2(b)(ii)(C)(III)

In connection with an affiliate’s Chapter 11 proceeding, for the short-term stay to be extended, whether or not the covered affiliate credit support is transferred: . The affiliate support provider (or any transferee) . The covered affiliate support provider (or any must remain obligated to the ‘‘same extent’’ as transferee) must remain obligated to the “same immediately prior to becoming a Party in Chapter or substantially similar extent” as immediately 11 Proceedings, and prior to entering the respective insolvency proceedings. . The direct party must remain duly registered and licensed by relevant regulatory bodies. Section 252.84(f)(3) Sections 2(b)(ii)(B)(II) and 2(b)(ii)(C)(I) (and definition of “Transfer Stay Conditions” in Section 6)

If the top-tier U.S. parent of the direct party remains outside of U.S. Insolvency Proceedings (as defined in the Universal Protocol): . Cross-defaults based solely on an affiliate of the No additional protection. direct party becoming subject to insolvency or resolution proceedings (other than U.S. Insolvency Proceedings) may be exercised. Section 6 (defining “Unrelated Default Right”)

OCTOBER 26, 2017

SIDLEY UPDATE

U.S. Treasury Department Outlines Regulatory Initiatives Related to Equity Market Structure

On October 6, 2017, the Department of the Treasury (Treasury) released a report describing potential policy proposals for U.S. capital markets regulation that would “promote economic growth and vibrant financial markets while maintaining strong investor protections.”1 The Treasury issued the report in response to President Donald Trump’s Executive Order 13772, published in February, which called on the Treasury to identify financial laws and regulations that are inconsistent with a set of “core principles” identified by the President.2

With respect to equity market structure, the Treasury identifies seven specific areas it believes may need to be addressed to align with President Trump’s core principles. Each of these is summarized below.

Fragmentation of Liquidity and Promoting Liquidity in Less Liquid Stocks The Treasury Report recognizes that recent regulatory and technological developments have fueled an increase in the number of trading venues on which to execute equity trades. While the proliferation of trading venues has enhanced competition, resulting in innovation and reduced transaction costs, the fragmentation of liquidity across these venues has also increased complexity and may negatively affect price discovery and execution quality. For thinly traded stocks, the Treasury notes that market fragmentation can be especially problematic; with limited volume spread across many venues, finding a trading counterparty has become more complicated.

To combat the effects of market fragmentation, the Treasury recommends that the Securities and Exchange Commission (SEC) should consider amending Regulation NMS to allow issuers of thinly traded stocks to elect that their stock trade on a limited number of venues until trading hits a minimum threshold. While the Treasury does not advocate a specific method to determine such a threshold, it suggests that average daily volume could be a useful metric. The Treasury observes that issuers have a unique interest in promoting the liquidity of their stocks and would be able to consult underwriters or listing exchanges to make the best decision on where their stocks should trade. Notably, the Treasury states that broker-dealers should still be able to internalize executions of thinly traded securities.

1 U.S. Department of the Treasury, A Financial System That Creates Economic Opportunities: Capital Markets (October 6, 2017), available at https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf (Treasury Report). The Treasury also released an accompanying five-page “fact sheet,” available at https://www.treasury.gov/press-center/press-releases/Documents/2017- 044856_CAPITALMRKTS_factsheet_v1%20FINAL-FINAL.pdf. 2 See Executive Order 13772, available at https://www.whitehouse.gov/the-press-office/2017/02/03/presidential-executive-order-core- principles-regulating-united-states.

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Dynamic Tick Sizes The Treasury notes that participants in U.S. equity markets have seen a reduction in trading costs in recent years, crediting decimalization and the attendant reduction of tick sizes as contributing factors to this trend. However, the Treasury believes that the penny trading increments currently mandated by regulation are not optimal for all stocks. In particular, since trades with larger tick sizes generally provide market makers with more compensation per trade, thinly traded stocks would likely attract more market making if such stocks were traded with tick sizes larger than one penny. To address this, the Treasury notes that the SEC launched the Tick- Size Pilot (allowing for multiple, larger tick sizes) in October 2016, with mixed and inconclusive results so far. While the Treasury acknowledges that the effects of requiring different tick sizes for different stocks may complicate markets, the Treasury nonetheless believes that the SEC should consider allowing issuers to determine tick size for trading of their stocks across exchanges, as occurs in futures markets.

