2012-1244
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Federal Register, Volume 77 Issue 33 (Friday, February 17, 2012)[Federal Register Volume 77, Number 33 (Friday, February 17, 2012)]
[Rules and Regulations]
[Pages 9734-9835]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-1244]
[[Page 9733]]
Vol. 77
Friday,
No. 33
February 17, 2012
Part II
Commodity Futures Trading Commission
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17 CFR Parts 4 and 23
Business Conduct Standards for Swap Dealers and Major Swap Participants
With Counterparties; Final Rule
Federal Register / Vol. 77 , No. 33 / Friday, February 17, 2012 /
Rules and Regulations
[[Page 9734]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 4 and 23
RIN 3038-AD25
Business Conduct Standards for Swap Dealers and Major Swap
Participants With Counterparties
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rules.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is adopting final rules to implement Section 4s(h) of the
Commodity Exchange Act (``CEA'') pursuant to Section 731 of Title VII
of the Dodd-Frank Wall Street Reform and Consumer Protection Act of
2010 (the ``Dodd-Frank Act''). These rules prescribe external business
conduct standards for swap dealers and major swap participants.
DATES: Effective Date: These final rules will become effective on April
17, 2012.
Compliance Date: Swap dealers and major swap participants must
comply with the rules in subpart H of part 23 on the later of 180 days
after the effective date of these rules or the date on which swap
dealers or major swap participants are required to apply for
registration pursuant to Commission rule 3.10.
FOR FURTHER INFORMATION CONTACT: Phyllis J. Cela, Chief Counsel,
Division of Enforcement; Katherine Scovin Driscoll, Senior Trial
Attorney, Division of Enforcement; Theodore M. Kneller, Attorney
Advisor, Division of Enforcement; Mary Q. Lutz, Attorney Advisor,
Division of Enforcement; Barry McCarty, Attorney Advisor, Division of
Enforcement; Michael Solinsky, Chief Trial Attorney, Division of
Enforcement; Mark D. Higgins, Counsel, Office of General Counsel; and
Peter Sanchez, Special Counsel, Division of Swap Dealer and
Intermediary Oversight, Commodity Futures Trading Commission, 1155 21st
Street NW., Washington, DC 20581. Telephone number: (202) 418-7642.
SUPPLEMENTARY INFORMATION: The Commission is adopting final rules
Sec. Sec. 23.400-402, 23.410, 23.430-434, 23.440, and 23.450-451 under
Section 4s(h) of the CEA and Sec. 4.6(a)(3) under Section 1a(12) of
the CEA.
Table of Contents
I. Introduction
II. Regulatory Intersections
A. Securities and Exchange Commission Business Conduct Standards
for Security-Based Swap Dealers and Major Security-Based Swap
Participants
B. Department of Labor ERISA Fiduciary Regulations
C. Securities and Exchange Commission Municipal Advisor
Registration
D. Commodity Trading Advisor Status for Swap Dealers
III. Final Rules for Swap Dealers and Major Swap Participants
Dealing With Counterparties Generally
A. Sections 23.400, 23.401 and 23.402--Scope, Definitions and
General Provisions
1. Section 23.400--Scope
a. Proposed Sec. 23.400--Scope
b. Comments and Final Sec. 23.400--Scope
2. Section 23.401--Definitions
a. Proposed Sec. 23.401
b. Comments
c. Final Sec. 23.401
3. Section 23.402--General Provisions
a. Section 23.402(a)--Policies and Procedures to Ensure
Compliance and Prevent Evasion
b. Section 23.402(b)--Know Your Counterparty
c. Section 23.402(c)--True Name and Owner
d. Section 23.402(d)--Reasonable Reliance on Representations
e. Section 23.402(e)--Manner of Disclosure
f. Section 23.402(f)--Disclosures in a Standard Format
g. Section 23.402(g)--Record Retention
B. Section 23.410--Prohibition on Fraud, Manipulation and Other
Abusive Practices
1. Sections 23.410(a) and (b)
a. Proposed Sec. 23.410(a)
b. Comments
c. Final Sec. 23.410(a) and (b)
2. Section 23.410(c)--Confidential Treatment of Counterparty
Information
a. Proposed Sec. 23.410(b)
b. Comments
c. Final Sec. 23.410(c)
3. Proposed Section 23.410(c)--Trading Ahead and Front Running
Prohibited--Not Adopted as Final Rule
a. Proposed Sec. 23.410(c)
b. Comments
c. Commission Determination
C. Section 23.430--Verification of Counterparty Eligibility
1. Proposed Sec. 23.430
2. Comments
3. Final Sec. 23.430
D. Section 23.431--Disclosure of Material Risks,
Characteristics, Material Incentives and Conflicts of Interest
Regarding a Swap
1. Proposed Sec. 23.431--Generally
2. Comments--Generally
3. Final Sec. 23.431--Generally
a. Section 23.431(a)(1)--Material Risk Disclosure
b. Section 23.431(b)--Scenario Analysis
c. Section 23.431(a)(2)--Material Characteristics
d. Section 23.431(a)(3)--Material Incentives and Conflicts of
Interest
e. Section 23.431(d)--Daily Mark
E. Section Sec. 23.432--Clearing Disclosures
1. Proposed Sec. 23.432
2. Comments
3. Final Sec. 23.432
F. Section 23.433--Communications--Fair Dealing
1. Proposed Sec. 23.433
2. Comments
3. Final Sec. 23.433
G. Section 23.434--Recommendations to Counterparties--
Institutional Suitability
1. Proposed Sec. 23.434
2. Comments
3. Final Sec. 23.434
IV. Final Rules for Swap Dealers and Major Swap Participants Dealing
With Special Entities
A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)
1. Section 23.401--Proposed Definition of ``Special Entity''
2. Comments
a. State and Municipal Special Entities
b. Employee Benefit Plans and Governmental Plans
c. Master Trusts
d. Endowments
e. Collective Investment Vehicles: The ``look through'' Issue
3. Final Sec. 23.401(c) Special Entity Definitions
a. Federal Agency
b. State and Municipal Special Entities
c. Employee Benefit Plans and Governmental Plans
d. Endowment
e. Collective Investment Vehicles: The ``look through'' Issue
B. Section 23.440--Requirements for Swap Dealers Acting as
Advisors to Special Entities
1. Proposed Sec. 23.440
2. Comments
a. Scope of the Proposed ``Acts as an Advisor to a Special
Entity'' and ``Recommendation'' Definitions
b. Meaning of ``Best Interests''
c. Comments on Sec. 23.440(b)(2)--Duty to Make Reasonable
Efforts
3. Final Sec. 23.440
a. Acts as an Advisor to a Special Entity
b. Commenters' Alternative Approaches
c. Best Interests
d. Commenters' Alternative ``Best Interests'' Approaches
e. Final Sec. 23.440(c)(2)--Duty to Make Reasonable Efforts
f. Final Sec. 23.440(d)--Reasonable Reliance on Representations
C. Section 23.450--Requirements for Swap Dealers and Major Swap
Participants Acting as Counterparties to Special Entities
1. Proposed Sec. 23.450
2. Comments
a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)
b. Duty to Assess the Qualifications of a Special Entity's
Representative
c. Representative Qualifications
d. Reasonable Reliance on Representations
e. Unqualified Representatives
f. Disclosure of Capacity
g. Transaction Costs and Risks
3. Final Sec. 23.450
a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)
b. ERISA Plan Representatives That Are ERISA Fiduciaries
[[Page 9735]]
c. Duty to Assess the Qualifications of a Special Entity's
Representative
d. Representative Qualifications
e. Reasonable Reliance on Representations
f. Chief Compliance Officer Review
g. Disclosure of Capacity
D. Section 23.451--Political Contributions by Certain Swap
Dealers
1. Proposed Sec. 23.451
2. Comments
3. Final Sec. 23.451
V. Implementation
A. Effective Dates and Compliance Dates
B. Comments
C. Commission Determination
VI. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Cost-Benefit Considerations
I. Introduction
On July 21, 2010, President Obama signed the Dodd-Frank Act.\1\
Title VII of the Dodd-Frank Act amended the CEA \2\ to establish a
comprehensive new regulatory framework for swaps.\3\ The legislation
was enacted to reduce risk, increase transparency and promote market
integrity within the financial system by, among other things: (1)
Providing for the registration and comprehensive regulation of swap
dealers and major swap participants; (2) imposing clearing and trade
execution requirements on standardized derivative products; (3)
creating robust recordkeeping and real-time reporting regimes; and (4)
enhancing the Commission's rulemaking and enforcement authorities with
respect to, among others, all registered entities and intermediaries
subject to the Commission's oversight.
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\1\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010).
\2\ 7 U.S.C. 1 et seq., as amended by the Dodd-Frank Act. All
references to the CEA are to the CEA as amended by the Dodd-Frank
Act except where otherwise noted.
\3\ Title VII of the Dodd-Frank Act also amended the federal
securities laws to establish a similar comprehensive new regulatory
framework for security-based swaps.
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On December 22, 2010, the Commission published in the Federal
Register proposed subpart H of part 23 of the Commission's Regulations
to implement new Section 4s(h) of the CEA pursuant to Section 731 of
the Dodd-Frank Act (the ``proposed rules'' or ``proposing
release'').\4\ There was a 60-day period for the public to comment on
the proposing release, which ended on February 22, 2011. On May 4,
2011, the Commission published in the Federal Register a notice to re-
open the public comment period for an additional 30 days, which ended
on June 3, 2011.\5\ The Commission has determined to adopt the proposed
rules with a few exceptions and with certain modifications, discussed
below, to address the comments the Commission received. One rule that
the Commission has determined not to adopt at this time is proposed
Sec. 155.7, which would have required Commission registrants to comply
with swap execution standards.\6\ Should the Commission determine to
consider execution standards at a later date, it would re-propose such
rules.
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\4\ Proposed Rules for Business Conduct Standards for Swap
Dealers and Major Swap Participants With Counterparties, 75 FR
80638, Dec. 22, 2010 (``proposing release'').
\5\ Reopening and Extension of Comment Periods for Rulemakings
Implementing the Dodd-Frank Wall Street Reform and Consumer
Protection Act, 76 FR 25274, May 4, 2011 (``Extension of Comment
Periods''). As reflected in the public comment file, the Commission
continued to receive comments and meet with commenters after the
comment period officially closed.
\6\ Proposing release, 75 FR at 80648-49 and 80662.
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Section 731 of the Dodd-Frank Act amends the CEA by adding Section
4s(h).\7\ Section 4s(h) provides the Commission with both mandatory and
discretionary rulemaking authority to impose business conduct standards
on swap dealers and major swap participants in their dealings with
counterparties, including Special Entities.\8\ The proposing release
included rules mandated by Section 4s(h) as well as discretionary rules
that the Commission determined were appropriate in the public interest,
for the protection of investors and in furtherance of the purposes of
the CEA.\9\
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\7\ 7 U.S.C. 6s(h).
\8\ Section 4s(h)(2)(C) defines Special Entity as: ``(i) A
Federal Agency; (ii) a State, State agency, city, county,
municipality, or other political subdivision of a State; (iii) an
employee benefit plan, as defined in section 3 of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002); (iv) any
governmental plan, as defined in section 3 of the Employee
Retirement Income Security Act of 1974; or (v) any endowment,
including an endowment that is an organization described in section
501(c)(3) of the Internal Revenue Code of 1986.''
\9\ See Section 4s(h)(3)(D) (``Business conduct requirements
adopted by the Commission shall establish such other standards and
requirements as the Commission may determine are appropriate in the
public interest, for the protection of investors, or otherwise in
furtherance of the purposes of [the CEA.]''); see also Sections
4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6). The proposed and final rules
are informed by existing requirements for market intermediaries
under the CEA and Commission Regulations, the federal securities
laws, self-regulatory organization (``SRO'') rules, prudential
regulator standards for banks, industry ``best practices'' and
requirements applicable under foreign regulatory regimes. See
proposing release, 75 FR at 80639 for further discussion of the
sources the Commission considered in drafting the proposing release.
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In compliance with Sections 712(a)(1) and 752(a) \10\ of the Dodd-
Frank Act, Commission staff consulted and coordinated with the
Securities and Exchange Commission (``SEC''),\11\ prudential regulators
and foreign authorities. Commission staff also consulted informally
with staff from the Department of Labor (``DOL'') and the Internal
Revenue Service (``IRS'') with respect to certain Special Entity
definitions and the intersection of their regulatory requirements with
the Dodd-Frank Act business conduct standards provisions. This ongoing
consultation and coordination effort is described more fully in Section
II of this adopting release.
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\10\ Section 712(a)(1) of the Dodd-Frank Act requires that the
Commission consult with SEC and prudential regulators in
promulgating rules pursuant to Section 4s(h). Section 752(a) of the
Dodd-Frank Act states in part, that the Commission, SEC, and the
prudential regulators ``shall consult and coordinate with foreign
regulatory authorities on the establishment of consistent
international standards with respect to the regulation (including
fees) of swaps * * *.''
\11\ See proposing release, 75 FR at 80640 for further
discussion of the Commission's consultation and coordination with
the SEC before issuing the proposing release.
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In addition, Commission staff consulted with foreign authorities,
specifically European Commission and United Kingdom Financial Services
Authority staff. Commission staff also considered the existing and
ongoing work of the International Organization of Securities
Commissions (``IOSCO''). Staff consultations with foreign authorities
revealed similarities in the proposed rules and foreign regulatory
requirements.\12\
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\12\ See proposing release, 75 FR at 80640 for further
discussion of the Commission's consultation with foreign
authorities. See generally European Union Markets in Financial
Instruments Directive (``MiFID''), Directive 2004/39/EC of the
European Parliament and of the Council of 21 April 2004 on markets
in financial instruments; see also European Union Market Abuse
Directive (``Market Abuse Directive''), Directive 2006/6/EC of the
European Parliament and of the Council of 28 January 2003 on market
abuse; Proposal for a Directive of the European Parliament and of
the Council on markets in financial instruments repealing Directive
2004/39/EC, COM (2011) 656 final (Oct. 20, 2011) (``MiFID II
Proposal'').
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The Commission received more than 120 written submissions on the
proposing release from a range of commenters.\13\ Commission staff also
met with representatives from at least 33 of the commenters and other
members of the public. Commenters included members of Congress,
dealers, advisors, large asset managers, consumer advocacy groups and
pension beneficiaries, end-users, trade or professional organizations
and Special Entities such as State and municipal
[[Page 9736]]
governmental entities, ERISA pension plan sponsors and administrators,
government pension plan administrators and endowments. These comments
and meetings were in addition to seven written submissions received by
the Commission and at least 33 meetings held by Commission staff with
commenters and other members of the public prior to the publication of
the proposing release.\14\ The proposed rules included a scope
provision,\15\ definitions,\16\ general compliance provisions,\17\
rules that would apply to dealings with all counterparties \18\ and
rules that would apply to dealings with Special Entities.\19\ While the
comments touched on all aspects of the proposing release, many of them
concerned the proposed requirements for swap dealers and major swap
participants in their dealings with Special Entities.
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\13\ Subsequent to the issuance of the proposing release, the
Commission received written submissions from the public, available
in the comment file on www.cftc.gov, including, but not limited to
those listed in the table in Appendix 1 to this adopting release.
\14\ Prior to the publication of the proposing release, the
Commission received several written submissions from the public,
available in the comment file on www.cftc.gov, including, but not
limited to: American Benefits Council letter, dated Sept. 8, 2010;
American Benefits Council and the Committee on the Investment of
Employee Benefit Assets letter, dated Oct. 19, 2010; National
Futures Association letter, dated Aug. 25, 2010 (``NFA Aug. 25, 2010
Letter''); New York City Bar Association letter, dated Nov. 29,
2010; Ropes & Gray letter, dated Sept. 2, 2010; Securities Industry
and Financial Markets Association and International Swaps and
Derivatives Association letter, dated Oct. 22, 2010 (``SIFMA/ISDA
Oct. 22, 2010 Letter''); Swap Financial Group letter, dated Aug. 9,
2010; Swap Financial Group presentation entitled ``Briefing for SEC/
CFTC Joint Working Group,'' dated Aug. 9, 2010; and Morgan Stanley
letter, dated Dec. 3, 2010.
\15\ See proposed Sec. 23.400.
\16\ See proposed Sec. 23.401.
\17\ See proposed Sec. 23.402.
\18\ See proposed Sec. Sec. 23.410, 23.430, 23.431, 23.432,
23.433, and 23.434.
\19\ See proposed Sec. Sec. 23.440, 23.450 and 23.451.
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The Commission has reviewed and considered the comments and, in
Sections III and IV below, has endeavored to address both the primary
themes running throughout the comment letters and the significant
points made by individual commenters. The final rules, like the statute
and proposed rules, are principles based and generally follow the
framework of the proposed rules.\20\ The text has been clarified in a
number of respects to take into account the comments received by the
Commission and to harmonize with the SEC's and DOL's regulatory
approaches. The Commission discusses each of the final rules in
separate sections below, which address the changes from the proposed
rules, if any, and the content of the final rules.\21\ The discussions
address comments concerning costs and benefits, as well as alternative
approaches proposed by commenters. The Commission also provides
guidance, where appropriate, to assist swap dealers and major swap
participants in complying with their new duties. The Commission also
states that it does not view the business conduct standards statutory
provisions or rules in subpart H of part 23 to impose a fiduciary duty
on a swap dealer or major swap participant with respect to any other
party.
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\20\ The requirements under Section 4s(h), generally, do not
distinguish between swap dealers and major swap participants.
However, the Commission has considered the nature of the business
done by swap dealers and major swap participants and determined that
certain of the final rules will not apply to major swap
participants. In particular, major swap participants will not be
subject to the institutional suitability, ``know your counterparty''
and scenario analysis requirements, or to a pay-to-play restriction.
This is discussed further in the sections below addressing those
rules.
\21\ The Commission is not adopting a diligent supervision rule
in this rulemaking, finding that such a rule would be duplicative of
the proposed diligent supervision rule in a separate rulemaking. See
Regulations Establishing and Governing the Duties of Swap Dealers
and Major Swap Participants, 75 FR 71397, Nov. 23, 2010 (``Governing
the Duties of Swap Dealers'') (proposed Sec. 23.602 imposing
additional diligent supervision requirements on swap dealers and
major swap participants). The final rules also do not include a free
standing prohibition against front running or trading ahead of
counterparty transactions as proposed in Sec. 23.410(c) because the
Commission has determined that such trading, depending on the facts
and circumstances, would violate the Commission's prohibitions
against fraudulent, deceptive or manipulative practices, including
Sections 4b, 4s(h)(4)(A) and 6(c)(1) of the Act and Regulations
Sec. Sec. 23.410 and 180.1.
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II. Regulatory Intersections
A. Securities and Exchange Commission Business Conduct Standards for
Security-Based Swap Dealers and Major Security-Based Swap Participants
In addition to CEA Section 4s(h), which was added by Section 731 of
the Dodd-Frank Act, Section 764 of the Dodd-Frank Act added virtually
identical business conduct standards provisions in Section 15F(h) of
the Securities Exchange Act of 1934 (``Exchange Act'').\22\ Section
15F(h) \23\ of the Exchange Act provides the SEC with rulemaking
authority to impose business conduct standards on security-based swap
dealers (``SBS Dealers'') and major security-based swap participants
(``Major SBS Participants'' and collectively ``SBS Entities'') in their
dealings with counterparties, including Special Entities. Furthermore,
Section 712(a)(1) of the Dodd-Frank Act requires that the Commission
and SEC consult with one another in promulgating certain rules
including business conduct standards.\24\
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\22\ 15 U.S.C. 78a et seq. All references to the Exchange Act
are to the Exchange Act as amended by the Dodd-Frank Act.
\23\ 15 U.S.C. 78o-10(h).
\24\ Section 712(a)(1) of the Dodd-Frank Act requires that the
Commission consult with the SEC and prudential regulators in
promulgating rules pursuant to Section 4s(h).
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On July 18, 2011, the SEC published in the Federal Register
proposed rules for Business Conduct Standards for SBS Entities (``SEC's
proposed rules'').\25\ The comment period for the SEC's proposed rules
closed on August 29, 2011. Following publication of the SEC's proposed
rules, commenters requested that the Commission work with the SEC to
harmonize the rules for swap dealers, major swap participants, and SBS
Entities.\26\
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\25\ SEC proposed rules, Business Conduct Standards for
Security-Based Swap Dealers & Major Security-Based Swap
Participants, 76 FR 42396, Jul. 18, 2011.
\26\ See, e.g., FIA/ISDA/SIFMA Sept. 14 Letter, at passim; CFA/
AFR Aug. 29 Letter, at passim.
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Commission staff worked closely with SEC staff in the development
of the Commission's proposed rules,\27\ the SEC's proposed rules, and
these final rules. Additionally, the Commission and SEC staffs held
thirteen joint external consultations on business conduct standards
with interested parties following the publication of the SEC's proposed
rules.\28\ The Commission's objective was to establish consistent
requirements for CFTC and SEC registrants to the extent practicable
given the differences in existing regulatory regimes and approaches. At
this time, the SEC's business conduct standards rules for SBS Entities
remain at the proposal stage; however, the Commission believes it has
appropriately harmonized its final rules with the SEC's proposed rules,
to the extent practicable, and will continue to work with the SEC as it
approaches finalization of the SEC's proposed rules.
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\27\ See proposing release, 75 FR at 80640 (Commission staff and
SEC staff jointly held numerous external consultations with
stakeholders prior to publication of the proposed rules in the
Federal Register).
\28\ A list of Commission staff consultations in connection with
this final rulemaking is posted on the Commission's Web site,
available at http://www.cftc.gov/.
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B. Department of Labor ERISA Fiduciary Regulations
Special Entities defined in Section 4s(h)(2)(C) of the CEA include
``any employee benefit plan, as defined in Section 3'' \29\ of the
Employee Retirement Income Security Act of 1974 (``ERISA''). DOL is the
federal agency responsible for administering and enforcing Title I of
ERISA.\30\
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\29\ 29 U.S.C. 1002.
\30\ 29 U.S.C. 1001 et seq.; History of EBSA and ERISA,
available at http://www.dol.gov/ebsa/aboutebsa/history.html.
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[[Page 9737]]
On October 22, 2010, DOL published in the Federal Register proposed
revisions (``DOL's proposed fiduciary rule'') to the regulatory
definition of ``fiduciary'' under Section 3(21)(A)(ii) of ERISA.\31\
Section 3(21)(A)(ii) states that a person is a fiduciary (``ERISA
fiduciary'') to an employee benefit plan subject to Title I of ERISA
(``ERISA plan'') ``to the extent it renders investment advice for a fee
or other compensation, direct or indirect, with respect to any moneys
or other property of such plan, or has any authority or responsibility
to do so.'' \32\ In 1975, DOL issued a regulation that defines the
circumstances under which a person renders ``investment advice'' to a
plan within the meaning of Section 3(21)(A)(ii).\33\ The regulation
established a 5-part test that must be satisfied for a person to be
treated as an ERISA fiduciary by reason of rendering investment
advice.\34\ DOL's proposed fiduciary rule would have revised the 5-part
test and created a counterparty exception or ``limitation'' for a
person acting in its capacity as a purchaser or seller.\35\
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\31\ Definition of the Term ``Fiduciary,'' 75 FR 65263, Oct. 22,
2010 (``DOL's proposed fiduciary rule'').
\32\ 29 U.S.C. 1002(21)(A)(ii).
\33\ 29 CFR 2510.3-21(c); see also DOL's proposed fiduciary
rule, 75 FR at 65264.
\34\ See id., at 65264. The 5-part test states in relevant part:
For advice to constitute ``investment advice,'' an adviser * * *
must--(1) Render advice as to the value of securities or other
property, or make recommendations as to the advisability of
investing in, purchasing or selling securities or other property (2)
On a regular basis (3) Pursuant to a mutual agreement, arrangement
or understanding, with the plan or a plan fiduciary, that (4) The
advice will serve as a primary basis for investment decisions with
respect to plan assets, and that (5) The advice will be
individualized based on the particular needs of the plan.
\35\ DOL's proposed fiduciary rule provided that, unless the
person has expressly represented that it is acting as a fiduciary,
it will not be treated as one if it:
[C]an demonstrate that the recipient of the advice knows or,
under the circumstances, reasonably should know, that the person is
providing the advice or making the recommendation in its capacity as
a purchaser or seller of a security or other property, or as an
agent of, or appraiser for, such a purchaser or seller, whose
interests are adverse to the interests of the plan or its
participants or beneficiaries, and that the person is not
undertaking to provide impartial investment advice.
DOL's proposed fiduciary rule, 29 CFR 2310.3-21(c)(2), 75 FR at
65277.
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The Commission received numerous comments concerning the
intersection between ERISA, DOL's proposed fiduciary rule, and existing
fiduciary regulation with the business conduct standards under the CEA
and the Commission's proposed rules.\36\ Many commenters, including
ERISA plan sponsors, swap dealers and institutional asset managers,
stated that although many ERISA plans currently use swaps as part of
their overall hedging or investment strategy, the statutory and
regulatory intersections of ERISA and the CEA could prevent ERISA plans
from participating in swap markets in the future.\37\
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\36\ See, e.g., ERIC Feb. 22 Letter, at passim; SIFMA/ISDA Feb.
17 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 8; ABC/CIEBA Feb. 22
Letter, at 2-3.
\37\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 2-3; SIFMA/ISDA
Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 8.
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Commenters were primarily concerned that compliance with the
business conduct standards under the CEA or the Commission's proposed
rules would cause a swap dealer or major swap participant to be an
ERISA fiduciary to an ERISA plan and subject to ERISA's prohibited
transaction provisions.\38\ Thus, if a swap dealer or major swap
participant were to become an ERISA fiduciary to an ERISA plan, it
would be prohibited from entering into a swap with that ERISA plan
absent an exemption.\39\ Commenters stated that the penalties for
violating ERISA's prohibited transaction provisions are significant and
would discourage swap dealers or major swap participants from dealing
with ERISA plans.\40\
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\38\ Section 406(b) of ERISA (29 U.S.C. 1106(b)) states that an
ERISA fiduciary with respect to an ERISA plan shall not--(1) deal
with the assets of the plan in his own interest or for his own
account, (2) in his individual or in any other capacity act in any
transaction involving the plan on behalf of a party (or represent a
party) whose interests are adverse to the interests of the plan or
the interests of its participants or beneficiaries, or (3) receive
any consideration for his own personal account from any party
dealing with such plan in connection with a transaction involving
the assets of the plan.
\39\ In addition to other statutory exemptions, Section 408(a)
of ERISA (29 U.S.C. 1108(a)) gives DOL authority to grant
administrative exemptions from prohibited transactions prescribed in
Section 406 of ERISA.
\40\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 8 (``This
substantial penalty would serve as a serious disincentive for swap
dealers and [major swap participants] from engaging in swap
transactions with Special Entities subject to ERISA.''); SIFMA/ISDA
Feb. 17 Letter, at 5-6 (``there is a serious risk that [swap
dealers] will refuse to engage in swap transactions with an ERISA
plan to avoid the risks of costly ERISA violations'').
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Prior to proposing the business conduct standards rules, the
Commission received submissions from stakeholders concerning the
interaction with ERISA, DOL's proposed fiduciary rule and current
regulation regarding the definition of ERISA fiduciaries.\41\ Thus,
Commission and DOL staffs consulted on issues regarding Special Entity
definitions that reference ERISA and the intersection of ERISA
fiduciary status with the Dodd-Frank Act business conduct
provisions.\42\
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\41\ See, e.g., SIFMA/ISDA Oct. 22, 2010 Letter, at 8 fn. 19 (A
swap dealer ``should not be an advisor in circumstances where it is
not a fiduciary under [DOL's proposed] standard.'').
\42\ Proposing release, 75 FR at 80640 and 80650 fn. 101.
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Informed by discussions between the Commission and DOL staffs, the
Commission published its proposed business conduct standards rules.
Many commenters, however, expressed ongoing concern that the proposed
business conduct standards rules, if adopted in final form without
clarification, could have unintended consequences for swap dealers and
major swap participants dealing with ERISA plans. Commenters remained
concerned that compliance with the business conduct standards could
cause a swap dealer or major swap participant to be an ERISA fiduciary
to an ERISA plan, which would trigger the prohibited transaction
provisions of ERISA.\43\ Specifically, commenters expressed concerns
that the business conduct standards could: (1) Cause a swap dealer or
major swap participant to become an ERISA fiduciary under current law;
\44\ (2) require a swap dealer or major swap participant to cause a
third-party advisor to fail to meet DOL's Qualified Professional Asset
Manager (``QPAM'') prohibited transaction class exemption; \45\ (3)
require a swap dealer or major swap participant to perform certain
activities that could make it an ERISA fiduciary under DOL's proposed
fiduciary rule, such as calculating and providing a daily mark that is
the mid-market value of a swap or providing a scenario analysis of a
swap; \46\ (4) require a swap dealer or major swap participant to
engage in advisor-like activities such as those required under proposed
Sec. 23.401(c)--Know your counterparty, proposed Sec. 23.434--
Institutional suitability, or proposed Sec. 23.440--Swap dealers
acting as advisors to Special Entities; \47\ or (5) cause a swap dealer
to fail to satisfy the counterparty exception or ``limitation''
[[Page 9738]]
provision in DOL's proposed fiduciary rule.\48\
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\43\ See, e.g., ABC/CIEBA Feb. 22 Letter, at passim; ERIC Feb.
22 Letter, at passim.
\44\ SIFMA/ISDA Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter,
at 8; ABC/CIEBA Feb. 22 Letter, at 2-3.
\45\ SIFMA/ISDA Feb. 17 Letter, at 5 fn. 13; AMG-SIFMA Feb. 22
Letter, at 6; ERIC Feb. 22 Letter, at 14; see also DOL Amendment to
Prohibited Transaction Exemption (PTE) 84-14 for Plan Asset
Transactions Determined by Independent Qualified Professional Asset
Managers, 75 FR 38837, Jul. 6, 2010 (``DOL QPAM PTE 84-14'').
\46\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 5-6; SIFMA/ISDA
Feb. 17 Letter, at 32.
\47\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 5 fn. 13; AMG-
SIFMA Feb. 22 Letter, at 6; ERIC Feb. 22 Letter, at 14.
\48\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 5-6, 19-21, 23-24,
and 39; ABC/CIEBA Feb. 22 Letter, at passim; ERIC Feb. 22 Letter, at
passim.
