Regulators may not have authority to delay Dodd-Frank, warn lawyers

Market participants could face a surge in disputes as a result of legal ambiguity arising from the delayed implementation of the Dodd-Frank Act, say some lawyers.

Dodd-Frank is scheduled for implementation on July 16, but with large areas of rule-making unfinished – including fundamental definitions about the products and market participants covered by the rules – both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have issued notices to postpone the deadline.

That has been broadly welcomed by dealers, but lawyers warn it could create problems of its own. Over-the-counter derivatives were defined as ‘excluded commodities' by the Commodity Futures Modernization Act (CFMA) in 2000, putting them out of reach of the futures regulations contained in the Commodity Exchange Act (CEA). Dodd-Frank overhauls the OTC market by repealing the CFMA's exclusions and adding new rules to the CEA on clearing, execution and reporting for swaps and other OTC trades. Rolling back the CFMA without amending the CEA could leave swaps subject to legal challenge, some lawyers say.

"The CFMA had specific carve-outs for swaps, which expire on July 16. With Dodd-Frank unfinished, the fear is that people might be subject to lawsuits from plaintiffs claiming new or existing swaps would no longer be in compliance with the applicable securities laws. We're in this grey area, and there's a real question as to whether the SEC and CFTC have done enough," says Dan Crowley, Washington, DC-based partner at law firm K&L Gates.

It's not for lack of trying. The CFTC has grouped Dodd-Frank's OTC provisions into four categories – two of which it believes won't result in any legal risk for the market if left unaddressed. The other two were covered in a proposal filed with the Federal Register on June 17. The first of these are the so-called self-effectuating provisions of Dodd-Frank, which would come into effect on July 16 without the need for any additional rules from the CFTC. Many of these clauses reference terms that have not yet been defined, such as ‘swap', ‘swap dealer' and ‘major swap participants' – so the CFTC plans to provide a temporary exemption on any rule that contains these terms.

There’s a real question as to whether the CFTC and the SEC have the authority to do what they’ve done

The second part of the June 17 filing proposes that the repeal of the CFMA's safe harbour for ‘excluded commodities' is postponed, leaving OTC markets outside the CEA for now.

Then, on June 30, the CFTC announced it was crafting a no-action letter to provide further relief from three specific sections of Dodd-Frank – including a requirement for swap dealers to segregate margin in uncleared transactions at the request of their counterparties – which the agency said may not have been covered by the June 17 exemptions. Put simply, the no-action letter is a promise not to take enforcement action against firms that ignore the three specific sections the CFTC believes it may not have the authority to otherwise exempt. And on July 1, the SEC released an interim final rule and exemptive order that excludes OTC derivatives from various pieces of securities legislation.

The relief provided by the SEC lasts until the day the implementing rules become effective. In contrast, the CFTC proposes its exemptions last until December 31, 2011, or the day the implementing rules become effective – whichever is earlier.

While the December 31 deadline could yet be extended, legal sources say it is most likely a way of maintaining pressure to complete the rule-making process.

Some market participants remain unsatisfied. The Dodd-Frank Act gives regulators authority to "exempt persons, agreements, contracts, or transactions from the provisions of the act", but some lawyers question whether the CFTC and SEC have the legal authority to delay implementation for large parts of the rules.

"The Dodd-Frank Act extension raises more questions than it answers. What happens to the legal provisions that were supposed to be superseded by Dodd-Frank on July 16 is not quite clear. A rule-making or pronouncement from the CFTC or the SEC obviously does not have the legal authority of the US Congress," says Don Lamson, a counsel specialising in derivatives at law firm Shearman & Sterling in Washington, DC.

This raises the possibility that some end-users who have lost money on a trade might try to argue the transaction is illegal, says Crowley at K&L Gates. However, he notes there is little else regulators can do to further remedy the situation. "There's a real question as to whether the CFTC and the SEC have the authority to do what they've done. But I think they've done all they can do," he says.

Notwithstanding this, some legal experts believe hypothetical plaintiffs will have a tough time convincing a judge of the validity of their argument. "I've heard the argument, but I really don't see anything in the proposed extension that gives participants legal grounds to back out of otherwise binding contracts. I can't see courts saying contracts would be unenforceable on those grounds," says Andrea Kramer, head of the financial products, trading and derivatives group at law firm McDermott, Will & Emery in Chicago.

This article first appeared on Risk.net