Maker-Taker and Payment for Order Flow The Treasury Report identifies the manner in which market participants are compensated for transactions as an area in potential need of reform — specifically the “maker-taker” fee model and payment for order flow. Under a maker-taker fee model, a trading venue charges broker-dealers and other traders a fee for “taking” liquidity posted on the exchange and conversely pays a rebate to a broker-dealer for posting an order (i.e., “making” or adding liquidity).3 The structure is designed to encourage market participants to post liquidity on the trading venue. Payment for order flow is compensation paid to a broker-dealer for directing orders to a particular market maker or trading venue. The Treasury notes that these fee and payment arrangements can distort the incentives of broker-dealers tasked with executing clients’ trades under the obligation of best execution. The stated concern is that rather than routing client orders to a venue that may best accomplish a client’s execution objectives, a broker may instead be incentivized to route to venues that pay the broker a large trading rebate.

The Treasury recommends a multifaceted solution to address the maker-taker and payment for order flow issues. First, it recommends that the SEC adopt the amendments to Regulation NMS Rules 600 and 606 proposed in July 2016.4 These changes would enhance the required disclosures relating to payment for order flow or other compensation received by a broker-dealer in connection with executing a client’s orders and would provide additional execution statistics and information about conflicts of interest for institutional and retail investors to evaluate. Second, the Treasury endorses an access fee pilot that would allow the SEC to assess the impact of reduced maker-taker fees on execution quality and liquidity.5 While endorsing an access fee pilot, the Treasury stated that it may be appropriate to exempt thinly traded stocks from restrictions on maker-taker rebates and payment for order flow if such exemptions would facilitate greater market making in those stocks. Finally, the Treasury believes that the SEC should consider requiring broker-dealers to refund rebates and order flow payments back to their customers, allowing brokers’ incentives to be more appropriately aligned with those of their customers.

3 Other venues have adopted variations of the maker-taker fee structure. For example, “inverted venues” offer rebates for taking liquidity and charge fees for providing liquidity. 4 See Sidley Update “SEC Proposes Rules to Enhance Order Handling Information Available to Investors,” available at https://www.sidley.com/en/insights/newsupdates/2016/08/sec-proposes-rules-to-enhance-order-handling. 5 This is consistent with the Equity Market Structure Advisory Committee’s (EMSAC) recommendation for an access fee pilot and recent remarks by SEC Chairman Jay Clayton. See the EMSAC recommendation, available at https://www.sec.gov/spotlight/emsac/recommendation-access-fee- pilot.pdf. See Chairman Clayton’s remarks, available at https://www.sec.gov/news/speech/remarks-economic-club-new-york. Page 3

Market Data Existing rules governing the distribution of market data allow exchanges to sell proprietary, noncore trade data (e.g., data detailing depth-of-book quotations and odd-lot orders) at prices determined by the exchanges, subject to review by the SEC.6 The vast array of information found in proprietary data packages sold by each individual exchange is imperative to the operation of high-frequency trading firms (HFTs)7 and, as the Treasury states, some brokers believe that monitoring proprietary data feeds from each exchange is essential to the performance of their best execution obligations. These brokers and HFTs, who make up an important segment of the market, compete on speed and breadth of information processing and typically purchase costly proprietary data from all or nearly all exchanges. Proprietary data from one exchange cannot effectively substitute for data from another exchange. Given the demand for such data and lack of substitutes, the price of proprietary data feeds has rapidly increased in recent years. This pricing dynamic has led to the Treasury’s belief that “the market for proprietary data feeds is not fully competitive.”8

To address the concerns of the market participants described above, the Treasury recommends that the SEC and the Financial Industry Regulatory Authority (FINRA) issue guidance clarifying that brokers may satisfy best execution obligations by relying solely on core Security Information Processors (SIP) data, as opposed to requiring brokers to purchase costly proprietary data feeds from each exchange. Further, the Treasury recommends that the SEC more closely scrutinize fees charged for proprietary data to ensure that the fees are “fair and reasonable” and “not unreasonably discriminatory.” Finally, the Treasury recommends that the SEC should consider amending Regulation NMS to allow alternative data consolidators to compete with centralized SIPs, which the Treasury believes could foster innovation in the market data space.