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Many commenters also requested that the Commission and DOL publicly
coordinate the respective proposed rules to avoid swap dealers and
major swap participants being deemed ERISA fiduciaries.\49\ On April
28, 2011, DOL submitted a letter to the Chairman of the CFTC regarding
its views on DOL's proposed fiduciary rule and potential intersections
with the business conduct standards statutory provisions and the
Commission's proposed rules.\50\ The letter stated that DOL's proposed
fiduciary rule ``is not broadly intended to impose ERISA fiduciary
obligations on persons who are merely counterparties to plans in arm's
length commercial transactions * * * [and] is not intended to upend
these expectations by imposing ERISA fiduciary norms on parties who are
on the opposite side of plans in such arm's length deals.'' \51\ The
letter concludes, ``[in DOL's] view, with careful attention to fairly
straightforward drafting issues, we can ensure that the DOL regulation
and the CFTC business conduct standards are appropriately harmonized.''
\52\ Subsequently, the Commission received additional comments stating
that, although supportive of DOL's statement of intent and analysis of
DOL's proposed fiduciary rule, the letter did not resolve all of their
concerns and was non-binding.\53\
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\49\ AFSCME Feb. 22 Letter, at 4; BlackRock Feb. 22 Letter, at 2
and 5; AMG-SIFMA Feb. 22 Letter, at 9; ERIC Feb. 22 Letter, at 2 and
4; Sen. Kerry May 18 Letter, at 1; Sen. Harkin May 3 Letter, at 1-2;
Rep. Bachus Mar. 15 Letter, at 2; Rep. Smith July 25 Letter, at 1-2;
Sen. Johnson Oct. 4 Letter, at 2.
\50\ DOL Apr. 28 Letter.
\51\ DOL Apr. 28 Letter, at 1.
\52\ DOL Apr. 28 Letter, at 3.
\53\ See, e.g., ABC/CIEBA June 3 Letter, at 3.
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On September 19, 2011, DOL announced that it would re-propose its
rule on the definition of fiduciary and expected the new proposed rule
to be issued in early 2012.\54\ DOL also stated that it ``will continue
to coordinate closely with the * * * Commission to ensure that this
effort is harmonized with other ongoing rulemakings.'' \55\ The
Commission has continued to coordinate with DOL to ensure that the
final business conduct standards rules are appropriately harmonized
with ERISA and DOL regulations.\56\ DOL has reviewed the Commission's
final business conduct standards rules for swap dealers and major swap
participants and provided the Commission with the following statement:
---------------------------------------------------------------------------
\54\ Office of Public Affairs News Release, U.S. Dept. of Labor,
U.S. Labor Department's EBSA to re-propose rule on definition of a
fiduciary (Sept. 19, 2011).
\55\ Id.
\56\ Final Sec. 23.440--Requirements for swap dealers acting as
advisors to Special Entities and Sec. 23.450--Requirements for swap
dealers and major swap participants acting as counterparties to
Special Entities address the issues raised by commenters. See
Sections IV.B. and IV.C. of this adopting release for a discussion
of final Sec. Sec. 23.440 and 23.450.
The Department of Labor has reviewed these final business
conduct standards and concluded that they do not require swap
dealers or major swap participants to engage in activities that
would make them fiduciaries under the Department of Labor's current
five-part test defining fiduciary advice 29 CFR Sec. 2510.3-21(c).
In the Department's view, the CFTC's final business conduct
standards neither conflict with the Department's existing
regulations, nor compel swap dealers or major swap participants to
engage in fiduciary conduct. Moreover, the Department states that it
is fully committed to ensuring that any changes to the current ERISA
fiduciary advice regulation are carefully harmonized with the final
business conduct standards, as adopted by the CFTC and the SEC, so
that there are no unintended consequences for swap dealers and major
swap participants who comply with these business conduct
standards.\57\
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\57\ A copy of the statement is included as Appendix 2 of this
adopting release.
After considering the comments and DOL's statement, the Commission
has determined that the final business conduct standards are
appropriately harmonized with ERISA and DOL regulations. The Commission
understands from DOL that compliance with the business conduct
standards statutory provisions and Commission rules will not, by
itself, cause a swap dealer or major swap participant to be an ERISA
fiduciary to an ERISA plan. Furthermore, DOL stated its intention to
continue to coordinate and appropriately harmonize with Commission
rules when it re-proposes its rule on the definition of fiduciary.
Thus, the Commission has determined that issues and concerns raised by
commenters regarding ERISA requirements have been addressed
appropriately.
C. Securities and Exchange Commission Municipal Advisor Registration
The amendments to the CEA in Section 731 of the Dodd-Frank Act also
direct the Commission to adopt business conduct standards rules for
swap dealers and major swap participants dealing with Special Entities,
which include ``a State, State agency, city, county, municipality, or
other political subdivision of a State'' (``State and municipal Special
Entities'').\58\ In addition, Section 975 of the Dodd-Frank Act amended
Section 15B of the Exchange Act to provide for new regulatory oversight
of ``municipal advisors,'' \59\ that provide advice to a ``municipal
entity'' \60\ with respect to, among other things, municipal financial
products, which include municipal derivatives. Municipal advisors are
required to register with the SEC \61\ and are subject to the rules of
the Municipal Securities Rulemaking Board (``MSRB''), a self-regulatory
organization (``SRO'').\62\ On January 6, 2011, the SEC published in
the Federal Register proposed rules for the Registration of Municipal
Advisors (``SEC Proposed MA Rules'').\63\
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\58\ Section 4s(h)(2)(C)(ii) of the CEA (7 U.S.C.
6s(h)(2)(C)(ii)).
\59\ The definition of ``municipal advisor'' means a person (who
is not a municipal entity or an employee of a municipal entity) (i)
that provides advice to or on behalf of a municipal entity with
respect to municipal financial products (including municipal
derivatives) or the issuance of municipal securities, including
advice with respect to the structure, timing, terms, and other
similar matters concerning such financial products or issues, or
(ii) that undertakes a solicitation of a municipal entity. The
definition includes financial advisors, third-party marketers, and
swap advisors that engage in municipal advisory activities. 15
U.S.C. 78o-4(e)(4).
\60\ Section 975 of the Dodd-Frank Act amended Section 15B(e)(8)
of the Exchange Act to define the term ``municipal entity'' as any
State, political subdivision of a State, or municipal corporate
instrumentality of a State, including (A) any agency, authority, or
municipal corporate instrumentality; (B) any plan, program, or pool
of assets sponsored or established by the State, political
subdivision, or municipal corporate instrumentality or any agency,
authority, or instrumentality thereof, and (C) any other issuer of
municipal securities. 15 U.S.C. 78o-4(e)(8).
\61\ 15 U.S.C. 78o-4(a)(1).
\62\ 15 U.S.C. 78o-4(b)(2).
\63\ SEC Proposed Registration of Municipal Advisors, 76 FR 824,
Jan. 6, 2011 (``SEC Proposed MA Rules'').
---------------------------------------------------------------------------
The intersection of the business conduct standards provisions under
Section 731 of the Dodd-Frank Act and the municipal advisor provisions
under Section 975 raises two important issues. The first issue concerns
the regulatory intersection of requirements for SEC-registered
municipal advisors and Commission-registered commodity trading advisors
(``CTA'') that may serve as qualified independent representatives to a
Special Entity under Section 4s(h)(5) and proposed Sec. 23.450.
Section 4s(h)(5) of the CEA mandates the Commission to establish a duty
for swap dealers or major swap participants that offer to or enter into
a swap with a Special Entity to have a reasonable basis to believe that
the Special Entity has a qualified independent representative.\64\
Thus, an independent representative
[[Page 9739]]
under Section 4s(h)(5) that advises State and municipal Special
Entities will be subject to registration with the Commission as a
CTA,\65\ except for those independent representatives who are employees
of such entity or otherwise excluded or exempt under the CEA or
Commission rules. Similarly, municipal advisors include financial
advisors and swap advisors that engage in municipal advisory
activities, including providing advice with respect to municipal
derivatives, with municipal entities, which include all State and
municipal Special Entities. Additionally, registered CTAs ``who are
providing advice related to swaps'' are expressly excluded from the
definition of ``municipal advisor.'' \66\ Accordingly, a registered CTA
would be subject to the Commission's regulatory requirements, but not
those of the SEC or MSRB, even if such CTA registration were required
solely for swap advice provided to a municipal entity.\67\ Given these
intersections, commenters requested that the Commission coordinate with
the SEC to appropriately harmonize the regulatory regime for
Commission-registered CTAs that advise municipalities with the
regulatory regime for SEC-registered municipal advisors.\68\
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\64\ Section 4s(h)(5) of the CEA (7 U.S.C. 6s(h)(5)).
\65\ Section 1a(12) of the CEA (7 U.S.C. 1a(12)) defines
``commodity trading advisor'' to be any person who for compensation
or profit, engages in the business of advising others, either
directly or through publications, writings, or electronic media, as
to the value of or the advisability of trading in any swap, among
other CEA jurisdictional products.
\66\ The exclusion includes ``any commodity trading advisor
registered under the Commodity Exchange Act or persons associated
with a commodity trading advisor who are providing advice related to
swaps.'' 15 U.S.C. 78o-4(e)(4)(C).
\67\ To the extent that a registered CTA engages in any
municipal advisory activities other than advice related to swaps,
registration may still be required with the SEC. See SEC Proposed MA
Rules, 76 FR at 833; see also proposed rule 17 CFR 15Ba1-
1(d)(2)(iii), 76 FR at 882.
\68\ See, e.g., SFG Feb. 22 Letter, at 2 (``[t]here is a need
for a single, harmonized regulatory scheme for credentialing and
registering swap advisors''); GFOA Feb. 22 Letter, at 2.
---------------------------------------------------------------------------
A second issue raised by commenters concerns whether compliance
with the proposed business conduct standards rules would cause a swap
dealer or major swap participant dealing with a State or municipal
Special Entity to be deemed to be a municipal advisor.\69\ For example,
some commenters asked whether a swap dealer that complies with Section
4s(h)(4)(B) and proposed Sec. 23.440, which requires a swap dealer
that ``acts as an advisor to a Special Entity'' to ``act in the best
interests'' of the Special Entity, would trigger the municipal advisor
definition. These commenters opposed such an outcome and requested that
the Commission and SEC coordinate and harmonize the proposed rules.\70\
---------------------------------------------------------------------------
\69\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 6, 19-21, 24, and
34-35; BDA Feb. 22 Letter, at 2.
\70\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 24 and 34 (the
Commission and SEC should adopt a unified standard for recognizing
when ``advice'' is being given).
---------------------------------------------------------------------------
After considering the comments, the Commission has taken steps to
ensure that the business conduct standards provisions are appropriately
harmonized with the SEC and MSRB regulatory regime for municipal
advisors. Commission staff has engaged in several consultations with
the staffs of the SEC, MSRB, and the National Futures Association
(``NFA'') regarding the regulatory regimes for municipal advisors and
CTAs that provide advice to municipal entities with respect to swaps.
The Commission is considering several options with respect to CTAs and
municipal advisors, including proposing a CTA registration exemption
for CTAs that are registered municipal advisors whose CTA activity is
limited to swap advice to municipal entities. The Commission is also
considering developing rules for CTAs that would be comparable to those
adopted by the SEC and MSRB for municipal advisors. Such rules could be
adopted by the Commission or, for CTAs that are members of NFA, by NFA.
Commission staff continues to consult with SEC staff regarding
municipal advisor registration requirements to address the treatment of
swap dealers and major swap participants that comply with the
Commission's business conducts standards rules. At this time, the rules
for the registration of municipal advisors remain at the proposal
stage. Therefore, the Commission believes it has appropriately
harmonized these final rules and will continue to work with the SEC as
it approaches finalization of the SEC's Proposed MA Rules.
D. Commodity Trading Advisor Status for Swap Dealers
The Commission noted in its proposed rules that swap dealers would
likely be acting as CTAs when they make recommendations to their
counterparties, and particularly recommendations that are tailored to
the needs of their counterparty.\71\ Classification as a CTA under the
CEA subjects a person to various statutory and regulatory requirements
including, among others, the anti-fraud provisions of Section 4o of the
CEA and registration with the Commission.\72\ In addition, a CTA,
depending on the nature of the relationship, may also owe fiduciary
duties to its clients under applicable case law.\73\
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\71\ Proposing release, 75 FR at 80647-48.
\72\ 7 U.S.C. 6m and 6o.
\73\ See Commodity Trend Serv., Inc. v. CFTC, 233 F.3d 981, 990
(7th Cir. 2000).
---------------------------------------------------------------------------
Commenters expressed concerns about the implications of swap
dealers being treated as CTAs and urged the Commission to make clear
that a swap dealer would not be a CTA solely by virtue of providing
swap ``recommendations'' to counterparties. One of these commenters
noted that a swap dealer operates in a principal-to-principal market
and plays a different role than that of a typical CTA that provides
advice to ``retail'' clients.\74\ This commenter contended that a swap
dealer should not be required to register as a CTA in addition to
registering in its capacity as a swap dealer. A second commenter stated
that by using the term ``advisor'' rather than ``commodity trading
advisor'' in the relevant provisions of Section 4s(h)(4), Congress
likely regarded the provisions of the CEA regulating CTAs as unrelated
to those adopted under Section 4s(h)(4).\75\ This commenter requested
that the Commission specifically state that no requirement or
combination of requirements under the proposed rules would cause a swap
dealer, including a swap dealer that makes a recommendation to a
Special Entity, to be treated as a CTA.\76\
---------------------------------------------------------------------------
\74\ CEF Feb. 22 Letter, at 17.
\75\ SIFMA/ISDA Feb. 17 Letter, at 32 fn. 75.
\76\ Id., at 34.
---------------------------------------------------------------------------
A ``commodity trading advisor'' includes any person who, for
compensation or profit, engages in the business of advising others,
either directly or through publications, writings, or electronic media,
as to the value of or the advisability of trading in any swap.\77\ The
CEA, however, excludes from the CTA definition banks, floor brokers,
and futures commission merchants (``FCMs''), among others, whose advice
is ``solely incidental to the conduct of their business or
profession.'' Section 1a(12)(B)(vii) of the CEA also grants the
Commission authority to exclude ``such other persons not within the
intent of [the CTA definition] as the Commission may specify * * *'';
however, such exclusion is limited to advice that is ``solely
incidental to the conduct of their business or profession.'' The
Commission has determined to provide a similar exclusion for swap
dealers whose advice is solely incidental to their business as swap
dealers. In determining that a swap dealer's recommendations to a
counterparty regarding proposed swap
[[Page 9740]]
transactions or trading strategies should be considered ``solely
incidental'' to the conduct of its business, the Commission considered
the definition of ``swap dealer.'' Section 1a(49) of the CEA defines
the term ``swap dealer'' as a person who (1) holds itself out as a
dealer in swaps; (2) makes a market in swaps; (3) regularly enters into
swaps with counterparties as an ordinary course of business for its own
account; or (4) engages in any activity causing the person to be
commonly known in the trade as a dealer or market maker in swaps.\78\
---------------------------------------------------------------------------
\77\ Section 1a(12) of the CEA (7 U.S.C. 1a(12)).
\78\ Section 1a(49) of the CEA (7 U.S.C. 1a(49)).
---------------------------------------------------------------------------
Based on the types of activities that define a swap dealer's
business, commenters' views and the statutory scheme under Section
4s(h), the Commission has determined that making swap related
recommendations to counterparties is most appropriately considered
``solely incidental'' to the conduct of a swap dealer's business as a
dealer or market maker in swaps, including customized swaps, and is not
CTA business. Specifically, the Commission has determined that, when
making recommendations to a counterparty with respect to an otherwise
arm's length principal-to-principal swap transaction with a
counterparty a swap dealer will be acting solely incidental to its
business as a swap dealer as defined in the CEA and Commission rules.
Thus, the Commission has determined to exercise its authority under
Section 1a(12)(B)(vii) to add a new exclusion from the CTA definition
applicable to swap dealers, including swap dealers that may be excluded
or exempt from registration under the CEA or Commission rules, in
existing Sec. 4.6. Under new Sec. 4.6(a)(3) a swap dealer is excluded
from the definition of the term ``commodity trading advisor'' provided
that its ``advisory activities'' are solely incidental to its business
as a swap dealer.\79\ ``Swap dealer'' is defined for purposes of the
rule by reference to the definitions in Section 1a(49) of the CEA and
Sec. 1.3, and would include ``associated persons'' \80\ acting on
behalf of a swap dealer.
---------------------------------------------------------------------------
\79\ While swap dealers that make recommendations will be
excluded from the CTA definition, they must comply with other
applicable provisions (i.e., Sec. 23.434-Suitability and Sec.
23.440-Requirements for swap dealers acting as advisors to Special
Entities).
\80\ ``Associated person of a swap dealer or major swap
participant'' is a defined term in Section 1a(4) of the CEA (7
U.S.C. 1a(4)).
---------------------------------------------------------------------------
With respect to the scope of the ``solely incidental'' exclusion
for swap dealers, the Commission is generally of the view that making
recommendations to a counterparty would not cause a swap dealer to be a
CTA.\81\ The exclusion would cover customizing a swap for a
counterparty in response to a counterparty's expressed interest or on
the swap dealer's own initiative.\82\ Also, preparing a term sheet for
purposes of outlining proposed terms of a swap for negotiation or
otherwise would be an activity solely incidental to a swap dealer's
business.
---------------------------------------------------------------------------
\81\ See Section III.G. of this adopting release for a
discussion of the term ``recommendation'' in connection with the
institutional suitability rule in Sec. 23.434.
\82\ The ``solely incidental'' exclusion also would encompass
providing information to a counterparty that is general transaction,
financial, or market information, or swap terms in response to a
request for quote.
---------------------------------------------------------------------------
There are advisory activities that the Commission would consider to
be beyond the scope of the ``solely incidental'' exclusion, and
depending on the facts and circumstances could cause a swap dealer to
be a CTA within the statutory definition. For example, a swap dealer
that has general discretion to trade the account of, or otherwise act
for or on behalf of, a counterparty would be engaging in activity that
is not solely incidental to the business of a swap dealer. Limited
discretion related to the execution of a particular counterparty order,
however, would not cause a swap dealer to be a CTA. Also, the exclusion
would not apply if a swap dealer received separate compensation for, or
otherwise profited primarily from, advice provided to a counterparty.
Furthermore, a swap dealer that enters into an agreement with its
counterparty to provide advisory services or a swap dealer that
otherwise holds itself out to the public as a CTA would also not be
within the ``solely incidental'' exclusion. These examples are not
exhaustive. There may be other circumstances in which a swap dealer's
activity would fall outside the available exclusion. A determination of
whether activity is ``solely incidental'' would necessarily need to be
viewed in context based on the particular facts and circumstances.
III. Final Rules for Swap Dealers and Major Swap Participants Dealing
With Counterparties Generally
The final business conduct standards rules dealing with
counterparty relationships are contained in subpart H of new part 23 of
the Commission's Regulations.\83\ This section of the adopting release
discusses the following rules that apply to swap dealers' and, unless
otherwise indicated, major swap participants' dealings with
counterparties generally: Sec. 23.400--Scope; Sec. 23.401--
Definitions; Sec. 23.402--General provisions; Sec. 23.410--
Prohibition on fraud, manipulation and other abusive practices; Sec.
23.430--Verification of counterparty eligibility; Sec. 23.431--
Disclosures of material information; Sec. 23.432--Clearing
disclosures; Sec. 23.433--Communications-fair dealing; and Sec.
23.434--Recommendations to counterparties-institutional suitability. A
section-by-section description of the final rules follows.
---------------------------------------------------------------------------
\83\ The ``solely incidental'' CTA exclusion for swap dealers is
promulgated in part 4 of the Commission's Regulations.
---------------------------------------------------------------------------
A. Sections 23.400, 23.401 and 23.402--Scope, Definitions and General
Provisions
1. Section 23.400--Scope
a. Proposed Sec. 23.400--Scope
Proposed Sec. 23.400 set forth the scope of subpart H of new part
23 of the Commission's Regulations, which stated that the rules
contained in subpart H were not intended to limit or restrict the
applicability of other provisions of the CEA, Commission rules and
regulations, or any other applicable laws, rules and regulations.\84\
Moreover, the proposed rule provided that subpart H would apply to swap
dealers and major swap participants in connection with swap
transactions, including swaps that are offered but not entered
into.\85\ Some of the proposed rules required compliance prior to
entering into a swap, while others, such as the requirement to provide
a daily mark, were to be in effect during the entire life of a swap.
---------------------------------------------------------------------------
\84\ Proposing release, 75 FR at 80640.
\85\ In the proposing release, the Commission commented that the
external business conduct standards rules would be most applicable
when swap dealers and major swap participants have a pre-trade
relationship with their counterparty. Proposing release, 75 FR at
80641. The Commission noted that for swaps initiated on a designated
contract market (``DCM'') or swap execution facility (``SEF'') where
the swap dealer or major swap participant does not know the
counterparty's identity prior to execution, the disclosure and due
diligence obligations would not apply. See Section III.D.3. and fn.
338 of this adopting release for a discussion of final Sec. 23.431-
Disclosures of material information, which address the disclosure
duties of swap dealers and major swap participants pursuant to
Section 4s(h)(3)(B) with respect to bilateral swaps and swaps
executed on a DCM or SEF.
---------------------------------------------------------------------------
b. Comments and Final Sec. 23.400--Scope
The Commission received numerous comments regarding issues that
relate to the general scope of the proposed business conduct standards,
though not necessarily concerning the text of the proposed ``scope''
rule. One commenter requested that the Commission clarify that the
business conduct standards rules would not apply to unexpired swaps
executed prior to the effective
[[Page 9741]]
date of the final rules.\86\ Another commenter asked the Commission to
clarify that certain business conduct standards rules impose duties for
swap dealers and major swap participants that continue after the
execution of a swap.\87\ The Commission confirms that the business
conduct standards will not apply to unexpired swaps executed before the
effective date of this adopting release and will apply in accordance
with the implementation schedule set forth in Section V.C. of this
adopting release; however, the Commission will consider a material
amendment to the terms of a swap to be a new swap and subject to
subpart H of part 23 of the Commission's Regulations. For swaps that
are subject to the business conduct standards rules, the Commission
clarifies that certain rules by their terms impose ongoing duties on
the swap dealer or major swap participant (e.g., Sec. 23.410(a)--
Prohibitions on fraud, Sec. 23.410(c)--Confidential treatment of
counterparty information, and Sec. 23.433--Communications--fair
dealing); however, other rules by their terms do not impose ongoing
duties on the swap dealer or major swap participant (e.g., Sec.
23.430--Verification of counterparty eligibility).\88\
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\86\ SIFMA/ISDA Feb. 17 Letter, at 8.
\87\ See CFA/AFR Aug. 29 Letter, at 11.
\88\ Although certain rules do not impose an ongoing duty on a
swap dealer or major swap participant with respect to the swap, a
swap dealer or major swap participant would still be required to
comply with the duty with respect to subsequent swaps offered or
entered into with a counterparty.
---------------------------------------------------------------------------
Another concern raised by commenters was the meaning of the word
``offer'' in the context of negotiating a swap transaction because
certain requirements are triggered when an offer occurs. Other
commenters expressed views on the Commission's decision to use the
authority granted by Congress to draft discretionary rules for swap
transactions instead of solely drafting rules that are explicitly
mandated by statute. There were comments suggesting that the
discretionary rules should be delegated to an SRO.\89\ Commenters also
suggested that the rules should not apply to certain sophisticated
counterparties or that counterparties be afforded the opportunity to
opt in or opt out of these rules.\90\ Some believed that swap dealers
and major swap participants should be subject to different
regulations.\91\ Others were concerned about the extraterritorial reach
of the Commission's Regulations.\92\ Some commentators were concerned
that violating the rules could be a basis for a private right of action
under the CEA.\93\ The Commission addresses these issues in the
discussion below.
---------------------------------------------------------------------------
\89\ See, e.g. SIFMA/ISDA Feb. 17 Letter, at 3 and 25-26.
\90\ See, e.g. SIFMA/ISDA Feb. 17 Letter, at 26; NACUBO Feb. 22
Letter, at 3-4; VRS Feb. 22 Letter, at 3-4; HOOPP Feb. 22 Letter, at
3; NFP Energy End Users, Ex Parte Communication, Jan. 19, 2011
(citing NFP Energy End Users Sept. 20, 2010 Letter, at 14-15).
\91\ See, e.g., AMG-SIFMA Jan. 18 Letter, at 2-3; MFA Feb. 22
Letter, at 1-4; CEF Feb. 22 Letter, at 5-6; BlackRock Apr. 12
Letter, at 1-5.
\92\ See, e.g., Societe Generale Feb. 18 Letter, at 8-13;
Barclays Jan. 11 Letter, at 5-7; Bank of Tokyo May 6 Letter, at 5-6;
Barclays Feb. 17 Letter, at passim.
\93\ See, e.g., VRS Feb. 22 Letter, at 3; ABC/CIEBA Feb. 22
Letter, at 9-10; SIFMA/ISDA Feb. 17 Letter, at 4, 5-6, 10, and 34-
35; FHLBanks June 3 Letter, at 6 and 8; AMG-SIFMA Feb. 22 Letter, at
4-5 and 7-8; CEF Feb. 22 Letter, at 3-4 and 9-10; Exelon Feb. 22
Letter, at 3.
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i. Meaning of ``Offer''
Certain of the business conduct standards duties under the rules
are triggered at the time an ``offer'' is made.\94\ Two commenters
suggested that the rules should be modified to clarify when an
``offer'' occurs.\95\ One of the commenters suggested that the
Commission should define ``offer'' to mean when sufficient terms are
offered that, if accepted, would create a binding agreement under
contract law.\96\ They believe that this is necessary because, unlike
in securities or futures, the terms of the product are not preset but
can be negotiated.
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\94\ See, e.g., final Sec. 23.430(a)--Verification of
counterparty eligibility (``before offering to enter into * * * a
swap with that counterparty''); final Sec. 23.450(b)(1)--
Requirements for swap dealers and major swap participants acting as
counterparties to Special Entities (``Any swap dealer or major swap
participant that offers to enter or enters into a swap with a
Special Entity * * *'').
\95\ See APPA/LPPC Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17
Letter, at 35-36.
\96\ See SIFMA/ISDA Feb. 17 Letter, at 35 fn. 84.
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The Commission confirms that the term ``offer,'' as used in the
business conduct standards rules in subpart H, has the same meaning as
in contract law, such that, if accepted, the terms of the offer would
form a binding contract.\97\ The Commission notes, however, that not
all of the rules are triggered when an offer is made. For example, the
suitability duty is triggered when a swap dealer makes a
``recommendation.'' \98\ The final fair dealing rule \99\ will apply to
all communications by a swap dealer or major swap participant in
connection with a swap, including communications made prior to an
offer. Other final rules (e.g., the anti-fraud and confidential
treatment rules) will be triggered as indicated by their terms. In
addition, the Commission expects that for practical purposes swap
dealers and major swap participants will comply with certain of their
business conduct standards duties through counterparty relationship
documentation negotiated with their counterparties well before an
``offer'' or a ``recommendation'' is made.\100\
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\97\ See, e.g., Restatement (Second) of Contracts Sec. 24
(1981) (``An offer is the manifestation of willingness to enter into
a bargain, so made as to justify another person in understanding
that his assent to that bargain is invited and will conclude it.'').
In addition, as stated in Sec. 23.400, nothing in these rules is
intended to limit or restrict the applicability of other applicable
laws, rules and regulations, including the federal securities laws.
\98\ See Section III.G. of this adopting release for a
discussion of Sec. 23.434--Recommendations to Counterparties--
Institutional Suitability.
\99\ See Section III.F.3. of this adopting release for a
discussion of final Sec. 23.433.
\100\ For example, the verification of counterparty eligibility,
know your counterparty and the verification of a Special Entity's
independent representative would be completed prior to any
recommendation or offer. Other forms of documentation may suffice
depending on the circumstances. For instance, if a counterparty
requests a quote from a swap dealer with which it does not have
relationship documentation, the counterparty could book the swap
through its prime broker with which the swap dealer may have pre-
negotiated documentation.
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Swap dealers and major swap participants will be permitted to
arrange with third parties, such as the counterparty's prime broker, a
method of providing disclosures or verifying that a Special Entity has
an independent representative to satisfy its obligations under the
rules. But the swap dealer or major swap participant will remain
responsible for compliance with the rules.
ii. Discretionary Rules
In the proposing release, the Commission noted that some of the
requirements and duties in the proposed rules were mandated by specific
provisions in the Dodd-Frank Act, while others were proposed under the
Commission's discretionary authority.\101\ Some commenters recommended
that the final rules be limited to what is mandated by statute until
the CFTC gains more familiarity with these markets as they
develop.\102\ Another commenter expressed a contrary view that Congress
intended the Commission to use its discretionary authority because, if
it did not, such authority would not have been granted.\103\ A
commenter suggested that the rules that are promulgated based on the
Commission's discretionary authority, such as suitability and scenario
analysis, should apply only to a subset of eligible contract
participants (``ECPs'') that require additional
[[Page 9742]]
protections.\104\ Another commenter suggested that if the Commission
does adopt the discretionary rules, it should implement any such
additional proposals as SRO rules and allow sophisticated
counterparties to opt out of the heightened protections that they may
not need or want.\105\
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\101\ See proposing release, 75 FR at 80639.
\102\ See BlackRock Feb. 22 Letter, at 1-2; Encana Feb. 22
Letter, at 2.
\103\ CFA/AFR Feb. 22 Letter, at 18.
\104\ CEF Feb. 22 Letter, at 4-5.
\105\ SIFMA/ISDA Feb. 17 Letter, at 3 and 25-26.
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One commenter stated that the Commission's approach in proposing
discretionary rules that used industry best practices was reasonable
because the proposals have already been endorsed by the industry as
workable and achievable.\106\ The commenter stated that the Commission
should go further, however, because the industry's standards of conduct
have been so poor that the industry's own suggestions may not go far
enough.
---------------------------------------------------------------------------
\106\ CFA/AFR Feb. 22 Letter, at 19.
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The Commission has determined to adopt the rules proposed under the
Commission's discretionary authority along with the mandatory rules,
albeit with the changes and for the reasons discussed in the applicable
sections of this adopting release that address each final rule. In
exercising that discretion, the Commission has acted consistently with
the intent of Congress as expressed in Section 4s(h)(3)(D) to establish
business conduct standards that the Commission determines are
appropriate in the public interest, for the protection of investors, or
otherwise in furtherance of the purposes of the CEA.\107\ Many of the
discretionary rules adopted by the Commission are based generally on
existing Commission and SRO rules for registrants and industry best
practices, and extending them to swap dealers and, where appropriate,
to major swap participants will promote regulatory consistency. As
such, the discretionary rules reflect existing business conduct
standards that are time-tested, appropriate for swap dealers and major
swap participants, and are well within the Commission's broad
discretionary rulemaking authority under Section 4s(h). As a result,
the final rules strike an appropriate balance between protecting the
public interest and providing a workable compliance framework for
market participants. With regard to the comments that suggest the
Commission should implement any discretionary rules as SRO rules, the
Commission declines to take such an approach. The Commission has relied
in the past on SROs to fulfill a number of important functions in the
derivatives market, and it will continue to do so in the future.
