The 'Separate Entity' Question and Swaps Trading

By George Bollenbacher, Capital Markets Advisors

Originally published on TABB Forum

A well-known legal case in the commercial banking sector may have significant implications for clearing houses and other swaps market participants.

On Sept. 16, the New York Court of Appeals will hear arguments on a case that is rather well known in commercial banking circles, but perhaps less so in the swaps markets. As it turns out, the case may have significant implications for swaps market participants, including clearing houses.

The case itself, Motorola Credit Corp v. Standard Chartered Bank, nominally involves the question of whether a US branch of a foreign bank is considered a “separate entity” from the foreign bank. New York law has long held that to be true, but the Appeals Court is reviewing that holding in light of this case.

In the case, Motorola has been pursuing a defaulted debt by seeking to garnishee funds held by Standard Chartered offshore – specifically in the UAE. The UAE authorities have refused to recognize the garnishment, and have blocked the funds. Thus the question before the court is whether claims adjudicated in New York are payable by a New York branch of a foreign bank, even if the assets in question are held offshore, and the claim is rejected by the offshore regulators.

Recognizing that the appellate decision will have a big impact on financial markets, SIFMA has filed an amicus brief in the case. It makes several arguments:

1. That “separate entity” has been part of New York law for almost 100 years and should not be reversed.
2. That reversing it would prompt a wave of creditors’ claims in New York solely for the purpose of attaching assets, and
3. Reversing it would expose New York banks to double liability, where they would have to make payments in NY and not be able to secure the funds overseas.

The fact that the case appears to hinge on whether a NY branch is a separate entity from the parent bank could lead to some interesting implications for the swaps markets. To begin with, no such rule ever was promulgated by the legislature or a banking regulator. Instead, it has been part of a series of court rulings dating back as far as 1916. And these rulings almost always dealt with commercial banking activities such as taking deposits and making loans, not trading or settling transactions, and certainly not swaps transactions.

Not having a law or regulation, and relying on court decisions, leaves everyone in something of a state of flux on this issue. In some ways, of course, the separate entity rule is demonstrably false. If I make a deposit at a New York branch of Citibank and withdraw some of it from the London or Paris branches, there is no thought that I might not be able to access the money because I changed branches. In this instance, the branch where I made the deposit isn’t a “separate entity” from the bank itself; it’s just a place where I do business with the bank.

But what about in trading – and trading swaps, in particular? According to the SIFMA brief:

“Federal securities laws treat bank branches as separate entities in several respects,” such as “the exemption given to banks from general registration requirements for securities.”

In addition, SIFMA points out that:

“U.S. branches are required to maintain reserves with the Federal Reserve Bank only with respect to their reservable deposits in the U.S. branch, not deposits of the foreign bank outside the United States.” [emphasis provided]

Still, that mostly is about commercial banking transactions. And that is how the Appellate Court is thinking about it, I suspect. But what the court decides could impact swaps trading. The CFTC has had an ongoing discussion with other regulators about how and to whom its rules and enforcement apply. In fact, almost every regulator worldwide has been staking out its claim on whom it regulates, and the status of branches has been a central part of those discussions. The CFTC, in particular, generated both comment and legal action when it proposed to treat US branches of foreign banks differently from foreign branches of US banks.

So the New York Court of Appeals may not be thinking much about how its decision will affect US branches of foreign banks in the swaps world, but we should. For example, in what capacity is the US branch of a foreign swap dealer acting in such areas as margin movement and settlements? If a foreign bank is acting as an FCM for a foreign customer at a US CCP, how much access does the CCP have to customer funds if the customer defaults?

The whole concept of the national regulation of a global market has been fraught with complications, and even some recriminations. If we end up with a state court ruling, based on prior court decisions instead of legislation or regulation, that complicates everything, we will be even further away from sanity than we are now. So be sure to reserve your seat in the courtroom on Sept. 16.