Order Protection Rule The Order Protection Rule prohibits a broker-dealer from executing an order at a price that is worse than the best displayed price across all trading venues (i.e., the NBBO). The rule has helped to foster competition among exchanges as it allows any exchange to attract order flow any time it has the NBBO. The Treasury believes, however, that the Order Protection Rule has contributed to the complexity and fragmentation of U.S. equity markets. Brokers attempting to fulfill their best execution obligations often have to monitor or connect to trading venues that rarely offer meaningful liquidity but happen to be displaying the best price for a given stock at the time of execution. The Treasury notes that this presents a problem when broker-dealers attempt to execute a large block order, as having to execute small portions of the block against quotations displayed on several different venues increases the risk of tipping off other traders to the presence of a large trading interest, ultimately raising the execution costs of the block order. Broker-dealers often defend against this risk by trading in dark pools, which further fragments the market and reduces market transparency.

The Treasury recommends that the SEC consider amending the Order Protection Rule to withdraw protected quote status from exchanges that do not meet a minimum liquidity threshold. If the SEC finds that such

6 Market participants may purchase core data (i.e., last sale prices and National Best Bid or Offer or NBBO) packages from centralized securities information processors (SIPs). 7 Another key difference between SIP data and proprietary data is that trading firms can often consolidate and analyze proprietary data faster than the time it takes centralized SIPs to consolidate and disseminate data. 8 See Treasury Report at 63. Page 4

withdrawal would discourage formation of new exchanges, then the Treasury recommends that newly registered exchanges be granted a period of time to reach the established threshold.

Reducing Complexity in Equity Markets The Treasury reports over 2,000 different variations of equity order types (e.g., fill or kill, nondisplayed orders and nonroutable orders).9 The Treasury states that some institutional traders, who tend to trade in large blocks, have expressed concern that short-term HFTs may exploit these order types in a manner that allows them to determine the trading intentions of institutional traders, ultimately raising transaction costs to institutions. The Treasury further notes that some traders may not understand how HFTs and others exploit order types to gain information advantages. Because, in the Treasury’s view, the proliferation of order types has exacerbated market complexity, the Treasury recommends that the SEC consider whether trading venues can harmonize order types and examine whether certain order types sustain enough volume to merit continued existence.

Regulation ATS In November 2015, the SEC proposed to amend Regulation ATS to increase public information about alternative trading systems (ATSs) that trade National Market System (NMS) stocks (NMS Stock ATSs),10 the overwhelming majority of which are dark pools with limited transparency. The Treasury agrees with the SEC’s goals of increasing public information about NMS Stock ATSs, as this information would allow investors to make more informed decisions about whether to execute transactions on these venues. However, the Treasury recommends that the SEC revise aspects of the proposal to eliminate requirements for NMS Stock ATSs to publicly disclose confidential information that would be unnecessary and unhelpful to investors. For instance, the Treasury questioned the utility of the requirement in the SEC’s proposal that NMS Stock ATSs publicly disclose details of “outsourcing arrangements concerning any of its operations, services, or functions.”11 However, if the SEC can demonstrate that such information would improve its oversight of equity markets, then the Treasury recommends that the SEC require only confidential disclosure.

Conclusion The Treasury Report lays out a set of equity market structure policy recommendations that the Treasury asserts would improve the overall vibrancy of U.S. markets to foster economic growth, consistent with the stated regulatory goals of the Trump administration. With respect to many of the issues discussed in the Treasury Report, regulatory agencies have already taken initial steps by issuing certain policy proposals and appear poised to finalize a number of these reforms.12 In particular, Chairman Clayton has indicated that the SEC plans to launch an access fee pilot and adopt proposed amendments to Rule 606 and Regulation ATS in the near future,