Moreover, the Commission will consider SRO guidance, where relevant and
appropriate, in interpreting the Commission's final rules that are
based on SRO rules.\108\ If, in the future, it becomes beneficial to
delegate certain functions regarding the business conduct standards to
SROs, the Commission will do so at that time. Delegating all
discretionary rules to the SROs now, however, is premature and not
consistent with the regulatory scheme that was mandated by
Congress.\109\
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\107\ See also Sections 4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6).
\108\ For further discussions of SRO guidance see Section
III.A.3.b. of this release at fn. 188 discussing final Sec.
23.402(b) (know your counterparty), Section III.F.3. of this release
at fn. 500 discussing final Sec. 23.433 (communications-fair
dealing), and Section III.G.3. of this release at fn. 542 discussing
final Sec. 23.434 (recommendations to counterparties--institutional
suitability).
\109\ The SEC has taken a consistent approach in its proposed
business conduct standards rules. For example, the SEC's ``know your
counterparty,'' suitability and fair communications rules are based
on similar requirements under the rules of the Financial Industry
Regulatory Authority (``FINRA''). See SEC's proposed rules, 76 FR at
42414 fn. 125, 42415 fn. 128, and 42418 fn. 151. See also FINRA Rule
2090 (know your customer), FINRA Rule 2111 (suitability), and NASD
Rule 2210 (communications with the public).
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iii. Different Rules for Swap Dealers and Major Swap Participants
Some commenters recommended that there be different business
conduct standards rules for swap dealers and major swap
participants.\110\ Another commenter stated that the rules concerning
``know your counterparty,'' treatment of confidential information,
trading ahead and front running, the requirement to provide a daily
mark, fair dealing, and the determination of counterparty suitability
should not apply to major swap participants.\111\ This commenter
believed that major swap participants, however, should receive the
benefits of those rules when acting as counterparties to swap dealers.
They argued that major swap participants, regardless of their size,
cannot be presumed to possess a level of market or product information
equal to that of swap dealers and are less likely than swap dealers to
be members of a swap execution facility (``SEF''), a designated
contract market (``DCM'') or a derivatives clearing organization
(``DCO''). The commenter believed that major swap participants are
unlikely to have systems and personnel comparable to that of a swap
dealer to allow them to model and value complex instruments.\112\ As a
result, they argued that major swap participants, when dealing with
swap dealers, should be able to: (1) Elect where to clear trades; (2)
receive risk disclosure, the required scenario analyses for complex
high-risk bilateral swaps, information about incentives or compensation
the dealer is getting, and any new product analysis that the swap
dealer does for its risk management purposes; and (3) receive the
protection from the suitability provision the same as any other
counterparty would receive.
---------------------------------------------------------------------------
\110\ See AMG-SIFMA Jan. 18 Letter, at 2-3; MFA Feb. 22 Letter,
at 1-4; CEF Feb. 22 Letter, at 5-6; BlackRock Apr. 12 Letter, at 1-
5; BlackRock June 3 Medero and Prager Letter, at 4-5.
\111\ MetLife Feb. 22 Letter, at 4-5, contra CFA/AFR Nov. 3
Letter, at 7.
\112\ MetLife Feb. 22 Letter, at 4-5.
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The statutory business conduct standards requirements, generally,
do not distinguish between swap dealers and major swap participants.
However, the Commission has considered the definitions of swap dealer
and major swap participant, which are based on the nature of their swap
related businesses, including marketing activities, and has determined,
where appropriate, not to apply certain discretionary rules to major
swap participants. The final rules for major swap participants do not
include the suitability duty, pay-to-play, ``know your counterparty''
and scenario analysis provisions. Removing these requirements
alleviates some of the regulatory burden on major swap participants
without materially impacting the protections for counterparties
envisioned by Congress. This is discussed further in the sections below
that address these relevant rules.
With respect to one commenter's request that major swap
participants be the beneficiaries of the business conduct standards
rules,\113\ Congress appears to have made a contrary determination as
indicated, for example, in Section 4s(h)(3), which explicitly relieves
swap dealers from the duty to provide disclosures to major swap
participants. Following this approach in the statute, the Commission
has determined not to require that swap dealers provide major swap
participants with the same protections afforded to other
counterparties. Nor is the Commission requiring swap dealers to allow
major swap participants to opt in to receive certain protections, such
as a daily mark, suitability or scenario analysis, that are afforded to
counterparties generally. That would impose a burden on swap dealers
that is not contemplated by the statutory scheme. Of course, major swap
participants are free to negotiate with swap dealers for such
protections on a contractual basis.
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\113\ Id.
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[[Page 9743]]
iv. Opt In or Opt Out for Certain Classes of Counterparties
Some commenters suggested that the Commission should (1) provide an
exemption from the external business conduct standards for swap dealers
when they transact with certain sophisticated investors, which might
include certain Special Entities, or (2) narrowly tailor the external
business conduct standards to make them elective for the
counterparty.\114\ These commenters suggested that the Commission
should set the threshold for parties that decide to opt out to include
``qualified institutional buyers'' as defined in Rule 144A \115\ under
the Securities Act of 1933 (``Securities Act'') \116\ and corporations
having assets under management of $100 million or more.
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\114\ See VRS Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter,
at 26; NACUBO Feb. 22 Letter, at 3-4.
\115\ 17 CFR 230.144A.
\116\ 15 U.S.C. 77a et seq. All references to the Securities Act
are to the Securities Act, as amended by the Dodd-Frank Act.
---------------------------------------------------------------------------
Another commenter suggested that the Special Entity provisions
should not be applicable to certain not-for-profit electricity and
natural gas providers because of their sophistication in dealing with
swaps concerning such commodities.\117\ One commenter believed that the
business conduct standards rules should not apply to sophisticated
Special Entities,\118\ and another commenter suggested that they should
not apply to non-ERISA pension plans.\119\ According to these
commenters, many of the protections in place for Special Entities will
slow down the process for entering into swaps and make it more
difficult for Special Entities to do business. Two other commenters
believed that the rules will increase the price of swaps without any
material benefit.\120\ One of them suggested that the Commission
instead should (1) provide an exemption from the external business
conduct standards rules for swap dealers when transacting with certain
sophisticated investors, which would include certain government plans
such as the commenter, or (2) narrowly tailor the rules to make them
elective for the counterparty.\121\
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\117\ See NFP Energy End Users, Ex Parte Communication, Jan. 19,
2011 (citing NFP Energy End Users Sept. 20, 2010 Letter, at 14-15).
\118\ VRS Feb. 22 Letter, at 3 (business conduct standards rules
should not apply to sophisticated Special Entities).
\119\ HOOPP Feb. 22 Letter, at 3 (business conduct standards
rules should not apply to sophisticated non-ERISA plans such as
HOOPP).
\120\ VRS Feb. 22 Letter, at 3-4; EEI June 3 Letter, at 6.
\121\ VRS Feb. 22 Letter, at 3-4.
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That is not the approach that Congress took in Section 4s(h) of the
CEA. With a few exceptions not relevant here, the statute does not
distinguish among counterparties or types of transactions.\122\
Nevertheless, as discussed below in connection with the relevant rules,
the Commission has determined to permit means of compliance with the
final rules that should promote efficiency and reduce costs and, where
appropriate, allow the parties to take into account the sophistication
of the counterparty.\123\ The final rules grant swap dealers and major
swap participants, with approval of their counterparties, discretion in
selecting a reliable, cost-effective means for providing required
information, including using Web sites with password protection.\124\
Additionally, the Commission adopted approaches for swap dealers and
major swap participants dealing with Special Entities to streamline the
process for complying with the Special Entity provisions without
undermining the intent of Congress in enacting those provisions.
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\122\ Section 4s(h) distinguishes among counterparties in the
Special Entity provisions (Sections 4s(h)(4) and (5)), and among
swaps transactions where the counterparty to the swap dealer or
major swap participant is a swap dealer, major swap participant, or
SBS Entity (Section 4s(h)(3)).
\123\ For example, swap dealers will be able to rely on
counterparty representations with respect to sophistication, among
other things, to tailor their compliance with the suitability rule--
Sec. 23.434. To promote efficiency and lower costs, the rules allow
swap dealers and major swap participants to incorporate, as
appropriate, material information covered by the disclosure
requirements in counterparty relationship documentation or other
standardized formats to avoid having to make repetitious disclosures
on a transaction-by-transaction basis.
\124\ Section 23.402(e)--Manner of disclosure. The Commission
notes, however, that the disclosure rules are principles based and
set standards for required disclosures. The standards apply to each
swap covered by the rules. Therefore, whether any particular
disclosure or format (e.g., custom tailored or standardized in
counterparty relationship documentation) meets the standard in
connection with any particular swap will depend on the facts and
circumstances. Swap dealers and major swap participants will be
responsible for complying with the disclosure standards for each
swap.
---------------------------------------------------------------------------
In addition, an opt in or opt out regime for counterparties could
create incentives for swap dealers and major swap participants that
would be inconsistent with congressional intent in enacting the
business conduct standards. Rather than raising standards, pressure
from swap dealers or major swap participants could discourage
counterparties from electing to receive such protections and could
effectively force counterparties to waive their rights or be shut out
of many swaps transactions.\125\ Moreover, the Commission generally
frowns on attempts to get customers to waive protections under its
rules.\126\ As a result, the Commission declines to adopt such an opt
in or opt out regime.
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\125\ One commenter suggested that the Commission should impose
a minimum comprehension requirement on counterparties. See Copping
Jan. 12 Submission. The Commission declines to do so as it is beyond
the scope of the business conduct standards rules, which govern swap
dealer and major swap participant behavior and not counterparties.
Moreover, Congress determined to limit swaps trading, except on a
DCM, to ECPs, implicitly finding ECPs to be qualified to engage in
such transactions. Nevertheless, the final rules follow the
statutory scheme, which establishes a robust disclosure regime and
Special Entity protections, among others. The Commission has
determined to use its discretionary rulemaking authority to provide
for suitability and scenario analysis, in particular. Taken
together, the final rules materially enhance the ability of
counterparties to assess the merits of entering into any particular
swap transaction and reduce information asymmetries between swap
dealers and major swap participants and their counterparties.
\126\ See, e.g., First American Discount Corp. v. CFTC, 222 F.
3d 1008, 1016-17 (D.C. Cir. 2000) (the Commission contended that
permitting introducing brokers to waive the required guarantee
agreement with its FCM would undermine the protections provided by
Commission Regulation Sec. 1.10(j) (17 CFR 1.10(j))).
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v. SEF Transactions
Some commenters stated that certain business conduct standards
rules should not apply to SEF transactions where the swap dealer or
major swap participant learns the identity of the counterparty only
immediately prior to the execution of the swap such as in a request for
quote (``RFQ'') system.\127\ Another commenter opined that Section
4s(h)(7) is intended to exclude certain transactions from all of the
requirements of the Commission's business conduct standards rules.\128\
The commenter stated that, because the Commission only mentions the
exemption with respect to verification of counterparty eligibility
\129\ and the requirements for swap dealers acting as counterparties to
Special Entities,\130\ the exclusion could be read as applying only to
those rules. The commenter believed that the proper reading of Section
4s(h)(7) requires that all transactions initiated by a Special
[[Page 9744]]
Entity on a SEF or DCM are excluded from the business conduct standards
rules, not merely those that are initiated by a Special Entity where
the identity of the counterparty is not known.\131\ The commenter
believed the two prongs are intended to be disjunctive and carve out
from the business conduct standards rules (1) any transaction a Special
Entity enters into on a SEF or DCM, or (2) all SEF or DCM transactions
where the swap dealer or major swap participant does not know the
identity of the counterparty.\132\
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\127\ See SIFMA/ISDA Feb. 17 Letter, at 7 (asserting that the
Commission should clarify that the following proposed exceptions
would be available to a swap dealer or major swap participant in an
RFQ system where the counterparty's identity is known only
immediately prior to the execution of the swap: Sec. 23.430(c)--
Verification of counterparty eligibility, Sec. 23.431(b)--
Disclosures of material information, Sec. 23.450(g)--Acting as
counterparties to Special Entities, and Sec. 23.451(b)(2)(iii)--
Pay-to-play prohibitions); State Street Feb. 22 Letter, at 2-3; SWIB
Feb. 22 Letter, at 2.
\128\ ABC/CIEBA June 3 Letter, at 6-7.
\129\ See proposed Sec. 23.430(c).
\130\ See proposed Sec. 23.450(g).
\131\ ABC/CIEBA June 3 Letter, at 6-7.
\132\ Id.
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Based on the statutory language, the Commission's view is that
Section 4s(h)(7) creates an exclusion that applies when two conditions
are met: (1) When a transaction is initiated by a Special Entity on a
DCM or SEF; and (2) the swap dealer or major swap participant does not
know the identity of the counterparty to the transaction. Consistent
with Section 4s(h)(7), the Commission has determined that certain of
the business conduct standards rules will apply only where the swap
dealer or major swap participant knows the identity of the counterparty
prior to execution. These are the provisions for ``know your
counterparty,'' true name and owner, verification of eligibility,
disclosures, suitability, and the Special Entity rules.\133\
---------------------------------------------------------------------------
\133\ Swap market participants should be aware that the
Commission's anti-evasion rule in Sec. 23.402(a) requires swap
dealers or major swap participants to have policies and procedures
to prevent them from evading or facilitating an evasion of any
provision of the Act or Commission Regulation. The Commission
expects such policies and procedures to preclude routing pre-
arranged trades through a SEF or DCM for the purpose of avoiding
compliance with the business conduct standards rules. For example,
where a swap dealer or major swap participant has a relationship
with a counterparty and has discussed a transaction prior to
``anonymous'' execution on a SEF, the Commission will consider
whether the transaction was structured to avoid compliance with the
business conduct standards rules in determining whether to bring an
action for failure to have or comply with written policies and
procedures to prevent evasion under Sec. 23.402(a).
---------------------------------------------------------------------------
For uncleared swaps executed on a SEF, swap dealers and major swap
participants have ongoing duties to counterparties the same as they
would in uncleared non-SEF transactions. For example, the duties to
provide a daily mark, engage in fair dealing, and maintain
confidentiality of counterparty information will continue to apply.
For swaps where the identity of the counterparty is known just
prior to execution on a SEF, the Commission has determined that the
business conduct standards rules, including the disclosure duties, will
apply. Section 4s(h)(7), which limits application of the Special Entity
provisions of the business conduct standards in anonymous DCM and SEF
transactions, informs the applicability of other business conduct
standards that are also anonymous DCM or SEF transactions. It would be
inconsistent with the statutory language and blur the line of when
disclosures are required, for example, to exempt swaps from the
business conduct standards duties where the identity of the
counterparty is known just prior to execution on a SEF. Under the final
rules, swap dealers and major swap participants will have to develop
mechanisms for making disclosures in connection with such transactions
on a SEF, which may include working with the SEF itself, to develop
functionality to facilitate disclosures.\134\
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\134\ Providing required disclosures under Sec. 23.431 through
such mechanisms will not be considered evasion under Sec.
23.402(a).
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vi. Extraterritoriality
A few commenters addressed the international reach of the proposed
rules. Some commenters stated that the business conduct standards rules
should apply only to swaps with a U.S. customer and a U.S. based
salesperson.\135\ For other swaps, the commenters stated the Commission
should defer to foreign regulators \136\ and exercise supervision
through memoranda of understanding.\137\ One commenter also recommended
a new registration category for foreign dealers.\138\
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\135\ See, e.g., Societe Generale Feb. 18 Letter, at 8-13;
Barclays Jan. 11 Letter, at 5; Bank of Tokyo May 6 Letter, at 5-6;
Barclays Feb. 17 Letter, at 8-9.
\136\ See Bank of Tokyo May 6 Letter, at 6.
\137\ See Societe Generale Feb. 18 Letter, at 8.
\138\ Id.
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The Commission expects to address extraterritorial issues under the
Dodd-Frank Act in a separate release, which will include the issues
raised by these commenters concerning the application of the business
conduct standards rules to foreign customers and dealers.
vii. Private Rights of Action
Several commenters voiced concerns over the potential for
litigation that could arise because of the business conduct standards
rules.\139\ They are concerned that litigation costs will increase as a
result and be passed on to counterparties. Commenters noted that the
proposed rules may indirectly subject swap dealers and major swap
participants to private rights of action because of the statutory
language in Section 4s(h).\140\ While the Commission cannot exempt swap
dealers and major swap participants from private rights of action under
Section 22 of the CEA, and issues related to private rights of action
are beyond the scope of this rulemaking, in this adopting release and
in the rule text, the Commission has provided guidance to swap dealers
and major swap participants for complying with the final rules. In
addition, in the absence of fraud, the Commission will consider good
faith compliance with policies and procedures reasonably designed to
comply with the business conduct standards rules as a mitigating factor
when exercising its prosecutorial discretion for violation of the
rules.
---------------------------------------------------------------------------
\139\ See VRS Feb. 22 Letter, at 3; ABC/CIEBA Feb. 22 Letter, at
9-10; SIFMA/ISDA Feb. 17 Letter, at 4, 5-6, 10 and 34-35; FHLBanks
June 3 Letter, at 6 and 8; AMG-SIFMA Feb. 22 Letter, at 4-5 and 7-8;
CEF Feb. 22 Letter, at 3-4 and 9-10; Exelon Feb. 22 Letter, at 3.
\140\ For example, Section 22 of the CEA provides a private
right of action for any violation of the CEA, and Section 4s(h)(l)
states that ``[e]ach registered swap dealer and major swap
participant shall conform with such business conduct standards * * *
as may be prescribed by the Commission by rule or regulation. * *
*''
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viii. Inter-Affiliate Transactions
One commenter suggested that the Commission clarify that certain of
the requirements applicable to swap transactions and swap dealing
activities do not apply to transactions among affiliated entities
because such inter-affiliate transactions do not implicate the concerns
for systemic risk and market integrity that the Dodd-Frank Act is
intended to address and there is very limited potential for fraudulent
conduct.\141\ Another commenter suggested that, with regard to banks,
the Commission should provide relief from the business conduct
standards with respect to transactions among bank group members when
the transaction is with a group member that is a registered swap dealer
or major swap participant.\142\
---------------------------------------------------------------------------
\141\ Shell June 3 Letter, at 1.
\142\ Bank of Tokyo May 3 Letter, at 4-5.
---------------------------------------------------------------------------
The Commission confirms that swap dealers and major swap
participants need not comply with the subpart H external business
conduct standards rules for swaps entered into with their affiliates
where the transactions would not be ``publicly reportable swap
transactions.'' Under Sec. 43.2, recently adopted in the real time
reporting rulemaking, a publicly reportable swap transaction means,
among other things, any executed swap that is an arm's length
transaction between two parties that results in a corresponding change
in the market risk position between the two parties.\143\ The
definition of a publicly reportable swap transaction provides, by way
of example, that
[[Page 9745]]
internal transactions to move risk between wholly-owned subsidiaries of
the same parent, without having credit exposure to the other party
would not require public dissemination because such swaps are not
arm's-length transactions. Such transactions, however, are subject to
the anti-evasion requirements of Sec. 23.402(a) and the anti-fraud
provisions in Sec. 23.410.
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\143\ Real Time Public Reporting, 77 FR 1182 at 1187, Jan. 9,
2012.
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2. Section 23.401--Definitions
a. Proposed Sec. 23.401
Proposed Sec. 23.401 contained definitions for several terms that
are relevant to the Commission's proposed business conduct standards
rules. These include the terms ``counterparty,'' ``major swap
participant,'' ``Special Entity'' \144\ and ``swap dealer.'' The term
counterparty was defined to include prospective counterparties. The
proposed definitions of ``swap dealer'' and ``major swap participant''
incorporated by reference the proposed definitions in the Commission's
entity definitions rulemaking.\145\ In addition, these terms included,
as appropriate under this subpart, anyone acting for or on behalf of
such persons, including associated persons as defined in Section 1a(4)
of the CEA.
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\144\ See Section IV.A. of this adopting release for a
discussion of the comment letters received and the Commission's
determination regarding the definition of the term ``Special
Entity.''
\145\ See Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' Major Swap Participant,'' ``Major Security-
Based Swap Participant,'' and ``Eligible Contract Participant,'' 75
FR 80174, Dec. 21, 2010.
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b. Comments
The Commission did not receive any comments regarding the proposed
definitions of swap dealer or major swap participant.\146\ One
commenter stated that the Commission should revise the proposed
definition of counterparty to exclude swap dealers and major swap
participants.\147\ The commenter asserted that the Commission should
revise the definition of counterparty and clarify that none of the
business conduct standards rules applies where swap dealers or major
swap participants transact with another swap dealer or major swap
participant.\148\
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\146\ A commenter urged the Commission to refine the definition
of ECP so that the discretionary rules would provide protections
only for a subset of unsophisticated ECPs. Alternatively, this
commenter asked the Commission to exempt swap dealers and major swap
participants from compliance with the external business conduct
standards when they face counterparties who are sophisticated enough
to evaluate swap transactions without support from the swap dealer
or major swap participant. CEF Feb. 22 Letter, at 4-5, see also
Wells Fargo May 11 Letter, at passim. See Section III.A.1. of this
adopting release for a discussion of Sec. 23.400-Scope, including
how the Commission addressed these issues.
\147\ CEF Feb. 22 Letter, at 7-8.
\148\ Id.
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c. Final Sec. 23.401
The Commission has determined to adopt the definitions of
counterparty, swap dealer and major swap participant as proposed
(renumbered as Sec. 23.401(a)--Counterparty, Sec. 23.401(b)--Major
swap participant and Sec. 23.401(d)--Swap dealer). The Commission
declines to revise the definition of counterparty to exclude swap
dealers and major swap participants. Certain rules by their terms, such
as Sec. 23.431--Disclosures of Material Information and Sec. 23.434--
Institutional Suitability, do not apply to transactions among swap
dealers or major swap participants. However, the Commission has
determined that it would be inappropriate and inconsistent with the
statute to exclude such transactions from other rules, such as Sec.
23.433-Communications--fair dealing.
3. Section 23.402--General Provisions \149\
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\149\ The Commission proposed Sec. 23.402(b)--Diligent
supervision, but has determined not to adopt it as a final rule. See
fn. 21. As a result, the paragraphs in final Sec. 23.402 have been
renumbered as reflected in the final rules.
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a. Section 23.402(a)--Policies and Procedures To Ensure Compliance and
Prevent Evasion
i. Proposed Sec. 23.402(a)
Proposed Sec. 23.402(a) required swap dealers and major swap
participants to have policies and procedures reasonably designed to
ensure compliance and prevent evasion of any provision of the CEA or
any Commission Regulation, and to implement and monitor compliance with
such policies and procedures as part of their supervision and risk
requirements under subpart J of part 23.\150\
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\150\ The Commission has proposed that swap dealers and major
swap participants adopt policies and procedures regarding compliance
with the CEA and Commission Regulations. See, e.g., Governing the
Duties of Swap Dealers, 75 FR 71397; Designation of a Chief
Compliance Officer, Required Compliance Policies, and Annual Report
of a Futures Commission Merchant, Swap Dealer, Major Swap
Participant, 75 FR 70881, Nov. 19, 2010 (``CCO proposed rules'');
Implementation of Conflict-of-Interest Standards by Swap Dealers and
Major Swap Participants, 75 FR 71391, Nov. 23, 2010 (``Conflict-of-
Interest Standards by Swap Dealers'').
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ii. Comments
One commenter directly addressed proposed Sec. 23.402(a) and
asserted that the rule would require a swap dealer or major swap
participant to have a policy with respect to each statutory provision
or regulation that potentially applies to a swap dealer or major swap
participant.\151\ According to the commenter, because many regulations
only apply in limited circumstances, the scope of a swap dealer or
major swap participant's policies and procedures should be limited to
material provisions of the CEA and Commission Regulations.\152\
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\151\ CEF Feb. 22 Letter, at 19 (Appendix A).
\152\ Id.
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Another commenter, while not directly addressing proposed Sec.
23.402(a), recommended that the Commission convert certain prescriptive
requirements of the proposed rules and permit swap dealers and major
swap participants to comply by establishing and enforcing policies and
procedures.\153\ Conversely, another commenter opposed an approach that
would deem swap dealers or major swap participants to be in compliance
with the business conduct standards for complying with policies and
procedures.\154\
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\153\ SIFMA/ISDA Feb. 17 Letter, at 11 (discussing proposed
Sec. 23.410(b)--Confidential Treatment of Counterparty
Information); see also FIA/ISDA/SIFMA Aug. 26 Letter, at 17
(discussing the SEC's proposed institutional suitability
requirements and supporting the implementation of the SEC's proposed
``know your counterparty'' rule through policies and procedures).
\154\ CFA/AFR Aug. 29 Letter, at 12 (also noting, however, ``it
is certainly appropriate for the [SEC] to require SBS Entities to
establish, maintain, document and enforce policies and procedures
reasonably designed to achieve compliance with business conduct
rules'').
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iii. Final Sec. 23.402(a)
The Commission has considered the comments and has determined to
adopt Sec. 23.402(a) as proposed. The Commission clarifies, however,
that a swap dealer or major swap participant may consider the nature of
its particular business in developing its policies and procedures and
tailor such policies and procedures accordingly.\155\ A swap dealer or
major swap participant, however, remains responsible for complying with
all applicable provisions of the CEA and Commission
[[Page 9746]]
Regulations, including subpart H of part 23.
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\155\ As part of the materials submitted in an application for
registration as a swap dealer or major swap participant, an
applicant may submit its written policies and procedures to
``demonstrate, concurrently with or subsequent to the filing of
their Form 7-R with the National Futures Association, compliance
with regulations adopted by the Commission pursuant to section[] * *
* 4s(h) * * * of the [CEA] * * *'' The Commission adopted final
registration rules on the same day as these business conduct
standards rules. See also proposed Sec. 3.10(a)(1)(v)(A), Proposed
Rules for Registration of Swap Dealers and Major Swap Participants,
75 FR 71379, Nov. 23, 2010.
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A swap dealer or major swap participant will be expected to have
policies and procedures reasonably designed both to ensure compliance
and avoid evasion of the applicable requirements of the CEA and
Commission Regulations, including subpart H of part 23. Good faith
compliance with such policies and procedures will be considered by the
Commission in exercising its prosecutorial discretion in connection
with violations of the CEA and Commission Regulations. To be considered
good faith compliance, the Commission will consider, among other
things, whether the swap dealer or major swap participant made
reasonable inquiry and took appropriate action where the swap dealer or
major swap participant had information that would cause a reasonable
person to believe that any person acting for or on behalf of the swap
dealer, major swap participant or any counterparty was violating the
CEA or the Commission's Regulations in connection with the swaps
related business of the swap dealer or major swap participant.
b. Section 23.402(b)--Know Your Counterparty
i. Proposed Sec. 23.402(c)
Among the Commission's proposed business conduct rules was a ``know
your counterparty'' requirement.\156\ Proposed Sec. 23.402(c)
(renumbered as final Sec. 23.402(b)) required swap dealers and major
swap participants to use reasonable due diligence to know and retain a
record of the essential facts concerning each counterparty and the
authority of any person acting for such counterparty, including facts
necessary to: (1) Comply with applicable laws, regulations and rules;
(2) effectively service the counterparty; (3) implement any special
instructions from the counterparty; and (4) evaluate the previous swaps
experience, financial wherewithal and flexibility, trading objectives
and purposes of the counterparty.\157\
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\156\ Proposing release, 75 FR at 80641.
\157\ Id., at 80657.
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The Commission stated that, among other purposes, proposed Sec.
23.402(c) would assist swap dealers and major swap participants in
avoiding violations of Section 4c(a)(7) of the CEA, which makes it
``unlawful for any person to enter into a swap knowing, or acting in
reckless disregard of the fact, that its counterparty will use the swap
as part of a device, scheme, or artifice to defraud any third party.''
\158\ In proposing Sec. 23.402(c), the Commission noted that it was
guided by NFA Compliance Rule 2-30, Customer Information and Risk
Disclosure, which NFA has interpreted to impose ``know your customer''
duties and has been a key component of NFA's customer protection
regime.\159\
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\158\ Id., at 80641; 7 U.S.C. 6c(a)(7).
\159\ Proposing release, 75 FR at 80641 fn. 25 (citing NFA
Interpretive Notice 9013--NFA Compliance Rule 2-30: Customer
Information and Risk Disclosure (Staff, Nov. 30, 1990; revised Jul.
1, 2000)).
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ii. Comments
The Commission received several comments representing a diversity
of views on proposed Sec. 23.402(c). As a general matter, some
commenters believed the ``know your counterparty'' rule should not be
adopted because it was not mandated by the Dodd-Frank Act.\160\ These
commenters expressed concern about a number of specific issues as well.
---------------------------------------------------------------------------
\160\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 13-14; SIFMA/ISDA
Feb. 17 Letter, at 8-9.
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One commenter stated that the application of proposed Sec.
23.402(c) and certain other proposed rules to major swap participants
in connection with their trading with swap dealers and other registered
market intermediaries is inappropriate because they are customers of
swap dealers or registered market intermediaries and should be treated
as such rather than as dealers or quasi-dealers.\161\
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\161\ MetLife Feb. 22 Letter, at 4-5.
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Commenters stated that proposed Sec. 23.402(c) seemed to transform
swap dealers and major swap participants into ``service providers,''
which they contend is a departure from their actual status as
counterparties.\162\ In this regard, these commenters believed the
Commission erred by misapplying principles of agency to arm's length,
principal-to-principal relationships.\163\ These commenters contend
that, to the extent swap dealers and major swap participants are
transacting with counterparties at arm's length, the Commission should
clarify that the ``know your counterparty'' and corresponding
recordkeeping requirements do not apply.\164\ Similarly, these
commenters expressed concern that requiring swap dealers and major swap
participants to obtain financial information from their counterparties
would be inconsistent with ordinary business practice and would place
the counterparties at a severe negotiating and informational
disadvantage to the swap dealer or major swap participant.\165\
---------------------------------------------------------------------------
\162\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 14; SIFMA/ISDA
Feb. 17 Letter, at 9; HOOPP Feb. 22 Letter, at 3; BlackRock June 3
Medero and Prager Letter, at 5.
\163\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 9.
\164\ See, e.g., MFA Feb. 22 Letter, at 5.
\165\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 14; AMG-SIFMA Feb.