9 See Treasury Report at 66. It cites the following as its sources for the statistics. Herbert Lash, Complaints Rise over Complex U.S. Stock Orders, Reuters (Oct. 19, 2012), available at http://www.reuters.com/article/us-exchanges-ordertypes/analysis-complaints-rise-over-complex-u-s-stock-orders- idUSBRE89I0YU20121019. See also Paul G. Mahoney and Gabriel Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation, Virginia Law and Economics Research Paper No. 2017-07 (Apr. 19, 2017), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955112. 10 See Sidley Update “SEC Proposes New Rules to Increase the Transparency and Oversight of Alternative Trading Systems that Transact in NMS Stock,” available at https://www.sidley.com/en/insights/newsupdates/2015/11/sec-proposes-new-rules-to-increase. 11 See Treasury Report at 67. 12 Examples of this are the launching of the Tick-Size Pilot and the proposal of amendments to Regulation ATS and Rule 606. Page 5 with broad industry support for adopting amendments to Rule 606.13 The newly selected Director of the Division of Trading and Markets, Brett Redfearn,14 has been a leading voice in discussions related to these and other key market structure initiatives.15 In addition, we understand that FINRA plans to issue further guidance on best execution as it relates to the use of SIP data. It remains to be seen whether regulators will act on the other recommendations of the Treasury Report.16

If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or

James Brigagliano Michael D. Wolk Timothy B. Nagy Partner Partner Counsel [email protected] [email protected] [email protected] +1 202 736 8135 +1 202 736 8807 +1 202 736 8054

Andrew J. Sioson Charles A. Sommers Associate Associate [email protected] [email protected] +1 202 736 8351 +1 202 736 8125

Sidley Securities & Derivatives Enforcement and Regulatory Practice Sidley’s Securities & Derivatives Enforcement and Regulatory group advises and defends clients in a wide range of securities- and derivatives-related matters. With more than 150 lawyers in 10 offices worldwide, we provide comprehensive regulatory, enforcement, and litigation solutions in matters involving the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), self-regulatory organizations (SROs), state attorneys general and state securities regulators. Our team is distinctive in that it combines the strength of nationally recognized enforcement lawyers with the skills of equally prominent counseling lawyers. We work collaboratively to provide our clients with informed, efficient and effective representation.

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13 See Chairman Clayton’s testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs on “Oversight of the U.S. Securities and Exchange Commission,” available at https://www.sec.gov/news/testimony/testimony-clayton-2017-09-26. 14 See SEC Names Brett Redfearn as Director of the Division of Trading and Markets, available at https://www.sec.gov/news/press-release/2017-198. 15 Director Redfearn has written numerous statements to the SEC calling for changes to NMS Plan governance and addressing what he believes are problems with self-regulatory organization immunity and conflicts of interest that harm broker-dealers. See Director Redfearn’s comments to the EMSAC, available at https://www.sec.gov/comments/265-29/26529-43.pdf and https://www.sec.gov/comments/265-29/26529-64.pdf. 16 Sidley notes that in March 2015, the SEC proposed amendments to SEC Rule 15b9-1 to require broker-dealers active in off-exchange trading to become members of a national securities association. Neither the Treasury Report nor recent remarks from Chairman Clayton mentions support for this initiative.

August 8, 2017

SIDLEY UPDATE

Some Good Deeds Apparently Do Get Rewarded: CFTC Settles Spoofing Case and Indicates It Gave Substantial Credit for Cooperation and Voluntary Remediation

On August 7, 2017, the Commodity Futures Trading Commission (CFTC) entered a settlement order In the Matter of Tokyo-Mitsubishi UFJ, Ltd., CFTC Dkt. 17-21 (Order).1 It is the latest CFTC case to settle involving alleged extended “spoofing” trading, in which a trader is said to have entered orders without any intention to consummate trades, an unlawful activity under the Commodity Exchange Act. Most interestingly, the emphasis of the Order and the accompanying press release2 was on the CFTC giving substantial credit for self-reporting and self-initiated remediation steps. Compared to other recent settlements, the CFTC does appear to have ordered a notably milder sanction than it otherwise might have. This suggests that affirmative steps to self- report and remediate misconduct may well reap benefits in dealing with the CFTC in the coming years.

In the Order, which was settled without any admission or denial of the truth of the charges, the CFTC finds that a trader engaged in spoofing in the course of trading “a variety of futures contracts” on the Chicago Mercantile Exchange and the Chicago Board of Trade, including Treasury and Eurodollar futures. The CFTC said that the conduct continued over a period of almost five and a half years, from July 2009 through December 2014, but that most of the activity occurred over two years, 2010 and 2011. The conduct is described as similar to that addressed in most CFTC spoofing cases in recent years: the placement of a relatively small trade or trades on one side of the market, and then placing larger trades on the other side of the market, intending not to execute the larger orders but rather to move the market favorably to the smaller trade or trades. When the smaller trades executed, the trader would cancel the larger trades on the other side of the market.