22 Letter, at 10.
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Commenters opposed to proposed Sec. 23.402(c) also took issue with
the Commission's reference to NFA Compliance Rule 2-30 (Customer
Information and Risk Disclosure).\166\ In their view, the Commission's
proposal to require a swap dealer or major swap participant to conduct
an independent investigation in order to obtain information necessary
to evaluate a counterparty's flexibility is unclear and a costly
departure from NFA Compliance Rule 2-30 and FINRA Rule 2090 (Know Your
Customer).\167\ The commenters stated that the SRO rules are intended
to protect retail customers and are ill-suited to a sophisticated
institutional market.\168\ By transforming an SRO rule into a
Commission regulation, these commenters believed that the Commission's
proposal exposes swap dealers and major swap participants to
unnecessary and significant private litigation risk and associated
costs.\169\
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\166\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 8; MFA Feb. 22
Letter, at 3.
\167\ Id.
\168\ Id.
\169\ Id.
---------------------------------------------------------------------------
The concern regarding the proposal's potential to increase legal
risk and transaction costs extended to those commenters who were
generally supportive of the requirement in proposed Sec. 23.402(c)
that swap dealers and major swap participants use reasonable due
diligence to know and retain a record of the essential facts concerning
each counterparty.\170\ As one commenter stated, ``if the derivatives
markets are unduly constrained on account of increased legal risk, the
intended benefits of the external business conduct rules will not be
realized.'' \171\
---------------------------------------------------------------------------
\170\ See, e.g., FHLBanks June 3 Letter, at 6.
\171\ Id.
---------------------------------------------------------------------------
Another commenter strongly supported proposed Sec. 23.402(c) as an
essential component of an effective business conduct standards rule
regime and urged the Commission to strengthen the recordkeeping
requirements associated with the proposed ``know your counterparty''
rule.\172\ However, the commenter agreed with those generally opposed
to the proposal on one point: That it may be appropriate to scale any
``know your counterparty'' requirements according to the nature of
[[Page 9747]]
the relationship between the counterparties. Accordingly, the commenter
agreed that, where a truly arm's length relationship exists, for
example, it may be appropriate to limit the ``know your counterparty''
obligation to information necessary to comply with the law.\173\
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\172\ CFA/AFR Feb. 22 Letter, at 6 and 19.
\173\ Compare CFA/AFR Feb. 22 Letter, at 19, with SIFMA/ISDA
Feb. 17 Letter, at 8-9.
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In connection with the ``know your counterparty'' rule, commenters
urged the Commission to harmonize its rules with those proposed by the
SEC.\174\ These commenters stated their belief that Congress sought to
assure through Section 712(a) of the Dodd-Frank Act that the CFTC and
SEC adopt comparable and consistent regulations.\175\ These commenters
also highlighted that, from a cost-benefit perspective, inconsistent or
conflicting requirements would increase the costs to market
participants of implementing the measures necessary to comply with the
CEA.\176\
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\174\ See, e.g., FIA/ISDA/SIFMA Sept. 14 Letter, at 2-3.
\175\ Id., at 2.
\176\ Id.
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iii. Final Sec. 23.402(b)
The Commission has determined to adopt proposed Sec. 23.402(c)
(renumbered as Sec. 23.402(b)) with changes to reflect certain of the
comments it received. In making this determination, the Commission
concluded that final Sec. 23.402(b) is fully authorized by the
discretionary rulemaking authority vested in the Commission by Section
4s(h). In Section 4s(h), Congress granted the Commission broad
discretionary authority to promulgate business conduct requirements, as
appropriate in the public interest, for the protection of investors or
otherwise in furtherance of the purposes of the CEA.\177\ The
Commission considers the rule to be an appropriate exercise of its
discretionary authority because a ``know your counterparty''
requirement is an integral component of, and consistent with, sound
principles of legal and regulatory compliance and operational and
credit risk management.\178\ Many of the entities that will be subject
to this requirement should already have in place, as a matter of normal
business practices, ``know your counterparty'' policies and procedures
by way of their membership in an SRO \179\ or, for banks, compliance
with standards set forth by their prudential regulators.\180\ Given
this fact, the Commission believes the additional costs of complying
with this requirement, if any, will be minimal.
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\177\ Section 4s(h)(3)(D); see also Sections 4s(h)(1)(D),
4s(h)(5)(B) and 4s(h)(6).
\178\ See Derivatives Policy Group, ``Framework for Voluntary
Oversight,'' at Section V.III.B. (Mar. 1995) (``DPG Framework'').
\179\ See, e.g., NFA Compliance Rule 2-30; see also FINRA Rule
2090.
\180\ See also Trading & Capital-Markets Activities Manual,
sections 2050.3, 2050.4, 2060.3, 2060.4, 3030.1, and 3030.3 (Bd. of
Gov. Fed. Reserve Sys. Jan. 2009).
---------------------------------------------------------------------------
Final Sec. 23.402(b) seeks to harmonize the Commission's approach
with the SEC's proposed rules.\181\ As one commenter noted, the SEC's
``know your counterparty'' proposal benefited from the comments the
Commission received on proposed Sec. 23.402(c).\182\ This same
commenter highlighted the congressional mandate in Section 712(a) of
the Dodd-Frank Act that the Commission and the SEC consult for the
purposes of assuring regulatory consistency and comparability, to the
extent possible. The Commission believes that the ``know your
counterparty'' rule is an area where the Commission and the SEC can
achieve consistency. At the same time, there will be some variation to
account for the comments received on the Commission's proposal and the
fact that the Commission regulates different products, participants,
and markets.
---------------------------------------------------------------------------
\181\ SEC's proposed rules, 76 FR at 42414.
\182\ See FIA/ISDA/SIFMA Aug. 26 Letter, at 3.
---------------------------------------------------------------------------
The Commission agrees with comments calling for the exclusion of
major swap participants from the ``know your counterparty''
requirements. In most cases, major swap participants will themselves be
counterparties to or customers of swap dealers. By definition, their
business will not be dealing in or making a market in swaps.\183\
Accordingly, the Commission is deleting major swap participants from
final Sec. 23.402(b).
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\183\ The definition of ``major swap participant'' states that
the term ``means any person who is not a swap dealer.'' Section
1a(33) of the CEA (7 U.S.C. 1a(33)).
---------------------------------------------------------------------------
With respect to the requirement in proposed Sec. 23.402(c) that
the swap dealer evaluate the previous swap experience, financial
wherewithal and flexibility, trading objectives and purposes of the
counterparty, commenters expressed several objections. Rather than
fostering counterparty protections, commenters asserted, this
requirement could actually place counterparties at a negotiating and
information disadvantage relative to swap dealers.\184\ Further,
commenters claimed that such protections are unnecessary when swap
dealers and counterparties are dealing in arm's length transactions and
are more appropriate when swap dealers make recommendations to
counterparties.\185\
---------------------------------------------------------------------------
\184\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 14.
\185\ See, e.g., MFA Feb. 22 Letter, at 4.
---------------------------------------------------------------------------
In light of the foregoing comments, the Commission believes that
certain of the protections provided for in proposed Sec. 23.402(c) are
better addressed in connection with Sec. 23.434--Recommendations to
counterparties--institutional suitability.\186\ Accordingly, the
Commission is removing from final Sec. 23.402(b) the requirements in
proposed Sec. 23.402(c) to ``effectively service the counterparty''
and ``implement any special instructions from the counterparty.''
Through these changes, the Commission clarifies that the final ``know
your counterparty'' rule does not, by itself, create an ``advisor''
status or impose a fiduciary duty on a swap dealer.
---------------------------------------------------------------------------
\186\ See Section III.G. of this adopting release for a
discussion of Sec. 23.434.
---------------------------------------------------------------------------
The Commission believes comments opposing proposed Sec. 23.402(c)
on the basis that it transforms NFA Compliance Rule 2-30 (Customer
Information and Risk Disclosure) from an SRO rule to a Commission
regulation are misplaced. The Commission was guided by NFA Compliance
Rule 2-30 as a model for the proposal, with modification where
appropriate to achieve the Commission's policy objectives, including
assisting swap dealers to avoid violations of Section 4c(a)(7) of the
CEA.\187\ The Commission believes that NFA Compliance Rule 2-30 and the
precedent developed under it will serve as useful guidance to the
Commission and the public in the application of the final rule.\188\
However, as stated above, final Sec. 23.402(b), which essentially
codifies sound business practices,\189\ is an important component of
the Commission's overall business conduct standards framework. The
Commission views NFA's and the Commission's ``know your counterparty''
requirements as complementary.
---------------------------------------------------------------------------
\187\ Section 4c(a)(7) of the CEA makes it ``unlawful for any
person to enter into a swap knowing, or acting in reckless disregard
of the fact, that its counterparty will use the swap as part of a
device, scheme or artifice to defraud any third party.'' See also
discussion at fn. 158.
\188\ See, e.g., NFA Interpretive Notice 9004--NFA Compliance
Rule 2-30: Customer Information and Risk Disclosure (Board of
Directors, effective June 1, 1986; revised January 3, 2011).
\189\ See DPG Framework, at Section V.III.B.
---------------------------------------------------------------------------
Given the changes from the proposal to final Sec. 23.402(b), the
Commission believes it has ameliorated much of the burden commenters
attributed to compliance risk associated with the ``know your
counterparty'' requirements. Based on the foregoing, the Commission is
promulgating final Sec. 23.402(b) with modification from the
[[Page 9748]]
proposal to account for the specific comments received and to conform,
where appropriate, to the SEC's proposed ``know your counterparty''
rule. Accordingly, final Sec. 23.402(b) requires that each swap dealer
shall implement policies and procedures reasonably designed to obtain
and retain a record of the essential facts concerning each counterparty
whose identity is known to the swap dealer that are necessary for
conducting business with such counterparty.\190\ For purposes of final
Sec. 23.402(b), the essential facts concerning a counterparty are: (1)
Facts required to comply with applicable laws, regulations and rules;
(2) facts required to implement the swap dealer's credit and
operational risk management policies in connection with transactions
entered into with such counterparty; and (3) information regarding the
authority of any person acting for such counterparty.
---------------------------------------------------------------------------
\190\ Final Sec. 23.402(b) will not apply to swaps that are
executed on a SEF or DCM where the swap dealer does not know the
identity of the counterparty to the transaction.
---------------------------------------------------------------------------
In adopting this final rule, the Commission makes clear that
recordkeeping, in accordance with final Sec. 23.402(g), must be
sufficient so as to enable the Commission to determine compliance with
final Sec. 23.402(b). Unlike the SEC proposed rule, the Commission has
determined not to include the following as an essential fact in final
Sec. 23.402(b): ``If the counterparty is a Special Entity, such
background information regarding the independent representative as the
swap dealer reasonably deems appropriate.'' \191\ This requirement is
specifically addressed in Section 4s(h)(5) of the CEA as well as in the
final rules that address the independent representative
requirement.\192\
---------------------------------------------------------------------------
\191\ SEC's proposed rules, 76 FR at 42414.
\192\ See Section IV.C.3. of this adopting release for a
discussion of final Sec. 23.450.
---------------------------------------------------------------------------
As with other business conduct standards rules, final Sec.
23.402(b) does not allow counterparties to opt out. However, swap
dealers will be able to reduce the costs of compliance by receiving
written representations from their counterparties at the outset of the
relationship rather than on a transaction-by-transaction basis, where
appropriate, and in accordance with the requirements of final Sec.
23.402(d)--Reasonable Reliance on Representations.
c. Section 23.402(c)--True Name and Owner
i. Proposed Sec. 23.402(d)
Proposed Sec. 23.402(d) (renumbered as final Sec. 23.402(c))
required swap dealers and major swap participants to keep records that
show the true name, address, and principal occupation or business of
each counterparty, as well as the name and address of any other person
guaranteeing the performance of such counterparty and any person
exercising any control with respect to the positions of such
counterparty.\193\ This rule was proposed under the Commission's
discretionary rulemaking authority in Section 4s(h).
---------------------------------------------------------------------------
\193\ Proposing release, 75 FR at 80641.
---------------------------------------------------------------------------
ii. Comments
The Commission did not receive any comments regarding proposed
Sec. 23.402(d).
iii. Final Sec. 23.402(c)
As stated in the proposing release, proposed Sec. 23.402(d) was
based on existing Commission Regulation Sec. 1.37(a)(1),\194\ which
applies to FCMs, introducing brokers, and members of a DCM. The
Commission has determined that it is in the public interest to hold
swap dealers and major swap participants to this same standard.
Further, the Commission has determined that the recordkeeping
requirements under this rule will assist swap dealers and major swap
participants in meeting their other duties pursuant to the business
conduct standards in subpart H of part 23 (e.g., the ``verification of
counterparty eligibility'' requirement of final Sec. 23.430).
Accordingly, the Commission is adopting proposed Sec. 23.402(d)
(renumbered as Sec. 23.402(c)).
---------------------------------------------------------------------------
\194\ 17 CFR 1.37(a)(1).
---------------------------------------------------------------------------
d. Section 23.402(d)--Reasonable Reliance on Representations
i. Proposed Sec. 23.402(e)
Proposed Sec. 23.402(e) (renumbered as final Sec. 23.402(d))
stated that swap dealers and major swap participants that seek to rely
on counterparty representations to satisfy any of the business conduct
standards rules must have a reasonable basis to believe that the
representations are reliable under the circumstances.\195\ In other
words, proposed Sec. 23.402(e) would have allowed swap dealers and
major swap participants, as appropriate, to reasonably rely, absent red
flags, on representations of counterparties to meet due diligence
obligations. The counterparty's representations must have included
information that was sufficiently detailed for the swap dealer or major
swap participant to form a reasonable conclusion that the relevant
requirement was satisfied.
---------------------------------------------------------------------------
\195\ Proposing release, 75 FR at 80641.
---------------------------------------------------------------------------
ii. Comments
The Commission did not receive comments directly addressing
proposed Sec. 23.402(e). However, many commenters addressed the
concept in proposed Sec. 23.402(e) of reasonable reliance on
representations in connection with the due diligence requirements under
certain other proposed rules, such as proposed Sec. 23.430--
Verification of Counterparty Eligibility, proposed Sec. 23.434--
Recommendations to Counterparties--Institutional Suitability, and
proposed Sec. 23.450(d)--Requirements for Swap Dealers and Major Swap
Participants Acting as Counterparties to Special Entities.\196\
Commenters were particularly concerned with the language in these
proposed rules that the representations be reliable ``taking into
consideration the facts and circumstances of a particular relationship,
assessed in the context of a particular transaction'' and that the
representations be ``sufficiently detailed.'' \197\ According to some
commenters, the proposed rules that permitted reliance on
representations, including proposed Sec. 23.402(e), would require
transaction-by-transaction diligence that would delay execution and
increase costs for swap dealers, major swap participants and their
counterparties.\198\ Several commenters also asserted that a swap
dealer or major swap participant should not have an affirmative duty to
investigate the counterparty's representations.\199\
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\196\ See, e.g., ABA/ABC Feb. 22 Letter, at 2-3; ABC/CIEBA Feb.
22 Letter, at passim; AMG-SIFMA Feb. 22 Letter, at 9-11; APGA Feb.
22 Letter, at 2-3 and 6-7; APPA/LPPC Feb. 22 Letter, at 4; BlackRock
Feb. 22 Letter, at 3; CalPERS Oct. 4 Letter, at 1; CEF Feb. 22
Letter, at 12, 16, 19-20, and 23; CFA/AFR Feb. 22 Letter, at 6, 8
and 13; Comm. Cap. Mkts. May 3 Letter, at 2; Davis & Harman Mar. 25
Letter, at 5-6; FHLBanks Feb. 22 Letter, at 4-5; Ropes & Gray Feb.
22 Letter, at 3-4; SIFMA/ISDA Feb. 17 Letter, at 12, 15-16, 27, 27
fn. 59, 35-36 and 36 fn. 85; SWIB Feb. 22 Letter, at 4-5; VRS Feb.
22 Letter, at 5. See also NFA Aug. 25, 2010 Letter, at 2.
\197\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36; proposing
release, 75 FR at 80660.
\198\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA
Feb. 22 Letter, at 9-10; BlackRock Feb. 22 Letter, at 3; see also
SIFMA/ISDA Feb. 17 Letter, at 15-16 (discussing proposed Sec.
23.430, Verification of Counterparty Eligibility, ``an SD/MSP must
conduct affirmative diligence in order to determine whether it is
reasonable to rely on provided representations. Such an approach
effectively makes the relevant representation(s) superfluous.'').
\199\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 15-16 (``[swap
dealers] should be permitted to * * * rely[] on a written
representation by the counterparty * * * absent actual notice of
countervailing facts (or facts that reasonably should have put the
[swap dealer or major swap participant] on notice), which would
trigger a consequent duty to inquire further''); ABC/CIEBA Feb. 22
Letter, at 10-11 fn. 3 (asserting the Commission should adopt a
standard used under Rule 144A of the federal securities laws, which
would not impose a duty to inquire further ``unless circumstances
existed giving reason to question the veracity of a
certification''); AMG-SIFMA Feb. 22 Letter, at 10-11 (``A swap
dealer or [major swap participant] should be able to rely on an
investment adviser's representation unless the swap dealer or [major
swap participant] has information to the contrary.''); Comm. Cap.
Mkts. May 3 Letter, at 2 (``The dealer should be required to probe
beyond that representation only if it has reason to believe that the
Special Entity's representations with respect to its independent
representative are inaccurate.''); BlackRock Feb. 22 Letter, at 3
(``The CFTC should specifically permit the [swap dealer] to rely,
absent notice of facts that would require further inquiry * * *.'').
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[[Page 9749]]
iii. Final Sec. 23.402(d)
The Commission has considered the comments discussed above and, as
a result, has determined to refine the language in proposed Sec.
23.402(e) (renumbered as Sec. 23.402(d)). The revised language permits
a swap dealer or major swap participant to rely on the written
representations of a counterparty to satisfy its due diligence
requirements under subpart H of part 23. The Commission has determined,
however, that a swap dealer or major swap participant cannot rely on a
representation if the swap dealer or major swap participant has
information that would cause a reasonable person to question the
accuracy of the representation. In other words, a swap dealer or major
swap participant cannot ignore red flags when relying on
representations to satisfy its due diligence obligations.
The nature and specificity of the representations required under
subpart H of part 23 vary depending on the specific rule. Therefore,
the Commission has separately described in the discussion of the
relevant provisions the content and level of detail a particular
representation must have to satisfy the due diligence obligation of a
particular rule.\200\
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\200\ See Sections III.A.3.b., III.C., III.G., IV.B., and IV.C.
in this adopting release for a discussion of the following final
rules, respectively: Sec. 23.402(b)--Know your counterparty; Sec.
23.430--Verification of counterparty eligibility; Sec. 23.434--
Institutional suitability; Sec. 23.440--Requirements for swap
dealers acting as advisors to Special Entities; and Sec. 23.450--
Requirements for swap dealers and major swap participants acting as
counterparties to Special Entities.
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The Commission reaffirms that, if agreed to by the counterparty,
counterparty representations may be contained in counterparty
relationship documentation and may be deemed renewed with each
subsequent offer or transaction. However, a swap dealer or major swap
participant may only rely on representations in the counterparty
relationship documentation if the counterparty agrees to timely update
any material changes to the representations.\201\ In addition, the
Commission expects swap dealers and major swap participants to review
the representations on a periodic basis to ensure that they remain
appropriate for the intended purpose. The Commission believes that
``best practice'' would be at least an annual review in connection with
the required annual compliance review by the chief compliance officer
pursuant to proposed Sec. 3.3.\202\
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\201\ Such an agreement to update representations contained in
counterparty relationship documentation is only with respect to
subsequent (i.e., new) swaps offered or entered into. The
requirement to update representations is in the context of the
execution of the subsequent swap. The Commission does not intend to
require an ongoing duty to update representations except in
connection with a new transaction.
\202\ CCO proposed rules, 75 FR at 70887.
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e. Section 23.402(e)--Manner of Disclosure
i. Proposed Sec. 23.402(f)
Proposed Sec. 23.402(f) (renumbered as final Sec. 23.402(e))
provided flexibility to swap dealers and major swap participants by
allowing them to provide information required by subpart H of part 23,
including required disclosures, by any reliable means agreed to in
writing by the counterparty.\203\
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\203\ Proposing release, 75 FR at 80642.
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ii. Comments
One commenter suggested that the Commission establish minimum
requirements defining ``reliable means'' within the rule.\204\ In
addition, the use of password protected web pages to satisfy the daily
mark obligation was identified as a potential area of concern. The
commenter recommended that permitted interfaces should provide
counterparties with tools to initiate, track and close valuation
disputes and the interfaces should be designed to prevent any
unintentional or fraudulent addition, modification, or deletion of a
valuation record.\205\ Another commenter opposed permitting pre-
transaction oral disclosures to satisfy a disclosure obligation, even
where such disclosures are supplemented by post-transaction written
documentation.\206\
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\204\ Markit Feb. 22 Letter, at 3.
\205\ Id.
\206\ CFA/AFR Nov. 3 Letter, at 6.
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iii. Final Sec. 23.402(e)
The Commission is adopting proposed Sec. 23.402(f) (renumbered as
Sec. 23.402(e)) with a change to account for disclosures for certain
swaps initiated on a SEF or DCM. For such swaps, no written agreement
by the counterparty regarding the manner of disclosure is necessary,
but the manner of disclosure must be reliable. Otherwise, for swaps
executed bilaterally and not on a SEF or DCM, the rule requires
counterparties to agree, in writing, to the manner of disclosure.
In addition, the Commission is clarifying in this adopting release
that oral disclosures are permitted if agreed to by the counterparty
and the disclosures are confirmed in writing. To avoid confusion and
misunderstanding among the parties, however, written disclosures are
the preferred manner of disclosure. Written disclosures also facilitate
diligent supervision and auditing of compliance with the disclosure
duties and record retention rule.
In response to comments received prior to the publication of the
proposing release, daily marks may be provided by password protected
web pages.\207\ This approach is consistent with industry suggestions
and reflects cost of compliance concerns.\208\ Regarding the concerns
raised by the commenter,\209\ the Commission's internal business
conduct rules in new subpart J of part 23 of the Commission's
Regulations \210\ require swap dealers and major swap participants to
have policies and procedures in place that ensure communications,
including the daily mark, are reliable and timely.
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\207\ See proposing release, 75 FR at 80646 fn. 62.
\208\ Id.
\209\ Markit Feb. 22 Letter, at 3.
\210\ See proposed Sec. Sec. 3.3, 23.600, 23.602 and 23.606,
Governing the Duties of Swap Dealers, 75 FR 71397.
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Final Sec. 23.402(e) provides flexibility to swap dealers and
major swap participants to take advantage of technological innovations
while accommodating industry practice and counterparty preferences. The
Commission anticipates that technology will be adapted to expedite and
reduce the costs associated with satisfying the disclosure requirements
in the Commission's business conduct standards generally.
f. Section 23.402(f)--Disclosures in a Standard Format
i. Proposed Sec. 23.402(g)
Proposed Sec. 23.402(g) (renumbered as final Sec. 23.402(f))
allowed swap dealers and major swap participants to use, where
appropriate, standardized formats to make certain required disclosures
of material information to their counterparties and to include such
standardized disclosures in a master or
[[Page 9750]]
other written agreement between the parties, if agreed to by the
parties.\211\
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\211\ Proposing release, 75 FR at 80642.
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ii. Comments
The Commission received letters from several commenters regarding
proposed Sec. 23.402(g).\212\ Generally, the commenters endorsed the
proposed rule, but raised a variety of concerns, including the scope,
substance, timing, frequency and cost of the standardized disclosures.
Regarding scope and substance, some commenters suggested that the
Commission promote or develop standardized disclosures to ensure
adequate and consistent information, which would streamline the
disclosure process, foster legal certainty and reduce costs.\213\ One
commenter proposed, as an alternative to disclosing material
information, limiting the required disclosure to the provision of
robust market risk scenario analyses, defined in scope, in advance of
all swaps.\214\ Several commenters requested that the form of
disclosure be specified by the Commission as it has done for futures
trading under Sec. 1.55.\215\ One commenter suggested that DCOs
prepare certain standardized disclosures for cleared swaps.\216\
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\212\ See FHLBanks Feb. 22 Letter, at 3-4; ABC/CIEBA Feb. 22
Letter, at 13; ABC Aug. 29 Letter, at 2 and 10-11; CEF Feb. 22
Letter, at 13; BlackRock Feb. 22 Letter, at 6-7; APGA Feb. 22
Letter, at 3; ATA Feb. 22 Letter, at 3; State Street Feb. 22 Letter,
at 3-4; SIFMA/ISDA Feb. 17 Letter, at 16-18; NY City Bar Feb. 22
Letter, at 2-3; CFA/AFR Feb. 22 Letter, at 8.
\213\ See, e.g., FHLBanks Feb. 22 Letter, at 3-4.
\214\ NY City Bar Feb. 22 Letter, at 2-3.
\215\ See, e.g., APGA Feb. 22 Letter, at 3; ATA Feb. 22 Letter,
at 3; State Street Feb. 22 Letter, at 3-4; CEF Feb. 22 Letter, at
13. In addition, the NY City Bar recommended standardized
disclosures similar to those currently used for listed options
rather than the federal securities law model, which is directed at
retail investors and not sophisticated ECPs in the swaps market. NY
City Bar Feb. 22 Letter, at 2. See also 17 CFR 1.55.
\216\ CEF Feb. 22 Letter, at 13.
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Regarding the timing and frequency of standard form disclosures,
virtually all commenters agreed that, for standardized swaps,
disclosures by swap dealers and major swap participants to
counterparties should be allowed on a relationship basis and not
required on a transaction-by-transaction basis.\217\ For non-
standardized swaps, one commenter challenged the statement in the
proposing release that ``the Commission believes that most bespoke
transactions * * * will require some combination of standardized and
particularized disclosures[ ]'' \218\ asserting that bespoke issues can
be anticipated and included in standardized disclosures as part of
counterparty relationship documentation or other written
agreements.\219\ A different commenter commended the Commission for
recognizing that standardized disclosures alone would not be adequate
to elucidate the risks in customized swaps.\220\ Another commenter
acknowledged that there are certain instances in which standardized
disclosures may not provide adequate information and requested that the
Commission clarify that counterparties may require additional
disclosure from swap dealers and major swap participants.\221\
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\217\ See, e.g., FHLBanks Feb. 22 Letter, at 3; ABC/CIEBA Feb.
22 Letter, at 13; ABC Aug. 29 Letter, at 2 and 10-11; CEF Feb. 22
Letter, at 4; BlackRock Feb. 22 Letter, at 6-7.
\218\ Proposing release, 75 FR at 80643.
\219\ SIFMA/ISDA Feb. 17 Letter, at 18.
\220\ CFA/AFR Feb. 22 Letter, at 8.
\221\ FHLBanks Feb. 22 Letter, at 4.
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In addition, a commenter requested guidance regarding the required
disclosures and customary non-reliance language in swap documents.\222\
This commenter stated: ``It is anomalous to require swap dealers and
major swap participants to make certain disclosures to their end-user
counterparties pursuant to the proposed rule while those swap dealers
and major swap participants continue to include non-reliance agreements
in swap transaction documentation providing their end-user
counterparties may not rely on disclosures.'' \223\ The commenter
requested that the Commission clarify that any non-reliance provisions
contained in swap transaction documentation must exclude any disclosure
mandated by the Dodd-Frank Act and the rules promulgated
thereunder.\224\
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\222\ Id.
\223\ Id.
\224\ Id.
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iii. Final Sec. 23.402(f)
The Commission is adopting proposed Sec. 23.402(g) (renumbered as
Sec. 23.402(f)) with a slight modification for clarity purposes. The
language referencing ``a standard format, including in a master * * *
agreement * * *'' was changed to ``counterparty relationship
documentation.''
Regarding comments related to scope and substance and the request
that the Commission develop a standardized disclosure form for swaps,
the Commission has determined that a Sec. 1.55 \225\ type disclosure
form for swaps would be inconsistent with the requirements of Section
4s(h)(3). Because the types of swaps covered by the disclosure duties
will not be limited to standardized products and will include
negotiated, bilateral transactions, swap dealers and major swap
participants are required to develop the disclosures appropriate to the
transactions that they offer to and enter into with counterparties.
Unlike standardized exchange traded futures and options, swaps can be
bespoke instruments with a wide range of non-standardized economic
features that materially influence cash flows, which do not lend
themselves to a single form, futures-style risk disclosure statement
developed by the Commission.\226\
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\225\ 17 CFR 1.55.
\226\ The Commission has proposed a swap risk disclosure
statement for commodity pool operators (``CPOs'') and CTAs. See
Commodity Pool Operators and Commodity Trading Advisors: Amendments
to Compliance Obligations, 76 FR 7976, Feb. 11, 2011. The proposed
swap risk disclosure statement for CPOs and CTAs does not affect the
swap disclosure requirements under Section 4s(h)(3)(B) or any rules
promulgated pursuant to that statutory provision.
---------------------------------------------------------------------------
In addition, commenters suggested that the Commission provide
standardized disclosure to promote legal certainty. On the contrary,
such a disclosure could increase uncertainty because it would
necessarily have to be general enough to cover all conceivable swaps,
to such an extent that the purpose of disclosure would not be served.
Congress enacted this robust disclosure regime to reduce information
asymmetry and give counterparties the material information to make an
informed and reasoned decision before placing assets at risk. A
Commission generated standard disclosure also runs the risk of offering
a roadmap for evasion, or it would require constant updates to maintain
pace with innovations that are engineered and may not be covered by the
standard language.
To address legal certainty concerns, the Commission is clarifying
in this adopting release that, in the absence of fraud, it will
consider good faith compliance with policies and procedures reasonably
designed to comply with the business conduct standards rules as a
mitigating factor when exercising its prosecutorial discretion for
violation of the rules.
The Commission expects that swap dealers and major swap
participants will develop their own standard disclosures to meet
certain aspects of the disclosure requirements, where appropriate, that
will be tailored to the types of swaps that they offer and will be
provided to counterparties in counterparty relationship documentation
or through other reliable means. Such an approach will help to minimize
costs without diminishing the quality of risk disclosures provided to
[[Page 9751]]
counterparties. Where such standardized disclosures are inadequate to
meet the requirements of final Sec. 23.402(f), swap dealers and major
swap participants will have to make particularized disclosures in a
timely manner that are sufficient to allow the counterparty to assess
the material risks and characteristics of the swap. In addition, swap
dealers and major swap participants will need to have policies and
procedures to address when and how disclosures will be provided to
counterparties, including particularized disclosures in connection with
complex swaps. Factors that would be relevant include, but are not
limited to, the complexity of the transaction, the degree and nature of
any leverage,\227\ the potential for periods of significantly reduced
liquidity, and the lack of price transparency.\228\ This approach is
consistent with over-the-counter (``OTC'') industry best practice
recommendations for high-risk, complex financial instruments.\229\
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\227\ The leverage characteristic is particularly relevant when
the swap includes an embedded option, including one in which the
counterparty has sold an option to the dealer or the dealer retains
the option to alter the terms of the swap under certain
circumstances. Such features can significantly increase counterparty
risk exposure in ways that are not transparent.