The Order demonstrates the CFTC’s continued focus on bringing cases for violating Section 4c(a)(5)(C) of the Commodity Exchange Act, which Dodd-Frank added to the statute and which outlaws “spoofing” on any CFTC- regulated trading facility. 3 Most worthy of note, however, is that the Order and, more clearly, the accompanying

1 http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enftokyomitsubishiorder080717.pdf 2 http://www.cftc.gov/PressRoom/PressReleases/pr7598-17#PrRoWMBL 3 Section 4c(a)(5)(C) prohibits any trading, practice or conduct on a CFTC-regulated trading facility that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” A violation of this provision is a civil violation subject to the CFTC’s jurisdiction and is also a crime. Michael Coscia, the first person criminally indicted under the new spoofing provision, was convicted and sentenced to three years imprisonment. Mr. Coscia had previously settled civil actions related to the same spoofing allegations with the CFTC, the UK’s Financial Conduct Authority and various futures exchanges, agreeing to the payment of monetary penalties and a trading suspension. On August 7, 2017, a federal court of appeals upheld his conviction, finding that the Commodity Exchange Act’s spoofing prohibition is not unconstitutionally vague. United States v. Coscia, No. 16-3017 (7th Cir. Aug. 7, 2017).

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press release draw attention to the relatively modest sanctions imposed, which the Director of Enforcement expressly attributes to the company’s self-reporting and cooperation, including self-initiated remediation.

The Order and the press release note that the company, once aware of the conduct in question, “promptly suspended” the trader and reported the conduct to the CFTC’s enforcement division. The company also started “an expansive internal review,” as well as “assisted” in the division’s investigation. Moreover, the company also, “at the same time,” started “an overhaul of its systems and controls and implemented a variety of enhancements to detect and prevent similar misconduct,” as well as “revis[ing] its policies, updat[ing] its training, and implement[ing] electronic systems to identify spoofing.”

The CFTC’s Enforcement Director, James McDonald, states that the direct result of these steps is that the company “benefitted . . . in the form of a substantially reduced penalty.” The company was penalized $600,000. To put this in context, less than two weeks earlier, the CFTC entered a settlement with an individual, who traded from home and for himself, for spoofing over about three and a half years, in which the CFTC fined him $635,000 and imposed permanent trading and registration bans. Moreover, back in January, the CFTC settled with a major financial institution by fining it $25 million for spoofing that occurred over about 18 months, despite saying there was cooperation credit there was well.

Since the settlement in January, however, there is a new President, a new Chairman of the CFTC and a new Director of Enforcement. That Director stated in the press release in this matter that, “This case shows the benefits of self-reporting and cooperation, which I anticipate being an important part of our enforcement program going forward.” While one should not read too much into a single settlement, this case could be a harbinger of a clearer benefit to be gained by self-reporting and proactive remediation than has been discernable in the past. It will be important to watch to see if this harbinger becomes a trend; if it does, companies will need to look carefully at the value of embracing more willingly opportunities to self-report misconduct and actively engaging in substantial remediation of policies and practices, rather than waiting for the CFTC to come knocking.

If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or

Geoffrey F. Aronow William J. Nissen Michael S. Sackheim Partner Partner Senior Counsel [email protected] [email protected] [email protected] +1 202 736 8023 +1 312 853 7742 +1 212 839 5503

Securities & Derivatives Enforcement and Regulatory Practice Sidley’s Securities & Derivatives Enforcement and Regulatory group advises and defends clients in a wide range of securities- and derivatives-related matters. With more than 150 lawyers in 10 offices worldwide, we provide comprehensive regulatory, enforcement, and litigation solutions in matters involving the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), self-regulatory organizations (SROs), state attorneys general and state securities regulators. Our team is distinctive in that it combines the strength of nationally recognized enforcement lawyers with the skills of equally prominent counseling lawyers. We work collaboratively to provide our clients with informed, efficient and effective representation.

To receive Sidley Updates, please subscribe at www.sidley.com/subscribe. SIDLEY UPDATE Page 3

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