\228\ ``The aforementioned characteristics are neither an
exhaustive list nor should they be assumed to provide a strict
definition of high-risk, complex instruments, which the Policy Group
believes should be avoided. Instead, market participants should
establish procedures for determining, based on the key
characteristics discussed above, whether an instrument is to be
considered high-risk and complex and thus require the special
treatment outlined in this section.'' The Counterparty Risk
Management Policy Group, ``Containing Systemic Risk: The Road to
Reform, The Report of the CRMPG III,'' at 56 (Aug. 6, 2008) (``CRMPG
III Report'').
\229\ Id.
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With respect to scenario analysis, counterparties will be able to
opt in to receive scenario analysis for swaps that are not ``made
available for trading'' on a DCM or SEF.\230\ The Commission declines,
however, to determine, as suggested by commenters, that standard form
scenario analysis is sufficient to meet all business conduct standards
disclosure requirements, which include material risks, characteristics,
incentives and conflicts of interest.\231\
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\230\ See Section III.D.3.b. of this adopting release for a
discussion of final Sec. 23.431(b); see also discussion of Section
2(h)(8) of the CEA and swaps ``made available for trading'' on a DCM
or SEF at infra fn. 394.
\231\ See NY City Bar Feb. 22 Letter, at 2-3.
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Regarding the suggestion that DCOs be required to provide certain
standardized disclosures (other than the daily mark) for cleared swaps,
the Commission is not mandating such a rule in this rulemaking because
Section 4s(h) of the CEA and subpart H of part 23 only govern swap
dealers and major swap participants. Swap dealers and major swap
participants will be permitted, however, to arrange with third parties,
including DCOs and SEFs, to provide disclosures to a counterparty to
satisfy the swap dealer's or major swap participant's obligation under
Sec. 23.431. The Commission expects that a DCO or SEF may make
available certain information, such as the material economic terms of
cleared swaps, similar to the contract specifications provided by DCMs
today. Swap dealers and major swap participants may make arrangements
so that such information from the DCO or SEF satisfies certain
disclosure obligations (e.g., material characteristics of the swap).
Regardless, the swap dealer or major swap participant will remain
responsible for compliance with Sec. 23.431. Lastly, the Commission is
providing guidance that non-reliance provisions routinely included in
counterparty relationship documentation will not relieve swap dealers
and major swap participants of their duty to comply in good faith with
the business conduct standards requirements. It will be up to the
adjudicator in a particular case to determine the extent of any
liability of the swap dealer or major swap participant to a
counterparty under the business conduct standards rules, depending on
the facts and circumstances.
g. Section 23.402(g)--Record Retention
i. Proposed Sec. 23.402(h)
Proposed Sec. 23.402(h) (renumbered as final Sec. 23.402(g))
required swap dealers and major swap participants to create and retain
a written record of their compliance with the requirements of the
external business conduct rules in subpart H. Such requirements would
be (1) part of the overall recordkeeping obligations imposed on swap
dealers and major swap participants in the CEA and subpart F of part 23
of the Commission's Regulations, (2) maintained in accordance with
Sec. 1.31 \232\ of the Commission's Regulations, and (3) accessible to
applicable prudential regulators.\233\
---------------------------------------------------------------------------
\232\ 17 CFR 1.31.
\233\ Proposing release, 75 FR at 80642.
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ii. Comments
A commenter requested clarification regarding the requirement to
create a written record of compliance with the external business
conduct rules. In particular, guidance was requested regarding whether
master agreements, which contain certain counterparty representations,
qualify as a ``written record of compliance'' within the rule.\234\
Another commenter suggested that the Commission strengthen the
recordkeeping requirements throughout to ensure that records are
detailed enough to allow regulators to easily determine
compliance.\235\
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\234\ CEF Feb. 22 Letter, at 19.
\235\ CFA/AFR Feb. 22 Letter, at 6, 7, 13, 18 and 20.
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iii. Final Sec. 23.402(g)
After considering the comments, the Commission has determined to
adopt Sec. 23.402(h) as proposed (renumbered as Sec. 23.402(g)). In
addition, the Commission confirms that counterparty relationship
documentation containing standard form disclosures, other material
information and counterparty representations may be part of the written
record of compliance with the external business conduct rules that
require certain disclosures and due diligence. Further, swap dealers
and major swap participants may choose to use internet based
applications to provide disclosures and daily marks.\236\ Swap dealers
and major swap participants are required to have policies and
procedures for documenting disclosures and due diligence. Recordkeeping
policies and procedures should ensure that records are sufficiently
detailed to allow compliance officers and regulators to determine
compliance.
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\236\ Swap dealers and major swap participants will have to
retain a record of all required information irrespective of the
method used to convey such information.
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B. Section 23.410--Prohibition on Fraud, Manipulation and Other Abusive
Practices
1. Sections 23.410(a) and (b)
a. Proposed Sec. 23.410(a)
Section 4s(h)(1) grants the Commission discretionary authority to
promulgate rules applicable to swap dealers and major swap participants
related to, among other things, fraud, manipulation and abusive
practices.\237\ To implement this provision, the Commission proposed
several rules, including proposed Sec. 23.410(a), which incorporated
the statutory text in
[[Page 9752]]
Section 4s(h)(4)(A).\238\ The statutory provision prohibits fraudulent,
deceptive and manipulative practices by swap dealers and major swap
participants.\239\ While the heading of Section 4s(h)(4) reads
``Special Requirements for Swap Dealers Acting as Advisors,'' the plain
language of the statutory text within that section includes both more
general and more specific restrictions. The fraudulent, deceptive and
manipulative practices provision in Section 4s(h)(4)(A), by its own
terms, is not limited to the advisory context or to swap dealers.\240\
---------------------------------------------------------------------------
\237\ In addition, Section 753 of the Dodd-Frank Act provided
the Commission with expanded anti-manipulative and deceptive
practices authority by amending Section 6(c) of the CEA. (7 U.S.C.
9). On July 14, 2011, the Commission published in the Federal
Register final rules to implement the new anti-manipulative and
deceptive practices authority. Prohibition on the Employment, or
Attempted Employment, of Manipulative and Deceptive Devices and
Prohibition on Price Manipulation, 76 FR 41398, Jul. 14, 2011
(``Prohibition on Manipulative and Deceptive Devices'') (to be
codified at 17 CFR part 180).
\238\ The Commission also proposed Sec. Sec. 23.410(b) and
23.410(c), which prohibited swap dealers and major swap participants
from disclosing confidential counterparty information and trading
ahead and front running counterparty orders, respectively. See
proposing release, 75 FR at 80642.
\239\ In addition to the proposed antifraud rule, swap dealers
and major swap participants are subject to all other applicable
provisions of the CEA and Commission Regulations, including those
dealing with fraud and manipulation (e.g., Sections 4b, 6(c)(1) and
(3), and 9(a)(2) of the CEA (7 U.S.C. 6b, 9(c)(1) and (3), and
13(a)(2)), and Sec. Sec. 180.1 and 180.2 (17 CFR 180.1 and 180.2)).
\240\ Section 4s(h)(4)(A) states: (A) In general. It shall be
unlawful for a swap dealer or major swap participant--(i) to employ
any device, scheme, or artifice to defraud any Special Entity or
prospective customer who is a Special Entity; (ii) to engage in any
transaction, practice, or course of business that operates as a
fraud or deceit on any Special Entity or prospective customer who is
a Special Entity; or (iii) to engage in any act, practice, or course
of business that is fraudulent, deceptive or manipulative.
---------------------------------------------------------------------------
Proposed Sec. 23.410(a) followed the statutory text and applied to
swap dealers and major swap participants acting in any capacity, e.g.,
as an advisor or counterparty.\241\ The first two paragraphs of the
proposed rule focused on Special Entities and prohibited swap dealers
and major swap participants from (1) employing any device, scheme or
artifice to defraud any Special Entity, and (2) engaging in any
transaction, practice or course of business that operates as a fraud or
deceit on any Special Entity. The third paragraph of the proposed rule
was not limited to conduct with Special Entities and prohibited swap
dealers and major swap participants from engaging in any act, practice
or course of business that is fraudulent, deceptive or
manipulative.\242\
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\241\ Proposing release, 75 FR at 80642.
\242\ This language mirrored the language in Section 206(4) of
the Investment Advisers Act of 1940 (``Advisers Act'') (15 U.S.C.
80b-1 et seq.), which does not require scienter to prove liability.
See SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992) (``[S]ection
206(4) uses the more neutral `act, practice, or course or business'
language. This is similar to [Securities Act] section 17(a)(3)'s
`transaction, practice, or course of business,' which `quite plainly
focuses upon the effect of particular conduct * * * rather than upon
the culpability of the person responsible.' Accordingly, scienter is
not required under section 206(4), and the SEC did not have to prove
it in order to establish the appellants' liability. * * *'')
(internal citations omitted).
---------------------------------------------------------------------------
b. Comments
The Commission received a number of comments both supporting and
opposing aspects of proposed Sec. 23.410(a). One commenter urged that
the fraud prohibition in Section 4s(h)(4) should apply only when a swap
dealer is acting as an advisor to a Special Entity.\243\ The commenter
asserted that, while the prohibitions of Section 4s(h)(4)(A) do not
themselves contain language limiting them to instances where a swap
dealer is an advisor, the title ``Special Requirements for Swap Dealers
Acting as Advisors'' should be read as limiting the scope of any rules
promulgated thereunder.\244\ The commenter further asserted that the
lack of scienter in proposed Sec. 23.410(a)(3) is particularly
misplaced as the language of Section 4s(h)(4)(A)(iii) mirrors Section
206(4) of the Investment Advisers Act of 1940 (``Advisers Act''),\245\
which is in the context of an advisor relationship, and that in cases
where there is not an advisor relationship, the scienter standards of
Rule 10b-5 \246\ under the Exchange Act should prevail.\247\ This
commenter stated that the Commission should adopt a scienter
requirement when a swap dealer or major swap participant acts merely as
a counterparty to a non-Special Entity and does not act as an advisor
as it would be unfair to subject swap dealers or major swap
participants, not acting as advisors, to liability without a showing of
bad faith.\248\ The Commission also received comments urging that
proposed Sec. 23.410(a) not be adopted as it is redundant of the rules
promulgated in part 180.\249\
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\243\ SIFMA/ISDA Feb. 17 Letter, at 10.
\244\ Id.
\245\ 15 U.S.C. 80b-6.
\246\ 17 CFR 240.10b-5.
\247\ SIFMA/ISDA Feb. 17 Letter, at 10.
\248\ Id.
\249\ See CEF Feb. 22 Letter, at 12; Barnard May 23 Letter, at
2.
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Other commenters supported proposed Sec. 23.410(a). One commenter
asserted that the rule prohibiting fraud and manipulation by swap
dealers and major swap participants is appropriate as long as these
principles are properly applied to swap markets.\250\ Another commenter
supported the proposed rule because it believed the rule was largely
consistent with the recommendations contained in the July 2009 report
of the Investors' Working Group,\251\ and another commenter believed it
would strengthen the protection of market participants, encourage
investor confidence and promote integrity within the financial
system.\252\ One commenter asserted that the title ``Special
Requirements for Swap Dealers Acting as Advisors'' should not limit the
scope of the rule where the statutory language is broad, applying to
``any device, scheme or artifice to defraud,'' and that Congress
intended to apply these principles to the broad range of conduct
engaged in by swap dealers and major swap participants with regard to
counterparties generally and Special Entities in particular.\253\ This
commenter believed that, under the proposed rule, it should be
considered an abusive practice to recommend a swap or trading strategy
that achieves the counterparty's aim in a way that includes risks to
the counterparty greater than those it seeks to hedge and to recommend
customized swaps where the counterparty could achieve the same result
at a lower cost through standardized swaps.\254\
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\250\ Exelon Feb. 22 Letter, at 4.
\251\ CII Feb. 10 Letter, at 1 (citing A Report by the
Investors' Working Group, An Independent Taskforce Sponsored by CFA
Institute Centre for Financial Market Integrity and Council of
Institutional Investors, U.S. Financial Regulatory Reform: The
Investors' Perspective (July 2009)).
\252\ CFA/AFR Feb. 22 Letter, at 1.
\253\ Id., at 6-7.
\254\ Id.
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c. Final Sec. 23.410(a) and (b)
After considering the comments, the Commission decided to adopt
Sec. 23.410(a) as proposed. Inclusion of the rule in subpart H of part
23 of the Commission's Regulations provides swap dealers, major swap
participants and counterparties with easy reference to the business
conduct requirements under Section 4s(h) of the CEA without any
additional cost to market participants.
With respect to the concern regarding the rule's protections for
counterparties other than Special Entities, Sec. 23.410(a) mirrors the
language of the statute. In addition, the prohibition against engaging
in ``any act, practice, or course of business that is fraudulent,
deceptive, or manipulative'' has been interpreted by the courts as
imposing a non-scienter standard under the Advisers Act.\255\ Even if
the Commission were to limit the rule to require proof of scienter and
apply the rule only when a swap dealer is acting as an advisor to a
Special Entity, that would not restrict a court from taking a plain
meaning approach to the language in Section 4s(h)(4) in a private
action under Section 22 of the CEA.\256\ In addition, because
comparable non-scienter fraudulent and
[[Page 9753]]
manipulative practices provisions will apply to SBS Entities in
enforcement actions under Sections 9(j) \257\ and 15F(h)(4) \258\ of
the Exchange Act and Sections 17(a)(2) and (3) of the Securities Act,
it would be inconsistent to impose a different intent standard for swap
dealers and major swap participants.\259\
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\255\ See discussion at fn. 242.
\256\ 7 U.S.C. 25.
\257\ Section 763(g) of the Dodd-Frank Act amended the Exchange
Act by adding Section 9(j), which states in relevant part that ``It
shall be unlawful for any person * * * to effect any transaction in
* * * any security-based swap, in connection with which such person
* * * engages in any transaction, practice, or course of business
which operates as a fraud or deceit upon any person.'' Courts have
interpreted ``operates as a fraud'' provisions under a non-scienter
standard. On November 8, 2010, the SEC published proposed rule 17
CFR 240.9j-1 in the Federal Register to clarify that the provisions
of Section 9(j) apply to fraud in connection with (1) entering into
a security-based swap and (2) the exercise of any right or
performance of any obligation under a security-based swap.
Prohibition Against Fraud, Manipulation, and Deception in Connection
With Security-Based Swaps, 75 FR 68560, Nov. 8, 2010.
\258\ This provision mirrors Section 4s(h)(4) of the CEA.
\259\ One commenter stated that that the CFTC and SEC should
harmonize their regulatory structures for combating disruptive and
manipulative activities. SIFMA/ISDA Feb. 17 Letter, at 10.
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Finally, in response to commenters who urged that it would be
unfair to subject swap dealers or major swap participants to the non-
scienter provision of the rule, the Commission decided to provide an
affirmative defense in final Sec. 23.410(b) for swap dealers and major
swap participants in cases alleging non-scienter violations of Sec.
23.410(a)(2) and (3) based solely on violations of the business conduct
standards rules in subpart H. The affirmative defense enables swap
dealers and major swap participants to defend against such claims by
establishing that they complied in good faith with written policies and
procedures reasonably designed to meet the requirements of the
particular rule that is the basis for the alleged Sec. 23.410(a)(2) or
(3) violation. Whether the affirmative defense is established will
depend on the facts and circumstances of the case. However, by way of
non-exclusive example, a swap dealer or major swap participant would be
unable to establish that it acted in good faith if the evidence showed
that it acted intentionally or recklessly in connection with the
violation. Similarly, policies and procedures that were outdated or
failed to address the scope of swap business conducted by the swap
dealer or major swap participant would not be considered reasonable.
With respect to whether any particular type of conduct would be
abusive within the prohibitions under final Sec. 23.410(a) as urged by
commenters, the Commission will evaluate the facts and circumstances of
any particular case in light of the elements of an offense under the
final rule. This is consistent with the approach that the Commission
took in adopting Sec. 180.1.\260\
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\260\ In the release promulgating Commission Regulation Sec.
180.1, the Commission stated: ``In response to commenters requesting
that front running and similar misuse of customer information be
considered a form of fraud-based manipulation under final Rule
180.1, the Commission declines to adopt any per se rule in this
regard, but clarifies that final Rule 180.1 reaches all manner of
fraud and manipulation within the scope of the statute it
implements, CEA section 6(c)(1).'' Prohibition on Manipulative and
Deceptive Devices, 76 FR at 41401.
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2. Section 23.410(c)--Confidential Treatment of Counterparty
Information
a. Proposed Sec. 23.410(b)
The Commission proposed Sec. 23.410(b) (renumbered as final Sec.
23.410(c)), which prohibited swap dealers and major swap participants
from disclosing confidential counterparty information,\261\ using its
discretionary rulemaking authority under Section 4s(h)(1)(A).\262\ The
proposed rule extended existing Commission standards that protect the
confidentiality of customer orders.
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\261\ Proposing release, 75 FR at 80642.
\262\ Senator Lincoln noted in a colloquy that the Commission
should adopt rules to ensure that swap dealers maintain the
confidentiality of hedging and portfolio information provided by
Special Entities, and prohibit swap dealers from using information
received from a Special Entity to engage in trades that would take
advantage of the Special Entity's positions or strategies. 156 Cong.
Rec. S5923 (daily ed. July 15, 2010) (statement of Sen. Lincoln). In
consultations with stakeholders, Commission staff learned that these
concerns are shared by counterparties more generally. As a result,
the Commission proposed that the business conduct rules include
prohibitions on these types of activities in all transactions
between swap dealers or major swap participants and their
counterparties. See proposing release, 75 FR at 80658.
---------------------------------------------------------------------------
b. Comments
The Commission received comments regarding the proposed prohibition
against disclosing confidential counterparty information. One commenter
stated that the confidentiality of counterparty information should be
left to private negotiation rather than imposed by Commission
rule.\263\ The commenter urged that if the Commission determines to
promulgate a rule protecting the confidentiality of such information,
the Commission should alternatively require swap dealers and major swap
participants to establish, maintain and enforce policies and procedures
reasonably designed to prevent the improper use or disclosure of any
counterparty information that the swap dealer or major swap participant
has agreed with the counterparty to keep confidential.\264\ The
commenter also stated that the confidentiality rule should be
implemented as an SRO rule and should allow sophisticated
counterparties to opt out of heightened protections they may not want
or need.\265\ The commenter expressed concern that the proposed rule
would restrict swap dealers and major swap participants in properly
servicing counterparties through discussions with the swap dealer's or
major swap participant's affiliates.\266\ Further, the commenter
asserted that there would be facts and circumstances that would warrant
particular disclosures in certain contexts.\267\
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\263\ SIFMA/ISDA Feb. 17 Letter, at 11.
\264\ Id.
\265\ Id.
\266\ Id., at 10-11.
\267\ Id., at 11.
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Another commenter asserted that the confidential treatment and
trading ahead rules should not apply to major swap participants because
they are customers of swap dealers and should be treated as such,
rather than as dealers or quasi-dealers.\268\ Another commenter stated
that the Commission should avoid specifying in detail the conduct that
would violate the rule because doing so could have unintended
consequences of limiting its scope. This commenter stated that a broad,
enforceable principles based approach is the best approach for
promoting market integrity.\269\
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\268\ MetLife Feb. 22 Letter, at 4-5.
\269\ CFA/AFR Feb. 22 Letter, at 12.
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c. Final Sec. 23.410(c)
Upon consideration, the Commission has determined to adopt proposed
Sec. 23.410(b) (renumbered as Sec. 23.410(c)) with several changes.
First, the final rule has been changed to also permit swap dealers and
major swap participants \270\ to disclose confidential information to
an SRO designated by the Commission or as required by law. The proposed
rule addressed disclosure only to the CFTC, Department of Justice
(``DOJ'') and applicable prudential regulators. Second, the Commission
has clarified that the final rule will protect confidential
counterparty information from disclosure to third parties, as well as
from improper use by the swap dealer
[[Page 9754]]
or major swap participant. It is not intended to restrict the necessary
and appropriate use of the information by the swap dealer or major swap
participant, but is intended to address material conflicts of interest
that must be identified and managed to avoid trading or other
activities on the basis of confidential counterparty information that
would tend to be materially adverse to the interests of the
counterparty.\271\ By promulgating final Sec. 23.410(c), the
Commission does not intend to prohibit legitimate trading activities,
which, depending on the facts and circumstances, would include, among
other things, (1) bona fide risk-mitigating and hedging activities in
connection with the swap, (2) purchases or sales of the same or similar
types of swaps consistent with commitments of the swap dealer or major
swap participant to provide liquidity for the swap, or (3) bona-fide
market-making in the swap.\272\
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\270\ The Commission has determined to impose the final rule on
both swap dealers and major swap participants, which is consistent
with the application of Section 4s(h)(4)(A), prohibiting
manipulative, deceptive and fraudulent practices, to both swap
dealers and major swap participants.
\271\ The final rule is aimed at improper disclosure of the
counterparty's position, the transaction and the counterparty's
intentions to enter or exit the market, which may be detrimental to
the interests of the counterparty.
\272\ The Commission notes by analogy that Section 621 of the
Dodd-Frank Act, to be codified at Section 27B of the Securities Act
(15 U.S.C. 77z-2a), provides for exceptions to the conflict of
interest prohibitions in that section for risk-mitigating hedging
activities in connection with an asset-backed security, purchases or
sales made consistent with commitments to the underwriter or others
to provide liquidity for the asset-backed security, or bona-fide
market making in the asset-backed security. The Commission's final
Sec. 23.410(c) provides for exceptions for disclosure and use for
effective execution of the order, risk mitigation and hedging, and
when authorized in writing by the counterparty.
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The final rule requires swap dealers and major swap participants to
have written policies and procedures reasonably designed to protect
material confidential information provided by or on behalf of a
counterparty from disclosure and use by any person acting for or on
behalf of the swap dealer or major swap participant. Such policies and
procedures should be designed to identify and manage material conflicts
of interest between a swap dealer or major swap participant and a
counterparty through, for example, information barriers and
restrictions on access to confidential counterparty information on a
``need-to-know'' basis.\273\ Information barriers can be used to
restrict the dissemination of information within a complex organization
and to prevent material conflicts by limiting knowledge and
coordination of specific business activities among different units of
the entity. Examples of information barriers include restrictions on
information sharing, limits on types of trading and greater separation
between various functions of the firm. Such information barriers have
been recognized in the federal securities laws and rules as a means to
address or mitigate potential conflicts of interest or other
inappropriate activities within an organization.
---------------------------------------------------------------------------
\273\ For example, the Commission expects that the swap dealer
would generally have information barriers between its sales desk and
proprietary trading desk.
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Depending on the facts and circumstances, the Commission would
consider it to be an abuse of confidential counterparty information for
a swap dealer or major swap participant to disclose or use such
information for its own benefit if such use or disclosure would tend to
be materially adverse to the interests of the counterparty.\274\ Final
Sec. 23.410(c) does not prohibit disclosure or use that is necessary
for the effective execution of any swap for or with the counterparty,
to hedge or mitigate any exposure created by such swap or to comply
with a request of the Commission, DOJ, any SRO designated by the
Commission, or applicable prudential regulator, or is otherwise
required by law.
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\274\ The financial industry has long-held standards relating to
confidential treatment of counterparty information similar to those
set forth in the final rule. While not endorsing any particular
industry practice, the Commission notes, for example, that one
industry group has recommended that financial institutions ``have
internal written policies and procedures in place governing the use
of and access to proprietary information provided to them by trading
counterparties as a basis for credit evaluations.'' Improving
Counterparty Risk Management Practices, Counterparty Risk Management
Policy Group (June 1999) (``CRMPG I Report''), at 5; see also Toward
a Greater Financial Stability: A Private Sector Perspective,
Counterparty Risk Management Policy Group (July 2005) (``CRMPG II
Report''), at 47 (recommending that firms evaluate operational risks
with customized legal documents that deviate from a firm's existing
procedures for handing confidential counterparty information). Also
without endorsement by the Commission, one firm's code of conduct
states that employees ``must maintain the confidentiality of the
information with which you are entrusted, including complying with
information barriers procedures applicable to your business. The
only exception is when disclosure is authorized or legally mandated.
* * * Confidential or proprietary information * * * provided by a
third party [is provided with] the expectation that the information
will be kept confidential and used solely for the business purpose
for which it was conveyed.'' Goldman Sachs Code of Business Conduct
and Ethics (amended, effective January 11, 2011).
---------------------------------------------------------------------------
In response to the commenter that expressed concern that the
proposed rule would restrict swap dealers and major swap participants
in properly servicing counterparties through discussions with the swap
dealer's or major swap participant's affiliates,\275\ it is not the
intent of the rule to prohibit certain interactions needed to execute
the swap but is to ensure that the counterparty's confidential
information is disseminated only on a ``need to know'' basis. Further,
in response to a commenter that stated that there may be facts or
circumstances that would warrant particular disclosures or uses in
certain contexts,\276\ the Commission included a provision in the rule
that allows for use or disclosure of confidential counterparty
information if authorized in writing by the counterparty.
---------------------------------------------------------------------------
\275\ See SIFMA/ISDA Feb. 17 Letter, at 10-11.
\276\ See id., at 11.
---------------------------------------------------------------------------
The Commission decided it is appropriate to establish an explicit
confidential treatment duty for swap dealers and major swap
participants with respect to confidential counterparty information.
Because swap dealers and major swap participants principally act as
counterparties rather than as agents or brokers (unlike FCMs), in the
absence of such an explicit duty, it could be more difficult to
establish that disclosure or misuse of confidential counterparty
information is fraudulent, deceptive or manipulative. Depending on the
facts and circumstances, however, as set forth in final Sec.
23.410(b), good faith compliance with reasonably designed policies and
procedures will constitute an affirmative defense to a non-scienter
violation of final Sec. 23.410(a)(2) or (3) for improper disclosure or
abuse of counterparty information.
The Commission considered the commenter's suggestion that
confidential treatment of counterparty information should be left to
negotiation between counterparties or, alternatively, be implemented as
an SRO rule or on an opt in or opt out basis.\277\ The Commission
determined that such alternatives would be inconsistent with Congress'
intent that the Commission promulgate rules that raise business conduct
standards for the protection of all counterparties.\278\ The final rule
is in accordance with current industry practices where confidential
treatment is routinely part of negotiations among the parties that is
then incorporated into the counterparty relationship
documentation.\279\
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\277\ See SIFMA/ISDA Feb. 17 Letter, at 11.
\278\ See Section III.A.1. of this adopting release for a
discussion of ``Discretionary Rules'' and ``Opt in or Opt out for
Certain Classes of Counterparties.''
\279\ See SIFMA/ISDA Feb. 17 Letter, at 11 (stating that the
definition, treatment, use and disclosure of confidential
information are routinely the subject of negotiation between the
parties).
---------------------------------------------------------------------------
Adopting a confidential treatment rule will ensure that all
counterparties, irrespective of their negotiating power, will be able
to protect their confidential
[[Page 9755]]
information from disclosure and abuse by swap dealers and major swap
participants. Counterparties will continue to be free to negotiate
additional protections based on their individual needs. By establishing
such a duty, the Commission is not changing the ``counterparty'' nature
of the relationship between a swap dealer or major swap participant and
a counterparty. Nor is the Commission imposing a general fiduciary duty
on swap dealers or major swap participants. Violation of the
confidential treatment duty, however, depending on the facts and
circumstances, could constitute a fraudulent, deceptive or manipulative
practice.
3. Proposed Sec. 23.410(c)--Trading Ahead and Front Running
Prohibited--Not Adopted as Final Rule
a. Proposed Sec. 23.410(c)
The Commission proposed Sec. 23.410(c), which prohibited swap
dealers and major swap participants from front running or trading ahead
of counterparty swap transactions.\280\ The proposed rule was based on
trading standards applicable to FCMs and introducing brokers that
prohibit trading ahead of customer orders.\281\
---------------------------------------------------------------------------
\280\ Proposing release, 75 FR at 80642.
\281\ See, e.g., 17 CFR 155.3-4.
---------------------------------------------------------------------------
b. Comments
One commenter urged that the Commission not adopt the trading ahead
and front running rule or, in the alternative, apply the rule only when
the swap dealer or major swap participant has an executable order and
not when a swap is still under negotiation.\282\ The commenter asserted
that the prohibition on trading during the negotiation of a swap fails
to appreciate the distinction between bilateral swaps and orders for
standardized products, as bilateral swap terms must be negotiated,
which can take weeks or months, and counterparties may negotiate with
multiple dealers to obtain the best price.\283\ The commenter further
asserted that enforcement of a front running ban would be untenable,
disruptive to the market and prevent hedging activity related either to
the pending transaction or the other liabilities of the swap dealer or
major swap participant.\284\ The commenter urged that, if the
Commission were to adopt the proposed rule, then it should prohibit
only a transaction (1) that is entered into for a non-hedging purpose
on the basis of actual knowledge of a non-public, executable order of a
counterparty, (2) that exhibits consistent and estimable positive price
correlation to the pending executable counterparty swap transaction,
and (3) whose execution is substantially likely to materially affect
the price of that pending executable swap transaction.\285\ The
commenter asserted that, without an actual knowledge standard, the
proposed rule would prohibit transactions by other parts of an
organization not privy to the order.\286\ Finally, the commenter urged
the Commission to clarify its proposed ``specific'' consent standard
and the duration of the prohibition.\287\
---------------------------------------------------------------------------
\282\ SIFMA/ISDA Feb. 17 Letter, at 13.
\283\ Id., at 12.
\284\ Id.
\285\ Id., at 13.
\286\ Id.
\287\ Id.
---------------------------------------------------------------------------
In addition, the commenter urged the Commission to clarify that the
following trades would not be considered front running under proposed
Sec. 23.410(c): (1) When a swap dealer or major swap participant
enters a trade at the request of another customer; (2) when the
specifics of a pending counterparty transaction are as yet undefined;
(3) when a swap dealer or major swap participant trades in the ordinary
course of hedging other transactions, assets or liabilities; (4) when
there is not a clear price-related nexus to the pending swap
transaction; (5) if the transaction would not affect the counterparty;
and (6) if the transaction is an anticipatory hedge of the subject
transaction and disclosed to the counterparty.\288\ The commenter also
urged that the prohibition should only exist until the transaction is
executed or cancelled, or the relevant information ceases to be
material, non-public information, and the proposed rule should not
require further specific consent to trade with respect to specific
transactions at specific times.\289\
---------------------------------------------------------------------------
\288\ Id., at 13-14.
\289\ Id.
---------------------------------------------------------------------------
Another commenter stated that it did not object to applying the
front running prohibition to trades executable on a DCM and for which a
swap dealer or major swap participant is merely an intermediary.\290\
However, the commenter believed proprietary trading desks should be
able to trade freely as long as they are unaware of the counterparty's
order.\291\ Without such a limitation, the commenter asserted, swap
dealers may have little incentive to accept swap orders that can be
executed electronically or may refuse to accept orders for such
transactions altogether.\292\
---------------------------------------------------------------------------
\290\ CEF Feb. 22 Letter, at 10-11.
\291\ Id.
\292\ Id., at 11.
---------------------------------------------------------------------------
Further, the commenter urged that the proposed front running
prohibition should not apply to bilaterally negotiated and settled
swaps. Since some swaps take months to negotiate, the commenter
believed front running rules would severely limit a swap dealer's
ability to be in the market.\293\ The commenter stated that front
running should be defined in a manner more appropriate for the swaps
markets as the present definition could be interpreted to force a swap
dealer to stop, or severely limit, physical trading related to the
swap.\294\ The commenter urged the Commission to eliminate the front
running rules or to exclude swap markets with actual physical
underlying commodities from such rules.\295\
---------------------------------------------------------------------------
\293\ Id.
\294\ Id.
\295\ Id.
---------------------------------------------------------------------------
Another commenter stated that the proposed rule is tailored to a
securities broker-dealer model and is not suited to the commodities
market.\296\ The commenter asserted that instruments relating to
derivatives of an underlying physical market are not susceptible to
insider trading or broker-dealer abuses, and that the disclosures
required in proposed Sec. 23.410(c) would chill the open interaction
that occurs between counterparties in a competitive swaps market.\297\
---------------------------------------------------------------------------
\296\ Exelon Feb. 22 Letter, at 3.
\297\ Id.
---------------------------------------------------------------------------
Another commenter stated that prohibiting front running would have
unintended consequences that would, along with other proposed rules,
increase the administrative and compliance burden on swap dealers.\298\
The combined effect of the proposed rules, the commenter asserted,
would slow the process of swap trading and increase costs by requiring
additional time, effort, and risks taken in trading swaps.\299\
---------------------------------------------------------------------------
\298\ HOOPP Feb. 22 Letter, at 2.
\299\ Id.
---------------------------------------------------------------------------
One commenter that generally supported the proposed rule
recommended imposing a time limit on the trading ahead prohibition for
swaps under negotiation and believed swap dealers should be required to
disclose the time limit to counterparties.\300\ Alternatively, the
commenter urged that swap dealers should have reasonable grounds for
believing the counterparty does not intend to enter into the
transaction in the near future.\301\
---------------------------------------------------------------------------
\300\ CFA/AFR Feb. 22 Letter, at 7.
\301\ Id.
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[[Page 9756]]
Another commenter that supported the proposed rule urged that the
entire front running section be removed because it is duplicative of
the rules promulgated by the Commission under Section 6(c)(1) of the
CEA (the new general fraudulent, deceptive and manipulative practices
provision).\302\
---------------------------------------------------------------------------
\302\ CEF Feb 22 Letter, at 12; see also Prohibition on
Manipulative and Deceptive Devices, 76 FR 41398.
---------------------------------------------------------------------------
c. Commission Determination
The Commission has considered the comments and has determined not
to promulgate proposed Sec. 23.410(c). The fraudulent, deceptive and
manipulative practices rule in final Sec. 23.410(a), coupled with the
confidential treatment rule in final Sec. 23.410(c), should
effectively protect counterparties from abuse of their material
confidential information by swap dealers and major swap
participants.\303\ The Commission agrees with the commenter that stated
that, depending on the facts and circumstances, improperly trading
ahead or front running counterparty orders would constitute fraudulent,
deceptive or manipulative conduct under final Sec. 23.410(a) and Sec.
180.1, among other fraudulent, deceptive and manipulative practices
protections under the CEA and Commission Regulations.
---------------------------------------------------------------------------
\303\ The Commission's other deceptive and manipulative
practices provisions, including Sections 4b and 6(c)(1) of the CEA
and Sec. 180.1 of the Commission's Regulations also prohibit
trading ahead and front running.
---------------------------------------------------------------------------
In response to commenters seeking clarity as to the types of
transactions that would constitute illegal trading ahead or front
running by a swap dealer or major swap participant, the Commission
declines to adopt the request of certain commenters to list the trades
or specific situations that would not be considered illegal trading
ahead or front running in violation of the anti-fraud and confidential
treatment rules in final Sec. 23.410(a) and final Sec. 23.410(c),
respectively. The Commission expects swap dealers and major swap
participants to implement policies and procedures, including
establishing appropriate information barriers and other means to
protect material confidential counterparty information, that would
allow the swap dealer or major swap participant to continue to provide
liquidity in the swap or engage in bona-fide market-making in the swap.
The Commission states, however, that use of confidential counterparty
information to trade ahead of or front run a counterparty's order would
tend to be materially adverse to the interests of the counterparty,
depending on the facts and circumstances, and would be considered an
abuse of final Sec. Sec. 23.410(a) and (c), among other similar
protections under the CEA and Commission Regulations.
The Commission's decision not to adopt proposed Sec. 23.410(c) was
informed by commenters who stated that the proposed rule would have
unintended consequences of severely hampering the ability of swap
dealers and major swap participants to conduct swaps business and would
have the potential to impose additional costs on swap transactions.
While abuse of counterparty information, including trading ahead, will
still be prohibited under the manipulative, deceptive and fraudulent
practices rule in final Sec. 23.410(a) and the confidential treatment
rule in final Sec. 23.410(c), among other provisions, the approach
adopted by the Commission should eliminate the uncertainties identified
by commenters in the proposed trading ahead and front running rule, and
allow legitimate trading by swap dealers and major swap participants.
The Commission, however, will continue to monitor market conduct to
determine whether, in the future, there is a need to address explicitly
abuses related to trading ahead and front running of counterparty swap
transactions.
C. Section 23.430--Verification of Counterparty Eligibility
1. Proposed Sec. 23.430
The Dodd-Frank Act makes it unlawful for any person, other than an
ECP,\304\ to enter into a swap unless it is executed on or subject to
the rules of a DCM.\305\ Section 4s(h)(3)(A) also requires the
Commission to establish a duty for swap dealers and major swap
participants to verify that any counterparty meets the eligibility
standards for an ECP. Proposed Sec. 23.430 required swap dealers and
major swap participants to verify that a counterparty meets the
definition of an ECP prior to offering to enter into or entering into a
swap and to determine whether the counterparty is a Special Entity as
defined in Section 4s(h)(2)(C) and proposed Sec. 23.401.\306\
---------------------------------------------------------------------------
\304\ ``Eligible contract participant'' is a defined term in
Section 1a(18) of the CEA. (7 U.S.C. 1a(18)).
\305\ See Section 2(e) of the CEA. (7 U.S.C. 2(e)).
\306\ Proposing release, 75 FR at 80643.
---------------------------------------------------------------------------
The Commission contemplated that, in the absence of ``red flags,''
and as provided in proposed Sec. 23.402(e), a swap dealer or major
swap participant would be permitted to rely on reasonable written
representations of a potential counterparty to establish its
eligibility as an ECP. In addition, under proposed Sec. 23.402(g),
such written representations could be expressed in a master agreement
or other written agreement and, if agreed to by the parties, could be
deemed to be renewed with each subsequent swap transaction, absent any
facts or circumstances to the contrary. Finally, as set forth in
proposed Sec. 23.430(c), a swap dealer or major swap participant would
not be required to verify the ECP or Special Entity status of the
counterparty for any swap initiated on a SEF where the swap dealer or
major swap participant does not know the identity of the
counterparty.\307\
---------------------------------------------------------------------------
\307\ This provision was informed by the statutory language in
Sections 2(e) and 4s(h)(7).
---------------------------------------------------------------------------
2. Comments
The Commission received several comments regarding proposed Sec.
23.430.\308\ Two commenters recommended that swap dealers and major
swap participants be able to rely principally on counterparty
representations regarding eligibility.\309\ It was asserted that only
actual notice of countervailing facts or facts that reasonably put the
swap dealer or major swap participant on notice should trigger a duty
to inquire further, consistent with industry practice.\310\ One
commenter supported sufficiently detailed representations to facilitate
eligibility determinations and regulatory compliance audits.\311\ Other
commenters requested that the proposed rule be amended to specifically
allow counterparties to make eligibility representations in master
agreements.\312\ A different commenter recommended that the Commission
sponsor and promote standardized due diligence documentation to
facilitate compliance, reduce costs and promote legal certainty.\313\
Certain commenters questioned whether the verification duty was an
ongoing duty throughout the life of the swap.\314\ Two commenters
[[Page 9757]]
suggested amending the rule to require an update whenever there is a
change impacting a counterparty's eligibility or status.\315\ A
commenter recommended additional guidance regarding red flags and the
nature and timing of evidence necessary to establish ECP status.\316\
Lastly, a commenter supported the proposed exemption from the
verification duty for SEF and DCM transactions.\317\
---------------------------------------------------------------------------
\308\ See SIFMA/ISDA Feb. 17 Letter, at 15-16; CFA/AFR Feb. 22
Letter, at 8; CEF Feb. 22 Letter, at 12, 19 and 20; FHLBanks Feb. 22
Letter, at 4-5; APGA Feb. 22 Letter, at 2-3.
\309\ See SIFMA/ISDA Feb. 17 Letter, at 16 (recommending no
affirmative duty to investigate representations or obtain detailed
factual representations). Accord CEF Feb. 22 Letter, at 12, 19 and
20.
\310\ SIFMA/ISDA Feb. 17 Letter, at 16 fn. 35 (citing Regulation
D (17 CFR 230.501-508) and Rule 144A (17 CFR 230.144A) transactional
practice under the federal securities laws).
\311\ CFA/AFR Feb. 22 Letter, at 8.
\312\ See, e.g., NFA Aug. 25, 2010 Letter, at 2; SIFMA/ISDA Feb.
17 Letter, at 16; APGA Feb. 22 Letter, at 2-3.
\313\ FHLBanks Feb. 22 Letter, at 4.
\314\ SIFMA/ISDA Feb. 17 Letter, at 16. In addition, the
commenter questioned whether the loss of ECP status would limit the
counterparty's ability to terminate, modify or novate the swap.
\315\ CFA/AFR Feb. 22 Letter, at 8; SIFMA/ISDA Feb. 17 Letter,
at 16 (asserting that swap dealers and major swap participants
should be able to rely on eligibility representations deemed to be
made at the inception of each swap transaction and covenant to
notify if ECP status ceases).
\316\ CFA/AFR Feb. 22 Letter, at 8.
\317\ CEF Feb. 22 Letter, at 12.
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3. Final Sec. 23.430
After considering the comments, the Commission has determined to
adopt the rule with three changes. First, the Commission is adding a
new Sec. 23.430(c), Special Entity election, which will require a swap
dealer or major swap participant to determine whether a counterparty is
eligible to elect to be a Special Entity and notify such counterparty
as provided for in the Special Entity definition in final Sec.
23.401(c)(6).\318\ Second, the Commission has added a new safe harbor,
Sec. 23.430(d), to clarify that a swap dealer or major swap
participant may rely on written representations of counterparties to
meet the requirements in the rule. Third, the Commission is clarifying
that the exemption from verification applies to all transactions on a
DCM and to anonymous transactions on a SEF.
---------------------------------------------------------------------------
\318\ This addition is related to the Commission's
determinations regarding the final Special Entity definition
relating to certain Special Entities defined in Section 3 of ERISA.
See Section IV.A. of this adopting release.
---------------------------------------------------------------------------
In addition, the Commission is providing the following guidance in
response to the comments it received. A swap dealer or major swap
participant must determine ECP and Special Entity status before
offering to enter into or entering into a swap.\319\ Counterparties
will be able to make representations about their status at the outset
of a transaction or in counterparty relationship documentation and
update that representation if there is a change in status.\320\ Parties
will not be required to terminate a swap based solely on a change in
the counterparty's ECP status during the term of the swap.
---------------------------------------------------------------------------
\319\ OTC derivatives industry best practice advises
professional intermediaries, prior to entering into any transaction,
to evaluate the counterparty's legal capacity, transactional
authority and credit. See DPG Framework, at Section V.III.B.
\320\ The Commission expects swap dealers and major swap
participants to have policies and procedures in place that require
the review of counterparty relationship documentation to ensure that
representations and disclosures under subpart H of part 23 remain
accurate. Such review should be part of its annual compliance review
in accordance with subpart J of part 23. See proposed Sec. Sec.
23.600 and 23.602, Governing Duties of Swap Dealers, 75 FR 71397.
---------------------------------------------------------------------------
In addition, swap dealers and major swap participants may rely on
the written representations of counterparties in the absence of red
flags. With respect to the level of detail required in the
representation, a swap dealer or major swap participant will be deemed
to have a ``reasonable basis'' to rely on a representation that a
counterparty is eligible under the rule if the counterparty identifies
the paragraph of the ECP definition plus, in the case of a Special
Entity, the paragraph of the Special Entity definition that applies to
it, and the swap dealer or major swap participant does not have a
reason to believe the representation is inaccurate. In the absence of
counterparty representations, the swap dealer or major swap participant
will have to engage in sufficient due diligence to have a reasonable
basis to believe that the counterparty meets the eligibility standards
for an ECP and whether it is a Special Entity.
Further, the Commission is not adopting standardized due diligence
documentation at this time. The rule is principles based and allows the
parties flexibility in developing efficient means to address the
requirements of the rule. By providing non-exclusive guidance as to the
types of representations that will meet the ``reasonable basis''
standard, the Commission believes that the parties will be able to
comply with the rule without incurring undue cost. Lastly, the
Commission is confirming that, with respect to transactions initiated
on a SEF, the verification exemption is only applicable to anonymous
transactions consistent with Section 4s(h)(7). The proposed exemption
from the verification duty did not mention DCM transactions, unlike
Section 4s(h)(7) of the CEA, because Section 2(e) of the CEA does not
limit participation in DCM swap transactions to ECPs. However, for the
sake of clarity, the Commission has added language to final Sec.
23.430 that confirms that swap dealers and major swap participants do
not have to verify ECP status for DCM transactions, whether anonymous
or otherwise.
D. Section 23.431--Disclosure of Material Risks, Characteristics,
Material Incentives and Conflicts of Interest Regarding a Swap
Proposed Sec. 23.431 is a multipart rule that tracks Section
4s(h)(3)(B) of the CEA. Based on the structure of and comments relating
to proposed Sec. 23.431, the following discussion is divided into six
sections: Proposed Sec. 23.431--generally; material risk disclosure;
scenario analysis; material characteristics; material incentives and
conflicts of interest; and daily mark. Each of the six sections
includes a summary of the proposed subsections of Sec. 23.431, public
comments, and a description of the final rule and Commission guidance.
1. Proposed Sec. 23.431--Generally
Section 4s(h)(3)(B) of the CEA requires swap dealers and major swap
participants to disclose to their counterparties material information
about the risks, characteristics, incentives and conflicts of interest
regarding the swap. The requirements do not apply if both
counterparties are any of the following: Swap dealer; major swap
participant; or SBS Entities. Proposed Sec. 23.431 implemented the
statutory disclosure requirements and provided specificity with respect
to certain types of material information that must be disclosed under
the rule. The Commission stated that information is material if there
is a substantial likelihood that a reasonable counterparty would
consider it important in making a swap-related decision.\321\ The Dodd-
Frank Act does not address the timing and form of the required
disclosures. To satisfy its disclosure obligation, swap dealers and
major swap participants would be required to make such disclosures at a
time prior to entering into the swap and in a manner that was
reasonably sufficient to allow the counterparty to assess the
disclosures.\322\ Swap dealers and major swap participants would have
flexibility to make these disclosures using reliable means agreed to by
the counterparties, as provided in proposed Sec. 23.402(f).\323\ The
proposed rules allowed standardized disclosure of
[[Page 9758]]
some required information, where appropriate, if the information is
applicable to multiple swaps of a particular type or class.\324\ The
Commission noted, however, that most bespoke transactions would require
some combination of standardized and particularized disclosures.\325\
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\321\ Proposing release, 75 FR at 80643; cf. CFTC v. R.J.
Fitzgerald & Co., 310 F.3d 1321, 1328-29 (11th Cir. 2002) (``A
representation or omission is `material' if a reasonable investor
would consider it important in deciding whether to make an
investment.) (citing Affiliated Ute Citizens of Utah v. United
States, 406 U.S. 128, 153-54 (1972)).
\322\ Proposing release, 75 FR at 80643.
\323\ Additionally, under proposed Sec. 23.402(h), swap dealers
and major swap participants were required to maintain a record of
their compliance with the proposed rules.
\324\ Cf. SIFMA/ISDA Oct. 22, 2010 Letter, at 12 (recommending
the use of standard disclosure templates that could be adopted on an
industry-wide basis, with disclosure requirements satisfied by a
registrant on a relationship (rather than a transaction-by-
transaction) basis in cases where prior disclosures apply to and
adequately address the relevant transaction).
\325\ Proposing release, 75 FR at 80643.
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2. Comments--Generally
Commenters had a variety of general concerns with the disclosure
rules including: (1) The proposed rules should be tailored to the
institutional swaps market, not retail futures or securities markets;
\326\ (2) the proposed rules should not apply when a counterparty is a
certain size and level of sophistication; \327\ (3) counterparties
should be able to opt in to or opt out of the proposed rules; \328\ (4)
the proposed rules alter the relationship between counterparties and
swap dealers or major swap participants; \329\ (5) the Commission
should coordinate with the SEC and DOL to ensure that the proposed
rules do not trigger ERISA fiduciary status or municipal advisor
status; \330\ (6) only mandatory statutory rules should be promulgated
at this time and discretionary rules (e.g., scenario analysis) should
be delayed; \331\ (7) the statute does not require the same rules for
both swap dealers and major swap participants; different, less
burdensome rules consistent with the statute should be drawn for major
swap participants; \332\ (8) uncertainty regarding compliance with
principles based disclosure rules; \333\ and (9) the costs outweigh the
benefits of the proposed rule.\334\
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\326\ See SIFMA/ISDA Feb. 17 Letter, at 3-4 and 18; COPE Feb. 22
Letter, at 3-5; VRS Feb. 22 Letter, at 3-4; Exelon Feb. 22 Letter,
at 2-4; CEF Feb. 22 Letter, at 2-4; NY City Bar Feb. 22 Letter, at
2.
\327\ See VRS Feb. 22 Letter, at 1 and 4; NACUBO Feb. 22 Letter,
at 3-4; HOOPP Feb. 22 Letter, at 3; CEF Feb. 22 Letter, at 4-5.
\328\ See VRS Feb. 22 Letter, at 4; NACUBO Feb. 22 Letter, at 3-
4; ABC/CIEBA Feb. 22 Letter, at 13.
\329\ See BlackRock Feb. 22 Letter, at 2; CEF Feb. 22 Letter, at
3-4 and 8.
\330\ See Rep. Bachus Mar 15 Letter, at 1-3; SIFMA/ISDA Feb. 17
Letter, at 9; BlackRock Feb. 22 Letter, at 2 and 6; ABC/CIEBA Feb.
22 Letter, at 2-3; ERIC Feb. 22 Letter, at 2-3; AFSCME Feb. 22
Letter, at 4-5; AMG-SIFMA Feb. 22 Letter, at 8-9.
\331\ See BlackRock Feb. 22 Letter, at 2; SIFMA/ISDA Feb. 17
Letter, at 3; CEF Feb. 22 Letter, at 8.
\332\ See MFA Feb. 22 Letter, at 1-3; BlackRock Feb. 22 Letter,
at 2; MetLife Feb. 22 Letter, at 1 and 4-5; CEF Feb. 22 Letter, at
5-6.
\333\ See, e.g., FHLBanks Feb. 22 Letter, at 3-4; FHLBanks June
3 Letter, at 8-9; NY City Bar Feb. 22 Letter, at 2; SIFMA/ISDA Feb.
17 Letter, at 4 and 16-18. Contra CFA/AFR Feb. 22 Letter, at 18.
\334\ See BlackRock Feb. 22 Letter, at 6-7; VRS Feb. 22 Letter,
at 3-4; MFA Feb. 22 Letter, at 5-6; HOOPP Feb. 22 Letter, at 2-3;
ABC/CIEBA Feb. 22 Letter, at 13; COPE Feb. 22 Letter, at 2-4; COPE
June 3 Letter, at 5-6; Exelon Feb. 22 Letter, at 2-3; ETA June 3
Letter, at 20-21; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22
Letter, at 2.
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3. Final Sec. 23.431--Generally
Regarding the comment that the proposed rule should be tailored to
the institutional swaps market, not retail futures or securities
market, as indicated in the proposing release, the disclosure rules
follow the statute and are informed by industry practices and best
practice recommendations. The Commission reviewed OTC derivatives
industry reports, as well as futures and securities regulations and
related SRO business conduct rules, prior to drafting the rule.\335\ In
particular, reports by the Derivatives Policy Group (``DPG'') and
Counterparty Risk Management Policy Group (``CRMPG'') included industry
best practice recommendations regarding product disclosures.\336\ These
OTC derivatives industry reports confirmed that the industry is
familiar with product disclosure. In addition, a commenter reported
that:
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\335\ Proposing release, 75 FR at 80639.
\336\ See DPG Framework, supra fn. 178; CRMPG I Report, supra
fn. 274; CRMPG II Report, supra fn. 274; CRMPG III Report, supra fn.
228.
Swap dealers also generally distribute to their end-user
counterparties at the outset of a new swap relationship standardized
documentation setting forth the material characteristics, risks and
conflicts of interest with respect to the swaps to be entered into
with such end-user counterparty under an ISDA Master Agreement or
other master documentation.\337\
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\337\ See FHLBanks Feb. 22 Letter, at 2.
Moreover, the plain language of Section 4s(h)(3)(B) requires disclosure
of the material risks, characteristics, incentives and conflicts of
interest relating to the swap. Based on the statutory language,
industry practice and industry best practice recommendations, the
Commission believes that the final rule is tailored appropriately to
the swaps market.
With respect to whether the disclosure duties should apply when a
counterparty is a certain size and level of sophistication, and whether
counterparties should be able to opt in to or opt out of the
protections of the disclosure rule, the Commission notes that Section
4s(h)(3)(B) only limits the disclosure duty when a swap transaction is
between swap dealers, major swap participants, and/or SBS Entities. The
only exception in Section 4s(h)(3)(B) allows counterparties to obtain
the daily mark for cleared swaps upon request.\338\ Given that the
statute provides such limited opt in/opt out for disclosures, the final
rule is consistent with the plain language of the statute by not
allowing counterparties to opt in to or opt out of the disclosure rule
other than as provided by the statute.\339\
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\338\ The Commission also has clarified that the Sec. 23.431
disclosure obligations do not apply to transactions that are
initiated on a SEF or DCM where the swap dealer or major swap
participant does not know the identity of the counterparty to the
transaction. See final Sec. 23.431(c) (previously numbered as
proposed Sec. 23.431(b)). See also Section 4s(h)(7) of the CEA with
respect to the Special Entity provisions.
\339\ See Section III.A.1. of this adopting release for a
discussion of ``Opt in or Opt out for Certain Classes of
Counterparties.''
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Commenters claimed that the proposed disclosure rule alters the
relationship between counterparties and swap dealers or major swap
participants from arm's length dealings to advisory relationships.\340\
The Commission disagrees and confirms that the business conduct
standards rules alone do not cause a swap dealer or major swap
participant to assume advisory responsibilities or become a
fiduciary.\341\ The final rule tracks the statute and includes
explanatory language regarding the timing and content of the statutory,
principles based disclosure duty, and was informed by industry
practices \342\ and industry best practice recommendations.\343\ The
statute and
[[Page 9759]]
the disclosure rules are intended to level the information playing
field by requiring swap dealers and major swap participants to provide
sufficient information about a swap to enable counterparties to make
their own informed decisions about the appropriateness of entering into
the swap. The additional language in the rule, including ``at a
reasonably sufficient time prior to entering into a swap'' and
``information reasonably designed to allow a counterparty to assess,''
along with the material risks and characteristics standards in the
rule, is intended to provide guidance to swap dealers and major swap
participants in complying with the rule. This guidance will assist swap
dealers and major swap participants in designing reasonable policies
and procedures to comply with the requirements of the statute and the
final rule.
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\340\ Several commenters urged the Commission to coordinate with
the SEC and DOL to ensure that the final rule does not trigger ERISA
fiduciary or municipal advisor status. The Commission confirms that
it continues to coordinate with both agencies on these issues. See
Section II of this adopting release for a discussion of ``Regulatory
Intersections.'' See also Section III.A.1. of this adopting release
for a discussion of ``Discretionary Rules'' and ``Different Rules
for Swap Dealers and Major Swap Participants.'' Regarding the
relative costs and benefits of the disclosure rules, see Section
VI.C.4. of this adopting release for a discussion of Sec. 23.431.
\341\ The Commission is amending Sec. 4.6 to exclude swap
dealers from the CTA definition, which the Dodd-Frank Act amended to
include swaps, when their advice is solely incidental to its
business as a swap dealer. See Section II.D. of this adopting
release. See also Section II.B. of this adopting release for a
discussion of how compliance with the business conduct standards
rules, including the disclosure duties, will be considered by DOL.
\342\ See supra at fn. 336 and accompanying text.
\343\ The CRMPG III Report provides the following best practice
guidance regarding disclosure:
[I]t is critical that participants in the markets for high-risk
complex instruments must understand the risks that they face. An
investor or derivative counterparty should have the information
needed to make informed decisions. While the Policy Group has
recommended that each participant must develop a degree of
independence in decision-making, large integrated financial
intermediaries have a responsibility to provide their counterparties
with appropriate documentation and disclosures. Disclosures must
meet the standards established by the relevant regulatory
jurisdiction. The Policy Group believes that appropriate disclosures
should often go beyond those minimum standards, both through
enhancement for instruments currently requiring disclosure, and by
establishing documentation standards for instruments that currently
require little or none.
CRMPG III Report, at 59.
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The Commission has promoted efficiency and reduced costs by
allowing swap dealers and major swap participants to use standardized
formats to make required disclosures, as appropriate, in counterparty
relationship documentation.\344\ Depending on the facts and
circumstances, disclosures in a standard format may be appropriate if
the information is applicable to multiple swaps of a particular type
and class, particularly standardized swaps. Similarly, whether standard
form disclosures are appropriate for certain bespoke swaps will depend
on the facts and circumstances. Factors that would be relevant are the
complexity of the transaction, including, but not limited to, the
degree and nature of any leverage,\345\ the potential for periods of
significantly reduced liquidity, and the lack of price
transparency.\346\ This approach is consistent with OTC derivatives
industry best practice recommendations for high-risk, complex financial
instruments.\347\ Given the evolutionary nature of swaps, and
especially bespoke swaps, swap dealers and major swap participants will
be required to have and implement reasonably designed policies and
procedures concerning when and how to make particularized disclosures
on a transactional basis to account for changing characteristics, as
well as different and newly identified risks, incentives and conflicts
of interest. The statute is unequivocal regarding the duty to provide
disclosures of the material risks, characteristics, incentives and
conflicts of interest for each swap.
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\344\ See Section III.A.3.f. of this adopting release for a
discussion of proposed Sec. 23.402(g)--Disclosures in a standard
format (renumbered as final Sec. 23.402(f)).
\345\ This characteristic is particularly relevant when the swap
includes an embedded option that increases leverage. Such features
can significantly increase counterparty risk exposure in ways that
are not transparent. See also fn. 227.
\346\ CRMPG III Report, at 56; see also text at fn. 228.
\347\ CRMPG III Report, at 56.
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Regarding commenters' recommendations to delay discretionary rules
and urging different rules for major swap participants, the Commission
has addressed those issues above.\348\ In response to commenters
concerns about compliance with principles based disclosure duties, the
Commission will, in the absence of fraud, consider good faith
compliance with policies and procedures reasonably designed to comply
with the disclosure rules as a mitigating factor when exercising its
prosecutorial discretion for violation of the disclosure rule.
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\348\ See Section III.A.1.b.ii. and iii. of this adopting
release for a discussion of ``Discretionary Rules'' and ``Different
Rules for Swap Dealers and Major Swap Participants.''
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a. Section 23.431(a)(1)--Material Risk Disclosure
i. Proposed Sec. 23.431(a)(1)
The proposed rule tracked the statutory obligations under Section
4s(h)(3)(B)(i) and required the swap dealer or major swap participant
to disclose information to enable a counterparty to assess the material
risks of a particular swap. The Commission anticipated that swap
dealers and major swap participants typically would rely on a
combination of standardized disclosures and more particularized
disclosures to satisfy this requirement. The proposed rule identified
certain types of risks that are associated with swaps generally,
including market,\349\ credit,\350\ operational,\351\ and liquidity
risks.\352\ Required risk disclosure included sufficient information to
enable a counterparty to assess its potential exposure during the term
of the swap and at expiration or upon early termination. The Commission
noted that, consistent with industry ``best practices,'' information
regarding specific material risks had to identify the material factors
that influence the day-to-day changes in valuation, as well as the
factors or events that might lead to significant losses.\353\ As
described in the proposing release, disclosures under the proposed rule
should consider the effect of future economic factors and other
material events that could cause the swap to experience such losses.
Disclosures also should identify, to the extent possible, the
sensitivities of the swap to those factors and conditions, as well as
the approximate magnitude of the gains or losses the swap will likely
experience. The Commission noted that swap dealers and major swap
participants also should consider the unique risks associated with
particular types of swaps, asset classes and trading venues, and tailor
their disclosures accordingly.
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\349\ Market risk refers to the risk to a counterparty's
financial condition resulting from adverse movements in the level or
volatility of market prices.
\350\ Credit risk refers to the risk that a party to a swap will
fail to perform on an obligation under the swap.
\351\ Operational risk refers to the risk that deficiencies in
information systems or internal controls, including human error,
will result in unexpected loss.
\352\ Liquidity risk is the risk that a counterparty may not be
able to, or cannot easily, unwind or offset a particular position at
or near the previous market price because of inadequate market
depth, unique trade terms or remaining party characteristics or
because of disruptions in the marketplace.
\353\ See CRMPG III Report, at 60.
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ii. Comments
The Commission received comments on a variety of issues related to
proposed Sec. 23.431(a)(1). Comments included claims that disclosures
would increase costs, delay execution, expose parties to additional
market risk, intrude on counterparty confidential information and
result in ever longer lists of hypothetical risks.\354\ However, one
commenter specifically disagreed, arguing that the statute requires
material risk disclosure and not limited utility, generalized
disclosure.\355\ With respect to the importance of a robust risk
disclosure duty, the commenter\356\ referenced transactions profiled in
the report from the U.S. Senate Permanent Subcommittee on
Investigations, Committee on Homeland Security and Governmental
Affairs, ``Wall Street and the Financial Crisis: Anatomy of a Financial
Collapse,'' issued April 13, 2011 (``Senate Report'').\357\
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\354\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 17.
\355\ CFA/AFR Aug. 29 Letter, at 19.
\356\ Id., at 2-5 and 12.
\357\ The report concludes that transactions involving
structured collateralized debt obligations (``CDOs'') were
problematic because they were designed to fail and the disclosures
omitted and/or misrepresented the material risks, characteristics,
incentives and conflicts of interest related to these types of
transactions.
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Another commenter stated that the proposed rule was too vague
regarding what material risks must be disclosed, creating legal
uncertainty, potential
[[Page 9760]]
hindsight enforcement, and private rights of action.\358\ The commenter
claimed that, without guidance, swap dealers and major swap
participants may over disclose risks and/or limit the number of their
swap counterparties.\359\ Certain commenters recommended that the
Commission clarify that the ``material risks'' of a swap are limited to
the economic terms of the product and not risks associated with the
underlying asset.\360\
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\358\ FHLBanks June 3 Letter, at 8-9.
\359\ Id.
\360\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 17 (e.g., a
particular event in the Middle East that could impact currency
markets).
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Several commenters supported standardized risk disclosures.\361\
However, others were skeptical of the value of mandatory boilerplate
disclosures.\362\ Other commenters recommended that the Commission
specifically require risk disclosures regarding volatility, historic
liquidity and value at risk.\363\ One commenter recommended that, in
lieu of proposed Sec. 23.431, the Commission limit the disclosure duty
to a predefined scenario analysis.\364\ It was suggested, for example,
regarding interest rate sensitivity, that the rule could mandate an
analysis of interest rate conditions up to a certain number of standard
deviations away from expected interest rate movements based on
historical interest rates.\365\ It was asserted that such objective
standards would promote marketplace and legal certainty.\366\
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\361\ See, e.g., MetLife Feb. 22 Letter, at 5; ATA Feb. 22
Letter, at 3; APGA Feb. 22 Letter, at 3; FHLBanks Feb. 22 Letter, at
1 and 3-4; FHLBanks June 3 Letter, at 8-9; CII Feb. 10 Letter, at 2.
\362\ See COPE Feb. 22 Letter, at 3-4; Exelon Feb. 22 Letter, at
2-3; BlackRock Feb. 22 Letter, at 7.
\363\ See Better Markets Feb. 22 Letter, at 3 and 7; Barnard May
23 Letter, at 2.
\364\ NY City Bar Feb. 22 Letter, at 2.
\365\ Id.
\366\ Id.
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iii. Final Sec. 23.431(a)(1)
After considering the comments on proposed Sec. 23.431(a)(1), the
Commission has determined to adopt the rule as proposed. In addition,
the Commission is confirming that the rule will be interpreted
consistently with industry best practice regarding the disclosure of
material risks.\367\ This guidance will assist swap dealers and major
swap participants in designing policies and procedures to comply with
the final rule. The final rule is tailored to give effect to the plain
language of the statute by requiring swap dealers and major swap
participants to provide material risk disclosure that allows a
counterparty to assess the risks of the swap.
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\367\ As stated in the proposing release, consistent with
industry ``best practices,'' information regarding specific material
risks must identify the material factors that influence the day-to-
day changes in valuation, as well as the factors or events that
might lead to significant losses. Proposing release, 75 FR at 80644
(citing CRMPG III Report, at 60). Appropriate disclosures should
consider the effect of future economic factors and other material
events that could cause the swap to experience such losses.
Disclosures should also identify, to the extent possible, the
sensitivities of the swap to those factors and conditions, as well
as the approximate magnitude of the gains or losses the swap will
likely experience. Proposing release, 75 FR at 80644. See also
proposed 17 CFR 240.15Fh-3(b)(1), SEC's proposed rules, 76 FR at
42454 (SEC rule regarding material risks requires disclosure,
including, but not limited to, ``the material factors that influence
the day-to-day changes in valuation, the factors or events that
might lead to significant losses, the sensitivities of the security-
based swap to those factors and conditions, and the approximate
magnitude of the gains or losses the security-based swap will
experience under specified circumstances''). Accordingly, the
Commission's interpretation is consistent with the text of the SEC's
proposed risk disclosure rule, which furthers the harmonization goal
of the Commission and the SEC.
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Certain commenters recommended that the Commission clarify that the
material risk disclosure requirement under Sec. 23.431(a)(1) is
limited to disclosures about the risks associated with the economic
terms of the product and not risks associated with the underlying
asset.\368\ The Commission believes that for most swaps information
about the material risks and characteristics of the swap will relate to
the risks and characteristics of the economic terms of the swap.\369\
For certain swaps, however, where payments or cash-flows are materially
affected by the performance of an underlying asset for which there is
not publicly available information (or the information is not otherwise
accessible to the counterparty), final Sec. 23.431 would require
disclosures about the material risks and characteristics that affect
the value of the underlying asset to enable a counterparty to assess
the material risks of the swap.\370\ For example, for a total return
swap whose value is based on the performance of a broad-based index
consisting of unique assets that it created or acquired, a swap dealer
or major swap participant would be required to disclose information
about the material risks and characteristics of the broad-based index,
unless such information is accessible to the counterparty. Disclosure
regarding an underlying asset in such circumstances is consistent with
the duty to communicate in a fair and balanced manner based on
principles of fair dealing and good faith as required by Section
4s(h)(3)(C) and final Sec. 23.433. In connection with a swap based on
the price of oil, for example, a swap dealer or major swap participant
would not have to disclose information about the drivers of oil prices
because such information is readily available to market
participants.\371\
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\368\ See SIFMA/ISDA Feb. 17 Letter, at 17.
\369\ Such economic terms would include payout structures that
embed volatility or optionality features into the transaction,
including, but not limited to, caps, collars, floors, knock-in or
knock-out rights, or range accrual features. As noted above,
disclosures concerning these features would need to provide
sufficient information about these features to enable counterparties
to make their own informed decisions about the appropriateness of
entering into the swap.
\370\ Such a requirement is not intended to create, and does not
create, any general trading prohibition or general disclosure
requirement concerning ``inside information'' under the CEA. This
guidance addresses circumstances where information concerning the
risks of the underlying asset generally are not publicly available.
For example, where a swap dealer offered a total return swap on a
broad-based index based on unique assets that it created or
acquired, any potential counterparty would be unable to evaluate
that transaction absent some form of disclosure by the swap dealer.
This rule would require such disclosure. In contrast, where a swap
dealer offers a swap on an underlying asset for which it has
nonpublic information, for example, harvest information about an
agricultural commodity or production information about an energy
commodity, and the asset is one for which risk information is
publicly available, the swap dealer or major swap participant would
not be required to disclose the nonpublic information it holds.
However, depending on the facts and circumstances, the swap dealer
might have to disclose nonpublic information as part of its duty to
disclose material incentives and conflicts of interest. See Section
III.D.3.d.iii. of this release for a discussion of the duty to
disclose material incentives and conflicts of interest. In addition,
as part of its obligation to disclose the material economic terms of
the swap, the swap dealer would have to provide information about
the factors that would cause the value of the swap to change
including any correlations with the value of the underlying asset.
Of course, swap dealers and major swap participants also will be
subject to the fair dealing rule and antifraud provisions with
respect to their communications with counterparties. See Sections
III.B. and III.F. of this release for a discussion of Sec. 23.410-
Prohibition on Fraud, Manipulation and Other Abusive Practices, and
Sec. 23.433-Communications-Fair Dealing, respectively. In addition,
as stated in Sec. 23.400, nothing in these rules is intended to
limit or restrict the applicability of other applicable laws, rules
and regulations, including the federal securities laws.
\371\ With respect to the request by certain commenters that the
Commission require material risk disclosures regarding volatility,
historic liquidity, and value at risk, the Commission declines to
prescribe specific parameters for compliance with the risk
disclosure rule beyond the explanatory text of the final rule.
Nevertheless, the Commission believes that, depending on the facts
and circumstances, including whether the counterparty has elected to
receive scenario analysis, disclosure of these risk factors may be
appropriate.
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Without commenting on the Senate Report's findings, the Commission
considered how the final disclosure rules would address transactions
similar to those profiled in the Senate Report, as requested by
commenters.\372\ The
[[Page 9761]]
final rule addresses the types of concerns raised by the Senate Report
and by commenters by requiring the disclosure of material risks,
characteristics, incentives and conflicts of interest, as well the duty
to communicate in a fair and balanced manner based on principles of
fair dealing and good faith. These duties are consistent with
longstanding legal, regulatory and industry best practice standards,
which are familiar to the financial services industry and the OTC
derivatives industry.
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\372\ See, e.g., Sen. Levin Aug. 29 Letter, at passim; CFA/AFR
Feb. 22 Letter, at 2, 10 and 12; CFA/AFR Aug. 29 Letter, at 3-8, 18
and 20.
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The Commission declines to limit the disclosure duty to a
predefined scenario analysis as suggested by one commenter. The
Commission recognizes the benefits of, and encourages the use of, an
analysis such as the one suggested by the commenter \373\ to satisfy,
in part, the material risk disclosure requirement. In fact, the
Commission believes that the use of historical data in tabular form to
illustrate specific swap and/or asset prices, volatility, sensitivity,
liquidity risks and characteristics is consistent with industry
practice.\374\ However, the Commission has determined that such
analyses may not satisfy all aspects of the principles based disclosure
requirement in Section 4s(h)(3)(B) for all swaps. Accordingly, the
Commission has determined not to adopt a predefined scenario analysis
in lieu of proposed Sec. 23.431.
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\373\ NY City Bar Feb. 22 Letter, at 2-3.
\374\ See CRMPG III Report, at 60.
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In response to commenters asking that the Commission develop
standardized risk disclosures, the Commission decided not to adopt
futures style standard form swap disclosure for the reasons discussed
in connection with Sec. 23.402(f)-Disclosures in a standard
format.\375\
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\375\ See Section III.A.3.f. of this adopting release for a
discussion of final Sec. 23.402(f)-Disclosures in a standard
format.
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b. Section 23.431(b)--Scenario Analysis
i. Proposed Sec. 23.431(a)(1)(i)-(v)
The Commission's scenario analysis rule in proposed Sec.
23.431(a)(1)(i)-(v) (renumbered as Sec. 23.431(b)) required swap
dealers and major swap participants to provide scenario analyses when
offering to enter into a high-risk complex bilateral swap to allow the
counterparty to assess its potential exposure in connection with the
swap.\376\ In addition, the proposed rule allowed counterparties to
elect to receive scenario analysis when they were offered bilateral
swaps not available for trading on a DCM or SEF. The elective aspect of
the rule reflected the expectation that there would be circumstances
where scenario analysis would be helpful for certain counterparties,
even for swaps that are not high-risk complex. Proposed Sec.
23.431(a)(1) was modeled on the CRMPG III industry best practices
recommendation for high-risk complex financial instruments.\377\
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\376\ Scenario analysis was proposed in addition to required
disclosures for swaps that do not qualify as high-risk complex. Such
required disclosures included a clear explanation of the economics
of the instrument.
\377\ CRMPG III Report, at 60-61.
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Like the CRMPG III industry best practices recommendation, the term
``high-risk complex bilateral swap'' was not defined in the proposed
rule; rather, certain flexible characteristics were identified to
prevent concerns about over- or under-inclusivity. The characteristics
included: The degree and nature of leverage,\378\ the potential for
periods of significantly reduced liquidity and the lack of price
transparency.\379\ The proposed rule required swap dealers and major
swap participants to establish reasonable policies and procedures to
identify high-risk complex bilateral swaps and, in connection with such
swaps, provide the additional risk disclosure specified in proposed
Sec. 23.431(a)(1).
---------------------------------------------------------------------------
\378\ See fn. 227 and 345 discussing risks regarding leverage.
\379\ CRMPG III Report, at 56; see also text at fn. 228.
---------------------------------------------------------------------------
Scenario analysis, as required by the proposed rule, would be an
expression of potential losses to the fair value of the swap in market
conditions ranging from normal to severe in terms of stress.\380\ Such
analyses would be designed to illustrate certain potential economic
outcomes that might occur and the effect of these outcomes on the value
of the swap. The proposed rule required that these outcomes or
scenarios be developed by the swap dealer or major swap participant in
consultation with the counterparty. In addition, the proposed rule
required that all material assumptions underlying a given scenario and
their impact on swap valuation be disclosed.\381\ In requiring such
disclosures, however, the Commission did not require swap dealers or
major swap participants to disclose proprietary information about
pricing models.
---------------------------------------------------------------------------
\380\ These value changes originate from changes or shocks to
the underlying risk factors affecting the given swap, such as
interest rates, foreign currency exchange rates, commodity prices
and asset volatilities.
\381\ Material assumptions included (1) the assumptions of the
valuation model and any parameters applied and (2) a general
discussion of the economic state that the scenario is intended to
illustrate.
---------------------------------------------------------------------------
The Commission did not propose to define the parameters of the
scenario analysis in order to provide flexibility to the parties in
designing the analyses in accordance with the characteristics of the
bespoke swap at issue and any criteria developed in consultations with
the counterparty. Further, the proposed rule required swap dealers and
major swap participants to consider relevant internal risk analyses,
including any new product reviews, when designing the analyses.\382\ As
for the format, the proposed rule required both narrative and tabular
expressions of the analyses.
---------------------------------------------------------------------------
\382\ The Commission proposed that swap dealers and major swap
participants adopt policies and procedures regarding a new product
policy as part of their risk management system. See proposed Sec.
23.600(c)(3), Governing the Duties of Swap Dealers, 75 FR at 71405.
---------------------------------------------------------------------------
To ensure fair and balanced communications and to avoid misleading
counterparties, swap dealers and major swap participants also were
required to state the limitations of the scenario analysis, including
cautions about the predictive value of the scenario analysis, and any
limitations on the analysis based on the assumptions used to prepare
it. The Commission aligned the proposed rule with longstanding industry
best practice recommendations.\383\
---------------------------------------------------------------------------
\383\ See DPG Framework, at Section V.II.G.; CRMPG III Report,
at 59-61 and Appendix A, Bullet 5; but see SIFMA/ISDA Feb. 17
Letter, at 13-14.
---------------------------------------------------------------------------
ii. Comments
The Commission received comments on a broad range of issues
regarding the proposed scenario analysis rule. One commenter raised a
host of concerns, including: (1) That Section 4s(h)(3)(B) does not
require scenario analysis; (2) codifying industry best practice will
discourage future private sector initiatives; (3) scenario analysis is
a broad concept encompassing many potential analyses that are not
relevant for individual transactions and, absent a definition or
guidance regarding the parameters of the analysis, it is possible that
scenario analysis will be misleading; (4) scenario analysis may cause
swap dealers and major swap participants to become ERISA fiduciaries,
municipal advisors and/or CTAs; (5) swap dealers and major swap
participants may have liability for failing to provide mandatory
scenario analysis even though they have reasonable policies and
procedures for identifying high-risk complex bilateral swaps; (6) the
highly subjective definition of high-risk complex bilateral swap is
problematic from a liability perspective, particularly for hindsight
enforcement actions and private rights
[[Page 9762]]
of action; (7) the rule mandates delivery of scenario analysis even if
the counterparty neither requests nor wants the analysis; and (8) the
mandatory delivery of scenario analysis will delay execution, which
increases risk to the counterparty.\384\
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\384\ See SIFMA/ISDA Feb. 17 Letter, at 18-21.
---------------------------------------------------------------------------
Other commenters claimed that the scenario analysis rule would
increase counterparty dependence on swap dealers and major swap
participants thereby raising moral hazard concerns.\385\ Another
commenter was concerned that scenario analysis, or portions thereof, is
often proprietary, which raises confidentiality and liability
issues.\386\ The commenter also claimed that the proposed scenario
analysis rule is resource intensive and will increase the cost of swaps
to counterparties.\387\
---------------------------------------------------------------------------
\385\ See MFA Feb. 22 Letter, at 6; CEF Feb. 22 Letter, at 9;
SIFMA/ISDA Feb. 17 Letter, at 19.
\386\ CEF Feb. 22 Letter, at 9-10.
\387\ Id.
---------------------------------------------------------------------------
Certain commenters were in favor of the proposed scenario analysis
rule. For example, a commenter said it would like to receive scenario
analysis for the swaps covered by the proposed rule.\388\ Another
commenter believed that scenario analysis should not be expensive in
that swap dealers and major swap participants are expected to take the
other side of the swap and already do the analysis, which is easily
modified to the counterparty's purpose.\389\ Moreover, the commenter
asserted that swap dealers and major swap participants must do the
analysis as part of the suitability or Special Entity ``best
interests'' analysis.\390\ Another commenter supported the proposed
rule, but suggested allowing swap dealers and major swap participants
to delegate responsibility for the analysis to appropriately qualified
independent third party providers.\391\ In addition, this commenter
recommended that the scenario analysis be provided on a portfolio
basis.\392\ Lastly, certain commenters suggested that the proposed
scenario analysis only be required at the request of the
counterparty.\393\
---------------------------------------------------------------------------
\388\ MetLife Feb. 22 Letter, at 5.
\389\ CFA/AFR Feb. 22 Letter, at 9.
\390\ Id.
\391\ Markit Feb. 22 Letter, at 3-4; Markit June 3 Letter, at 7.
\392\ Id.
\393\ See COPE Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter,
at 21; Exelon Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 10.
---------------------------------------------------------------------------
iii. Final Sec. 23.431(b)
After considering the comments, the Commission has determined to
adopt proposed Sec. 23.431(a)(1)(i)-(v) (renumbered as Sec.
23.431(b)) with certain modifications. The Commission revised the
proposed rule to eliminate the requirement to provide scenario analysis
for ``high-risk complex bilateral swaps.'' Instead, the final rule
requires scenario analysis only when requested by the counterparty for
any swap not ``made available for trading'' on a DCM or SEF.\394\ To
comply with the rule, swap dealers will have to disclose to
counterparties their right to receive scenario analysis and consult
with counterparties regarding design. These changes eliminate both the
mandatory element and definitional issues associated with the term
``high-risk complex bilateral swap.'' They also address counterparty
concerns about execution delays and costs. In addition, major swap
participants will not have to provide scenario analysis. Because
modeling and providing scenario analysis is currently an industry best
practice for dealers, the Commission is limiting the duty to swap
dealers only.
---------------------------------------------------------------------------
\394\ Under Section 2(h)(8) of the CEA, a swap that is subject
to the clearing requirement of Section 2(h)(1) must be executed on a
DCM or SEF unless no DCM or SEF ``makes the swap available to
trade'' or the swap is subject to the clearing exception under
Section 2(h)(7) (i.e., the end-user exception). See Proposed Rules,
Swap Transaction Compliance and Implementation Schedule: Clearing
and Trade Execution Requirements under Section 2(h) of the CEA, 76
FR 58186, 58191, Sept. 20, 2011 (``Trade Execution Requirements'');
see also Proposed Rules, Process for a Designated Contract Market or
Swap Execution Facility to Make a Swap Available to Trade, 76 FR
77728, Dec. 14, 2011 (``Process to Make a Swap Available to
Trade''). Therefore, final Sec. 23.431(b) only requires a swap
dealer to provide scenario analysis upon request for swaps that are
not subject to the trade execution requirement under Section
2(h)(8).
---------------------------------------------------------------------------
Regarding parameters for scenario analysis, the Commission decided
to retain the language in proposed Sec. 23.431(a)(1)(ii), (iv) and
(v). The rule is principles based and allows flexibility in designing
the analysis. As guidance, the Commission directs swap dealers to
industry best practices for scenario analysis for high-risk complex
financial instruments.\395\ That best practice recommends:
---------------------------------------------------------------------------
\395\ See CRMPG III Report, at Appendix A, Bullet 5.
The analysis should be done over a range of assumptions,
including severe downside stress scenarios. Scenario analysis should
also include an analysis of what assumptions would result in a
significant percentage loss (e.g., 50%) of principal or notional.
All implicit and explicit assumptions should be clearly indicated
and calculation methodologies should be explained. Significant
assumptions should be stress-tested with the results plainly
disclosed.\396\
---------------------------------------------------------------------------
\396\ Id.
In addition, counterparties may request the type of information and
scenario analyses they consider useful. Such flexibility enhances the
benefits of scenario analysis to counterparties while limiting the
costs of the final rule. The counterparty gets what it needs and the
swap dealer has certainty about the type of analysis that will comply
with the rule. As noted in the proposing release, swap dealers have
informed Commission staff that they currently provide to counterparties
scenario analysis upon request and without charge.\397\
---------------------------------------------------------------------------
\397\ Proposing release, 75 FR at 80645.
---------------------------------------------------------------------------
Regarding comments that Section 4s(h)(3)(B) does not require
scenario analysis, the Commission notes that OTC derivatives industry
best practice dating back to 1995 discusses the provision of scenario
analysis to illustrate the risks of particular derivative
products.\398\ In addition, a recent OTC derivatives industry best
practice disclosure recommendation for high-risk complex financial
instruments calls for ``rigorous scenario analyses and stress tests
that prominently illustrate how the instrument will perform in extreme
scenarios, in addition to more probable scenarios.'' \399\ These
industry reports, coupled with letters from commenters,\400\ are
evidence of the value of scenario analysis in supplementing a
counterparty's ability to assess the risks and characteristics of swaps
and support the Commission's determination that requiring scenario
analysis, as provided for in the final rule, is in the public interest.
As discussed above in connection with final Sec. 23.400-Scope, the
Commission has ample discretionary authority to adopt the scenario
analysis rule.\401\
---------------------------------------------------------------------------
\398\ See DPG Framework, at Section V.II.G.
\399\ See CRMPG III Report, at 61.
\400\ See MetLife Feb. 22 Letter, at 5; CFA/AFR Feb. 22 Letter,
at 9; Better Markets Feb. 22 Letter, at 3 and 7; Barnard May 23
Letter, at 2; Markit Feb. 22 Letter, at 3-4. Accord COPE Feb. 22
Letter, at 4; CEF Feb. 22 Letter, at 10 (suggesting changing the
rule from mandatory to elective by the counterparty).
\401\ See Section III.A.1.ii. of this adopting release for a
discussion of ``Discretionary Rules.''
---------------------------------------------------------------------------
The Commission is not persuaded by the assertion that codifying
industry best practice will discourage future private sector
initiatives and enhance the potential for hindsight enforcement actions
and private rights of action.\402\ By adopting industry best practice
recommendations, it can be argued that the Commission is encouraging
industry efforts to try to shape regulatory solutions to industry
problems. The Commission also is not persuaded that adopting industry
best practice recommendations will cause hindsight enforcement actions
and private suits
[[Page 9763]]
filed against swap dealers. The Commission notes that litigation risk
is not new to swap dealers. Numerous private and enforcement actions
involving derivatives have been filed based on theories that existed
prior to the enactment of the Dodd-Frank Act.
---------------------------------------------------------------------------
\402\ SIFMA/ISDA Feb. 17 Letter, at 18.
---------------------------------------------------------------------------
With regard to the claim that scenario analysis needs a definition
and parameters to avoid potentially misleading counterparties, the
Commission notes that the final rule, unlike the proposed rule, will
require scenario analysis only as requested by the counterparty.\403\
The final rule also will require consultation with the counterparty and
disclosure of the material assumptions and calculation methodologies.
These aspects of the rule, coupled with the other disclosure and fair
dealing duties, should ameliorate the potential for misleading the
counterparty. In addition, the Commission has determined to adopt the
CRMPG III Report description of scenario analysis, which provides an
appropriate, principles based standard for swap dealers under the final
rule.\404\ This principles based standard should provide sufficient
guidance to swap dealers to achieve consistency regarding the minimum
parameters of scenario analyses. As indicated in the final rule,
counterparties may request additional information and analyses.
---------------------------------------------------------------------------
\403\ The final rule does not distinguish between high risk
complex swaps and other swaps. This and other changes in the final
rule address commenters' concerns about the meaning of ``high-risk
complex swap'' and resulting potential liability issues.
\404\ See CRMPG III Report, at Appendix A, Bullet 5.
---------------------------------------------------------------------------
The Commission is not persuaded by claims that the scenario
analysis rule would increase counterparty dependence on swap dealers
thereby raising moral hazard concerns. As discussed above, the scenario
analysis rule has been revised to eliminate the mandatory provision in
favor of a counterparty election. In addition, the counterparty
election covers swaps that are not ``made available for trading'' on a
DCM or SEF.\405\ This narrowing of the rule reduces both swap dealer
and counterparty costs, including potential delays in execution. Only
counterparties that want and request the scenario analysis will receive
it. This approach is consistent with industry practice, which was
confirmed during meetings with swap dealers, that upon request of
counterparties scenario analysis is provided and without any additional
charge.\406\ Therefore, the rule should not significantly change the
existing practice by unduly increasing counterparty dependence on swap
dealers or creating moral hazard concerns.
---------------------------------------------------------------------------
\405\ See discussion of Section 2(h)(8) and swaps ``made
available for trading'' on a DCM or SEF at fn. 394.
\406\ Proposing release, 75 FR at 80645.
---------------------------------------------------------------------------
With respect to claims that scenario analysis, or portions thereof,
are often proprietary, which may raise confidentiality and liability
issues,\407\ the Commission notes that the final rule does not require
the disclosure of ``confidential, proprietary information about any
model it may use to prepare the scenario analysis.'' However, the rule
does require the disclosure of all material assumptions and an
explanation of the calculation methodologies. The Commission does not
consider scenario analysis and its material assumptions and calculation
methodologies to be confidential, proprietary information. This
conclusion is based on several industry reports that confirm that
scenario analysis and its material assumptions and calculation
methodologies are best practice disclosure.\408\ Regarding commenter's
concerns relating to liability for the scenario analysis, the
Commission believes that forward-looking statements should not unduly
expose swap dealers to liability where the scenario analysis is
performed consistent with the rule, in consultation with the
counterparty and subject to appropriate warnings about the assumptions
and limitations underlying the scenario analysis. Such warnings also
would be consistent with Sec. 23.433--Communications--fair
dealing.\409\
---------------------------------------------------------------------------
\407\ See CEF Feb. 22 Letter, at 9-10.
\408\ See DPG Framework, at Section V.II.G.; CRMPG III Report,
at A2.
\409\ See Section III.F. of this adopting release for a
discussion of Sec. 23.433--Communications--fair dealing.
---------------------------------------------------------------------------
The elective approach in the final rule ameliorates concerns that
the proposed scenario analysis rule is resource intensive and will
increase the cost of swaps to counterparties. This approach was
supported by commenters and should be less burdensome.\410\ In
addition, the final rule provides for counterparty consultation in the
design of a requested scenario analysis. Where the counterparty does
not specify the assumptions, the swap dealer will have discretion to
design a scenario analysis consistent with the principles established
in the rule. This approach should assist the swap dealer in limiting
the costs associated with complying with the final scenario analysis
rule. The Commission notes that swap dealers are already preparing some
form of scenario analysis of the swap for their own purposes, including
new product review, daily product pricing, margin analysis and risk
management.
---------------------------------------------------------------------------
\410\ See, e.g., Exelon Feb. 22 Letter, at 4; COPE Feb. 22
Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 21.
---------------------------------------------------------------------------
The Commission agrees with the commenter that suggested that swap
dealers be able to use appropriately qualified independent third party
providers to perform the scenario analysis.\411\ However, swap dealers
will remain responsible for ensuring compliance with the rule. With
respect to the suggestion that the rule require that scenario analysis
be provided on a portfolio basis,\412\ the Commission notes that the
final rule is guided by the statute, which requires disclosure of
information about the risks of ``the swap.'' As a result, the
Commission has determined that it is appropriate to require swap
dealers to provide scenario analysis, upon request, with respect to a
particular swap. However, nothing in the rule precludes swap dealers
from agreeing to provide scenario analysis on a portfolio basis, upon
request. The Commission expects some counterparties may request
scenario analysis based on a portfolio while others, for a variety of
reasons, including confidentiality of portfolio positions, may not
request that analysis. Lastly, the Commission addressed the commenters'
concern that scenario analysis may cause swap dealers to become ERISA
fiduciaries, municipal advisors and/or CTAs elsewhere in this adopting
release.\413\
---------------------------------------------------------------------------
\411\ See Markit Feb. 22 Letter, at 2-4; Markit June 3 Letter,
at 7.
\412\ Id.
\413\ See Section II of this adopting release for a discussion
of ``Regulatory Intersections,'' including DOL ERISA Fiduciary, SEC
Municipal Advisor and CTA status issues.
---------------------------------------------------------------------------
c. Section 23.431(a)(2)--Material Characteristics
i. Proposed Sec. 23.431(a)(2)
Proposed Sec. 23.431(a)(2) required swap dealers and major swap
participants to disclose the material characteristics of the swap,
including the material economic terms of the swap, the material terms
relating to the operation of the swap and the material rights and
obligations of the parties during the term of the swap. Under the
proposed rule, the material characteristics included the material terms
of the swap that would be included in any ``confirmation'' of a swap
sent by the swap dealer or major swap participant to the counterparty
upon execution.\414\
---------------------------------------------------------------------------
\414\ Proposing release, 75 FR at 80645.
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[[Page 9764]]
ii. Comments
Commenters raised objections to language in the proposing release
concerning delivery of a summary of the material characteristics of the
swap to be provided by swap dealers and major swap participants to
counterparties prior to entering into a swap.\415\ One commenter
claimed it would be both unnecessary given the ECP status of the
counterparty and potentially confusing due to differences between a
pre-execution summary and the post-execution transaction
documentation.\416\
---------------------------------------------------------------------------
\415\ See Exelon Feb. 22 Letter, at 3; SIFMA/ISDA Feb. 17
Letter, at 21-22.
\416\ SIFMA/ISDA Feb. 17 Letter, at 21-22.
---------------------------------------------------------------------------
Commenters that support the disclosure rule recommended that the
rule be interpreted to require for bespoke swaps that disclosures
separately detail standardized components of the swap and price of each
component, including embedded credit for forgone collateral.\417\ In
addition, a commenter recommended that the disclosure obligation
include the features of the swap that could disadvantage the
counterparty.\418\
---------------------------------------------------------------------------
\417\ See CFA/AFR Feb. 22 Letter, at 10; Better Markets Feb. 22
Letter, at 4-6; Better Markets June 3 Letter, at 13; CFA/AFR Nov. 3
Letter, at 6.
\418\ CFA/AFR Feb. 22 Letter, at 11 (for example, situations
where the proposed swap has basis risk and/or an interest rate
mismatch).
---------------------------------------------------------------------------
iii. Final Sec. 23.431(a)(2)
After considering the comments, the Commission has determined to
adopt Sec. 23.431(a)(2) as proposed. To address questions about the
manner and substance of disclosure that must be provided prior to
entering into a swap, and the nature of transaction documentation that
will be required post execution, the Commission provides the following
guidance. As noted above, for a counterparty to assess the merits of
entering into a swap, it will need information about the material risks
and characteristics of the swap at a reasonably sufficient time prior
to entering into the swap. The disclosure rules grant discretion to
swap dealers and major swap participants, consistent with the rules on
manner of disclosure, disclosures in a standard format and record
retention, to adopt a reliable means of disclosure agreed to by a
counterparty.\419\
---------------------------------------------------------------------------
\419\ See Sections III.A.3.e., f. and g. of this adopting
release for a discussion of final Sec. 23.402(e)--Manner of
disclosure, final Sec. 23.402(f)--Disclosures in a standard format,
and final Sec. 23.402(g)--Record retention, respectively. While the
rules allow disclosures by any reliable means agreed to by the
counterparty, pursuant to Sec. 23.402(f) written disclosures are
the preferred method to avoid confusion and counterparty disputes.
Written disclosures enhance the ability to monitor compliance and
facilitate compliance with the record retention requirements in
Sec. 23.402(g).
---------------------------------------------------------------------------
Disclosures made prior to entering into a swap should not be
confused with transaction documentation. The final internal business
conduct standards rules in subpart J of part 23 will apply to
transaction documentation.\420\ The final external business conduct
standards rules in subpart H of part 23 establish requirements to make
disclosures about the material characteristics, among other
information, of the swap. The two sets of rules will work together. To
the extent that the final internal business conduct standards rules
require that swap dealers and major swap participants provide to
counterparties pre-execution information about the characteristics of a
swap, such information should be considered by swap dealers and major
swap participants in determining what, if any, additional information
must be provided to counterparties pre-execution to comply with the
material characteristics disclosure duty in Sec. 23.431(a)(2).
---------------------------------------------------------------------------
\420\ See, e.g., Confirmation, Portfolio Reconciliation, and
Portfolio Compression Requirements for Swap Dealers and Major Swap
Participants, 75 FR 81519, Dec. 28, 2010.
---------------------------------------------------------------------------
One commenter requested that the Commission clarify that the
disclosure requirement is satisfied when a counterparty has or is
provided a copy of each item of documentation that governs the terms of
its swap with the swap dealer or major swap participant.\421\ The
Commission declines to make such a determination because whether the
material characteristics disclosure requirement is met in any
particular case will be a facts and circumstances determination, based
on the standards set forth in the rule. This will be particularly true
when certain features including, but not limited to, caps, collars,
floors, knock-ins, knock-outs, range accrual features, embedded
optionality or embedded volatility increase the complexity of the swap.
The disclosure rule, coupled with Sec. 23.433--Communications--Fair
Dealing,\422\ requires the swap dealer or major swap participant to
provide a sound factual basis for the counterparty to assess how these
features and others would impact the value of the swap under various
market conditions during the life of the swap.\423\
---------------------------------------------------------------------------
\421\ SIFMA/ISDA Feb. 17 Letter, at 21-22.
\422\ See Section III.F. of this adopting release for a
discussion of Sec. 23.433--Communications--fair dealing.
\423\ Because Sec. 23.431(a)(2) creates a flexible disclosure
regime, the Commission declines, at this time, to interpret Sec.
23.431(a)(2) as requiring, with respect to bespoke swaps, a separate
detailing of all standardized components of the swap and the pricing
of each component, including embedded credit, for forgone
collateral, especially where the swap dealer has not made a
recommendation to the counterparty. However, nothing in the final
rule would preclude the parties from negotiating disclosures of this
type. See Section III.D.3.d. of this adopting release for a
discussion of disclosures in connection with a swap dealer's
recommendation.
---------------------------------------------------------------------------
Swap dealers and major swap participants will be permitted to
include certain disclosures about material characteristics (other than
information normally contained in a term sheet, such as price and
dates) in counterparty relationship documentation, where appropriate,
consistent with final Sec. 23.402(f)--Disclosures in a standard
format.
Commenters sought guidance on whether the material characteristics
disclosure duty requires a swap dealer or major swap participant to
determine and then disclose how the terms of a particular swap relate
to the circumstances of a particular counterparty.\424\ The Commission
believes that, for most swaps, information about the material
characteristics of the swap will relate to the economic terms of the
swap rather than the circumstances of the particular counterparty.
However, if a swap dealer or major swap participant has contractually
undertaken to do so, or a swap dealer has made a ``recommendation,''
which triggers a suitability duty or is acting as an advisor to a
Special Entity, the swap dealer or major swap participant will be
required to act consistently with the relevant duty, including
exercising reasonable due diligence and making appropriate disclosures.
Of course, in all circumstances, swap dealers and major swap
participants are required to communicate in a fair and balanced manner
based on principles of fair dealing and good faith in accordance with
final Sec. 23.433. Additionally, for a Special Entity, the swap dealer
or major swap participant will have to have a reasonable basis to
believe that the qualified independent representative will act in the
Special Entity's best interests and evaluate the appropriateness of
each swap based on the needs and characteristics of the Special Entity
before the Special Entity enters into the swap with a swap dealer or
major swap participant.\425\
---------------------------------------------------------------------------
\424\ See CFA/AFR Feb. 22 Letter, at 11.
\425\ See Section IV.C. of this adopting release for a
discussion of Sec. 23.450--Requirements for swap dealers and major
swap participants acting as counterparties to Special Entities.
---------------------------------------------------------------------------
[[Page 9765]]
d. Section 23.431(a)(3)--Material Incentives and Conflicts of Interest
i. Proposed Sec. 23.431(a)(3)
Proposed Sec. 23.431(a)(3) tracked the statutory language under
Section 4s(h)(3)(B)(ii) and required a swap dealer or major swap
participant to disclose to any counterparty the material incentives and
conflicts of interest that the swap dealer or major swap participant
may have in connection with a particular swap. The Commission also
proposed that swap dealers and major swap participants be required to
include with the price of the swap, the mid-market value of the swap as
defined in proposed Sec. 23.431(c)(2). In addition, swap dealers and
major swap participants were required to disclose any compensation or
benefit that they receive from any third party in connection with the
swap. The Commission also stated in the proposing release that, in
connection with any recommended swap, swap dealers and major swap
participants were expected to disclose whether their compensation
related to the recommended swap would be greater than for another
instrument with similar economic terms offered by the swap dealer or
major swap participant.\426\ With respect to conflicts of interest, the
Commission stated that it expected such disclosure would include the
inherent conflicts in a counterparty relationship, particularly when
the swap dealer or major swap participant recommends the transaction.
The Commission also indicated it expected that a swap dealer or major
swap participant that engages in business with the counterparty in more
than one capacity should consider whether acting in multiple capacities
creates material incentives or conflicts of interest that require
disclosure.\427\
---------------------------------------------------------------------------
\426\ Proposing release, 75 FR at 80645.
\427\ This may exist, for example, when the swap dealer or major
swap participant acts both as an underwriter in a bond offering and
as counterparty to the swaps used to hedge such financing. In these
circumstances, the swap dealer's or major swap participant's duties
to the counterparty would vary depending on the capacities in which
it is operating and should be disclosed. With respect to swaps
entered into with Special Entities, swap dealers and major swap
participants are required to disclose the capacity in which they are
acting and, if they engage in multiple capacities, disclose the
difference in such capacities in accordance with Section 4s(h)(5) of
the CEA and proposed Sec. 23.450(f) (renumbered and adopted as
final Sec. 23.450(g)).
---------------------------------------------------------------------------
ii. Comments
The Commission received comments addressing a variety of issues.
Several commenters generally supported the disclosure requirement.\428\
One commenter stated that it wanted to receive information about
incentives or compensation that the swap dealer was receiving.\429\ Two
other commenters said they did not object to swap dealers being
required to disclose conflicts of interest because such disclosures
would seem to be embedded in the concept of fair dealing.\430\ Another
commenter recommended allowing the use of standardized disclosures to
satisfy conflicts of interest and compensation matters but supported
specific disclosure on a transaction-by-transaction basis for any
compensation received by the swap dealer or major swap participant in
connection with a particular swap.\431\
---------------------------------------------------------------------------
\428\ See, e.g., MetLife Feb. 22 Letter, at 5; COPE Feb. 22
Letter, at 4; Exelon Feb. 22 Letter, at 4.
\429\ MetLife Feb. 22 Letter, at 5.
\430\ COPE Feb. 22 Letter, at 4; Exelon Feb. 22 Letter, at 3-4.
\431\ CEF Feb. 22 Letter, at 13.
---------------------------------------------------------------------------
A commenter approved of the proposed rule and the guidance in the
proposing release requiring swap dealers and major swap participants to
disclose whether their compensation for a recommended swap would be
greater than for another instrument with similar economic terms offered
by the swap dealer or major swap participant.\432\ However, a different
commenter objected to, and requested withdrawal of, that same statement
asserting that swap dealers and major swap participants should not be
obligated to identify and evaluate comparable instruments on behalf of
the counterparty as such a comparative analysis would be an advisory
service that is the responsibility of the counterparty and its
advisors.\433\
---------------------------------------------------------------------------
\432\ CFA/AFR Feb. 22 Letter, at 11.
\433\ SIFMA/ISDA Feb. 17 Letter, at 23.
---------------------------------------------------------------------------
Another commenter urged full disclosure to counterparties of the
incentives to swap dealers and major swap participants for use of
various market infrastructures (swap data repositories (``SDRs''),
DCOs, DCMs, and SEFs).\434\ Similarly, the commenter recommended
prohibiting fee rebates, discounts, and revenue and profit sharing,
which it asserts are substantively the same as preferential access to
market infrastructures. The commenter maintained that such practices
simply transfer costs to less influential participants who must follow
the lead of large liquidity providers.\435\
---------------------------------------------------------------------------
\434\ See Better Markets June 3 Letter, at 6-7.
\435\ Id.
---------------------------------------------------------------------------
In addition, certain commenters that supported the rule also would
like the Commission to require separate pricing of each ``amalgamated''
standardized component of a customized swap and a comparison of the
risks and costs of the customized swap with comparable standardized,
listed swaps.\436\ The commenters identified, for example, embedded
credit for forgone collateral as an amalgamated component that should
be priced separately. These commenters also urged the Commission to
clarify that the material incentives and conflicts of interest
disclosure obligation applies not only to specific alternative
instruments but also to alternative strategies.\437\
---------------------------------------------------------------------------
\436\ See Better Markets June 3 Letter, at 13-17; CFA/AFR Feb.
22 Letter, at 11-12; CFA/AFR Nov. 3 Letter, at 6.
\437\ Id.
---------------------------------------------------------------------------
In addition, a commenter recommended that the Commission issue
guidance that the following situations are not conflicts of interest
that warrant disclosure because counterparties are aware of or expect
these common business practices: (1) Simply taking the opposite side of
a swap; (2) swap dealers, major swap participants or affiliates
entering into other swaps that take an opposite view from that of the
counterparty for reasons unrelated to the swap with the counterparty;
and (3) swap dealers and major swap participants having a physical
business that would benefit from a price movement that would be adverse
to the counterparty's economic position under the swap.\438\ This same
commenter also requested that the final rules formally recognize that
no disclosure obligation exists with respect to knowledge regarding a
swap's reference commodity (specifically, swaps referencing energy
commodities), the physical markets in which it trades, or any
particular entity's positions or business in such commodity.\439\
---------------------------------------------------------------------------
\438\ CEF Feb. 22 Letter, at 13.
\439\ Id.
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iii. Final Sec. 23.431(a)(3)
After considering the comments, the Commission has determined to
adopt the proposed rule with the following revision. In proposed Sec.
23.431(a)(3)(i), when disclosing the price of a swap, swap dealers and
major swap participants would have to disclose the ``mid-market value''
of the swap. In the final rule, the Commission decided to change the
term ``mid-market value'' to ``mid-market mark'' \440\ to more
accurately describe the requirement and mitigate concerns that the duty
would constitute valuation, appraisal or advisory services or impose a
fiduciary status on swap dealers and major swap
[[Page 9766]]
participants.\441\ The Commission notes that information about the
spread between the quote and mid-market mark is relevant to disclosures
regarding material incentives and provides the counterparty with
pricing information that facilitates negotiations and balances
historical information asymmetry regarding swap pricing.
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\440\ Further, the Commission confirms that ``mid-market mark''
can be determined through mark-to-model calculations when a liquid
market does not exist.
\441\ The Commission has made the same change in proposed Sec.
23.431(c)--Daily Mark (renumbered as Sec. 23.431(d)).
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In addition, the Commission is clarifying certain guidance provided
in the proposing release regarding recommended swaps.\442\ The
proposing release indicated that, in connection with the duty to
disclose material incentives and conflicts of interest, swap dealers
and major swap participants would be expected to disclose whether their
compensation relating to a recommended swap would be greater than for
another instrument with ``similar economic terms'' offered by the swap
dealer or major swap participant.\443\ In response to commenter
concerns that such disclosure would constitute advice,\444\ the
Commission has determined to limit the guidance to instances where more
than one swap and/or strategy is recommended to accomplish a particular
financial objective.\445\ Generally, these multi-product presentations
include a comparison of swaps or strategies. In addition, the
Commission understands that counterparties often ask dealers for
alternatives to a particular swap, which may lead to a comparison.
Considering this common industry practice, which facilitates sales, the
comparison should include the relative compensation related to the
different alternatives. This information is material to the swap
dealer's or major swap participant's incentives underlying the
recommendations and should assist the counterparty in making an
assessment. Lastly, the Commission notes that this guidance does not
prevent counterparties from requesting, or swap dealers and major swap
participants from providing, comparisons of other swaps or products
that may or may not have similar economic terms.
---------------------------------------------------------------------------
\442\ Proposing release, 75 FR at 80645.
\443\ Id.
\444\ See SIFMA/ISDA Feb. 17 Letter, at 23.
\445\ See also Section III.G.3. of this adopting release and
Appendix A to subpart H of part 23 of the Commission's Regulations
for a discussion of what constitutes a ``recommendation.''
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The Commission declines to state categorically that swap dealers
and major swap participants will be required to separately price each
standardized component of a customized swap, compare the risks and
costs of customized swaps with those of standardized swaps, or disclose
the embedded cost of credit for forgone collateral. Similarly, the
Commission believes that facts and circumstances, including whether the
swap dealer or major swap participant recommended the swap, will
determine whether a swap dealer or major swap participant is required
to disclose that it is trying to move a particular position off its
books and that the swap is part of that strategy.\446\ Swap dealers and
major swap participants will be required to have policies and
procedures reasonably designed to identify material incentives and
conflicts within the scope of Sec. 23.431(a)(3). The Commission will
consider good faith compliance with such policies and procedures when
exercising its prosecutorial discretion in connection with any
violation of the rule.
---------------------------------------------------------------------------
\446\ See, e.g., the Senate Report, at 518-531 ($2 billion
Hudson CDO deal included $1.2 billion in assets from Goldman's
balance sheet. The marketing materials did not disclose that $1.2
billion of the assets were from Goldman's balance sheet.).
---------------------------------------------------------------------------
With respect to the use of standardized disclosures to satisfy
conflicts of interest and incentives disclosures, the Commission
reminds swap dealers and major swap participants, as it has with
respect to other disclosure obligations, that whether such disclosures
will be sufficient to satisfy the disclosure rule in connection with
any particular swap will depend on the facts and circumstances.\447\ As
discussed elsewhere in this adopting release, the statute places the
disclosure duty on swap dealers and major swap participants to ensure
that all material incentives and conflicts of interest relating to the
swap are disclosed.
---------------------------------------------------------------------------
\447\ See, e.g., Section III.A.3.f. of this adopting release for
a discussion of final Sec. 23.402(f)--Disclosures in a standard
format.
---------------------------------------------------------------------------
Concerning disclosure to counterparties of the incentives to swap
dealers and major swap participants for use of various market
infrastructures (DCOs, SDRs, DCMs, and SEFs), the Commission agrees
that incentives paid to swap dealers and major swap participants by
various market infrastructures for a swap transaction are a required
disclosure within the statute and Sec. 23.431(a)(3).\448\ With respect
to fee rebates, discounts, and revenue and profit sharing, the
Commission has determined not to prohibit these payments at this time,
but rather to require disclosure of such payments because the payments
would constitute material incentives or conflicts of interest in
conjunction with the swap. Such disclosure also is encompassed in the
duty to communicate in a fair and balanced manner. Further, the failure
to disclose this information or other material disclosures under the
rule may be a material omission under the Commission's anti-fraud
provisions, including final Sec. 23.410(a).
---------------------------------------------------------------------------
\448\ Such payments can be considered both incentives and
conflicts of interest within the meaning of the statute and rule
and, either way, must be disclosed. See Section 4s(h)(3)(C) of the
CEA and final Sec. 23.433--Communications-fair dealing.
---------------------------------------------------------------------------
The Commission declines the commenters' request that the Commission
issue guidance that certain enumerated situations are not conflicts of
interest that warrant disclosure. The plain language of Section
4s(h)(3)(B)(ii) of the CEA requires disclosure of all material
conflicts of interest that a swap dealer or major swap participant has
in connection with the swap. Without assessing the list of situations
provided by commenters, the Commission notes that the statute does not
limit or exempt the disclosure of certain conflicts of interest where
counterparties may be aware of or expect certain common business
practices.
One commenter requested confirmation that the material incentives
and conflicts of interest disclosure obligation does not apply to
information known by the swap dealer or major swap participant
regarding a swap's reference commodity, the physical markets in which
it trades or any particular entity's positions or business in such
commodity.\449\ Based on the statutory language in Section
4s(h)(3)(B)(ii), the Commission cannot confirm the commenter's point.
The statute requires swap dealers and major swap participants to
disclose ``any material incentives or conflicts of interest that the
swap dealer or major swap participant may have in connection with the
swap.'' It is certainly possible, particularly in the energy context
mentioned by the commenter, that activities of the swap dealer or major
swap participant related to the underlying commodity could create
material incentives or conflicts of interest ``in connection with'' the
swap offered to a counterparty. In addition, the Commission believes
that transactions similar to those described in the Senate Report \450\
would warrant disclosures concerning activities related to the
underlying commodity. Without commenting on the transactions
themselves, the Commission notes that the Senate Report raised concerns
[[Page 9767]]
regarding proprietary trading and the limited transparency of
underlying assets.\451\ Whether such disclosure is required in
connection with any particular swap will depend on the facts and
circumstances.\452\
---------------------------------------------------------------------------
\449\ See CEF Feb. 22 Letter, at 13.
\450\ Senate Report, at 513-636.
\451\ See Section III.D.3.a. of this adopting release for a
discussion of Sec. 23.431(a)(1)--Material risk disclosure.
\452\ Such a requirement is not intended to create, and does not
create, any general trading prohibition or general disclosure
requirement concerning ``inside information.'' See discussion at fn.
370; see also fn. 499.
---------------------------------------------------------------------------
e. Section 23.431(d)--Daily Mark
i. Proposed Sec. 23.431(c)
Section 4s(h)(3)(B)(iii) directs the Commission to adopt rules that
require: (1) For cleared swaps, upon request of the counterparty,
receipt of the daily mark of the transaction from the appropriate DCO;
and (2) for uncleared swaps, receipt of the daily mark of the swap
transaction from the swap dealer or major swap participant.\453\
---------------------------------------------------------------------------
\453\ The Commission noted that the term ``daily mark'' is not
defined in the statute and that the term ``mark'' is used
colloquially to refer to various types of valuation information. See
proposing release, 75 FR at 80645.
---------------------------------------------------------------------------
For cleared swaps, proposed Sec. 23.431(c)(1) required swap
dealers and major swap participants to notify counterparties of their
rights to receive, upon request, the daily mark from the appropriate
DCO. For uncleared swaps, proposed Sec. 23.431(c)(2) and (3) required
swap dealers and major swap participants to provide a daily mark to
their counterparties on each business day during the term of the swap
as of the close of business, or such other time as the parties agree in
writing. The Commission proposed to define daily mark for uncleared
swaps as the mid-market value of the swap, which would specifically not
include amounts for profit, credit reserve, hedging, funding, liquidity
or any other costs or adjustments.\454\ Based on consultations with
stakeholders, the consensus was that mid-market value was a transparent
measure that would assist counterparties in calculating valuations for
their own internal risk management purposes. Further, the Commission
proposed that swap dealers and major swap participants disclose both
the methodology and assumptions used to prepare the daily mark, and any
material changes to the methodology or assumptions during the term of
the swap. The Commission noted that the daily mark for certain bespoke
swaps may be generated using proprietary models. The proposed rule did
not require the swap dealer or major swap participant to disclose
proprietary information relating to its model.\455\
---------------------------------------------------------------------------
\454\ Proposing release, 75 FR at 80645-46.
\455\ Id. at 80646.
---------------------------------------------------------------------------
Lastly, the Commission proposed that swap dealers and major swap
participants provide appropriate clarifying statements relating to the
daily mark.\456\ Such disclosures could include, as appropriate, that
the daily mark may not necessarily be: (1) A price at which the swap
dealer or major swap participant would agree to replace or terminate
the swap; (2) the basis for a variation margin call; nor (3) the value
of the swap that is marked on the books of the swap dealer or major
swap participant.
---------------------------------------------------------------------------
\456\ Id.
---------------------------------------------------------------------------
ii. Comments
One commenter favored disclosure of a daily mark.\457\ The
commenter concurred with the Commission's definition of daily mark as
the ``mid-market value'' of the swap.\458\ The commenter noted that
many end-user counterparties already receive daily swap valuations at
mid-market as determined under the definition of ``Exposure'' included
in the 1994 ISDA Credit Support Annex and requested that the Commission
clarify that the daily mark valuations under the rule are to be
determined by reference to the same definition.\459\ Some commenters
recommended that the daily mark be calculated on a portfolio basis
rather than for each individual swap because margin calls are based on
a net or portfolio basis.\460\ Several commenters recommended that the
rule be revised from a mandatory daily disclosure to ``upon request''
by the counterparty model.\461\ Others asserted that daily mark
disclosure should be negotiable, including an opt out alternative.\462\
---------------------------------------------------------------------------
\457\ FHLBanks Feb. 22 Letter, at 5.
\458\ Id.
\459\ Id., at 6.
\460\ See, e.g., Exelon Feb. 22 Letter, at 4; CEF Feb. 22
Letter, at 15.
\461\ See, e.g., COPE Feb. 22 Letter, at 4; MFA Feb. 22 Letter,
at 6; SIFMA/ISDA Feb. 17 Letter, at 23.
\462\ See, e.g., ERIC Feb. 22 Letter, at 16-17; CEF Feb. 22
Letter, at 15; MFA Feb. 22 Letter, at 6.
---------------------------------------------------------------------------
One commenter recommended revising the rule to allow swap dealers
and major swap participants to delegate responsibility for providing
the daily mark to appropriately qualified independent third party
providers.\463\ Another commenter stated that counterparties should not
rely on swap dealers or major swap participants, but instead should
seek marks from independent third parties.\464\ Several commenters
expressed concern that requiring swap dealers and major swap
participants to provide a daily mark may be considered appraisal
services that trigger ERISA fiduciary status, which prohibits
principal-to-principal swap transactions.\465\
---------------------------------------------------------------------------
\463\ Markit Feb. 22 Letter, at 2-3; Markit June 3 Letter, at 7.
\464\ MFA Feb. 22 Letter, at 6.
\465\ See BlackRock Feb. 22 Letter, at 6; SIFMA/ISDA Feb. 17
Letter, at 24; ABC/CIEBA Feb. 22 Letter, at 5-6; AMG-SIFMA Feb. 22
Letter, at 7; ERIC Feb. 22 Letter, at 16-17.
---------------------------------------------------------------------------
One commenter recommended revising the rule to require swap dealers
and major swap participants, upon request of a counterparty, to provide
the mark used for determining either party's mark-to-market margin
obligation or entitlement under an outstanding swap because this
approach is consistent with statutory text and the daily mark
requirement for cleared swaps.\466\
---------------------------------------------------------------------------
\466\ SIFMA/ISDA Feb. 17 Letter, at 23-24.
---------------------------------------------------------------------------
A different commenter recommended deeming the daily mark obligation
for cleared swaps satisfied if the counterparty can access the
information directly from the DCO or its FCM.\467\ In addition, the
commenter requested that the final rule provide that swap dealers and
major swap participants, absent fraud, have no liability for a
counterparty's use of the provided daily mark.\468\ Further, the
commenter asserted that requiring disclosure of the daily mark
methodology and assumptions encourages improper reliance by the
counterparty on the swap dealer or major swap participant.\469\ Lastly,
one commenter suggested that the rule require swap dealers and major
swap participants to deliver the daily mark via communication media
that are secure, timely and auditable.\470\
---------------------------------------------------------------------------
\467\ CEF Feb. 22 Letter, at 14.
\468\ Id., at 15.
\469\ Id.
\470\ Markit Feb. 22 Letter, at 2-3.
---------------------------------------------------------------------------
iii. Final Sec. 23.431(d)
After considering the comments, the Commission has determined to
adopt Sec. 23.431(c) (renumbered as Sec. 23.431(d)) as proposed, but
change the term ``mid-market value'' to ``mid-market mark.'' This
change more accurately describes the requirement and mitigates concerns
that the duty would constitute valuation, appraisal or advisory
services or impose a fiduciary status on swap dealers and major swap
participants.\471\
[[Page 9768]]
The Commission has determined to define the term daily mark as the
``mid-market mark'' using its discretionary authority to define terms
under the Dodd-Frank Act.\472\ Because ``mid-market'' represents an
objective value, it provides counterparties with a baseline to assess
swap valuations for other purposes, including margin or terminations.
This term has been used by many industry participants since at least
1994.\473\
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\471\ The Commission has made the same change in final Sec.
23.431(a)(3)--Disclosures of material information, which requires
disclosures of material incentives and characteristics. The
Commission repeats that, with respect to final Sec. 23.431(d), the
Dodd-Frank Act disclosures, including the daily mark and mid-market
mark, alone do not cause a swap dealer or major swap participant to
be an advisor to a counterparty, including a Special Entity. The
Commission does not consider the Dodd-Frank Act disclosures to be
advice or a recommendation. See Section II of this adopting release
for further discussion of the intersection of the subpart H
requirements with DOL and SEC requirements.
\472\ Section 721(b)(2) of the Dodd-Frank Act.
\473\ See FHLBanks Feb. 22 Letter, at 6-7. In addition, the term
``mid-market value'' is used in CRMPG I Report, at 7. See also Bank
One Corp. v. IRS, 120 T.C. 174 (U.S. Tax Court 2003). For a
discussion of mid-market value and costs, see ISDA Research Notes,
The Value of a New Swap, Issue 3 (2010), available at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf.
---------------------------------------------------------------------------
The Commission notes that certain comments conflict directly with
the plain language of Section 4s(h)(3)(B)(iii)(I) and (II) of the CEA.
For example, the suggestion that the daily mark be provided on a
portfolio basis rather than for each swap conflicts with the plain
language of the statute.\474\ If counterparties want additional marks
(e.g., marks on a portfolio basis or marks used to calculate margin),
then they are free to negotiate the receipt of such information with
swap dealers and major swap participants.
---------------------------------------------------------------------------
\474\ Section 4s(h)(3)(B)(iii) of the CEA states: ``(I) for
cleared swaps, upon the request of the counterparty, receipt of the
daily mark of the transaction from the appropriate derivatives
clearing organization; and (II) for uncleared swaps, receipt of the
daily mark of the transaction from the swap dealer or major swap
participant.''
---------------------------------------------------------------------------
With respect to the recommendation that a swap dealer or major swap
participant be deemed to satisfy the daily mark duty for cleared swaps
if the counterparty can access the information directly from the DCO or
its FCM, the Commission agrees, provided that the swap dealer or major
swap participant apprises the counterparty and the counterparty agrees
to such substituted compliance. The Commission notes that the swap
dealer's or major swap participant's daily mark obligation for cleared
swaps is prompted by the request of the counterparty. As a result,
under the statute, it is up to the counterparty to decide whether it
wishes to receive the daily mark through access to the DCO or FCM or
from the swap dealer or major swap participant.
As to the request to limit the liability of swap dealers or major
swap participants in relation to a counterparty's use of a provided
daily mark, the Commission considers the request to be beyond the scope
of the rulemaking.\475\ Nevertheless, the Commission notes that it will
consider good faith compliance with policies and procedures reasonably
designed to meet the daily mark requirements, including the calculation
of mid-market mark under final Sec. 23.431(d), in exercising its
prosecutorial discretion for violations of the rule.\476\
---------------------------------------------------------------------------
\475\ See Section III.A.1. of this adopting release for a
discussion of ``Private Rights of Action.''
\476\ The Commission agrees with a commenter's suggestion that
the rule should require swap dealers and major swap participants to
deliver the daily mark via communication media that are secure,
timely and auditable. Markit Feb. 22 Letter, at 3. This is
consistent with final Sec. 23.431(d)--Daily mark, as well as final
Sec. 23.402(e)--Manner of disclosure. See Section III.A.3.e. of
this adopting release for a discussion of final Sec. 23.402(e).
---------------------------------------------------------------------------
The Commission disagrees with the assertion that requiring
disclosure of the daily mark methodology and assumptions will encourage
improper reliance by the counterparty on the swap dealer or major swap
participant. The statutory daily mark requirement is meaningless unless
the counterparty knows the methodology and assumptions that were used
to calculate the mark. To make its own assessment of the value of the
swap for its own purposes, the counterparty has to have information
from the swap dealer or major swap participant about how the mid-market
mark was calculated. To satisfy the duty to disclose both the
methodology and assumptions used to prepare the daily mark, swap
dealers and major swap participants may choose to provide to
counterparties methodologies and assumptions sufficient to
independently validate the output from a model generating the daily
mark, collectively referred to as the ``reference model.'' The
Commission does not intend that disclosure of the ``reference model''
would require swap dealers and major swap participants to disclose
proprietary information. While the Commission does not define what
currently constitutes proprietary information, the Commission is aware
that, in light of the disclosure requirements relating to the
methodology and assumptions used to prepare the daily mark, market
participants may aid in the establishment of appropriate ``reference
models'' and, in so doing, potentially alter the extent of undisclosed
proprietary information in the future. With proper disclosures,
counterparties should not be misled or unduly rely on the mid-market
mark provided by the swap dealer or major swap participant.\477\
Therefore, the Commission's final rule requires disclosure of the
methodology and assumptions underlying the daily mark. The Commission's
determination is based on the statutory disclosure provisions as well
as the duty to communicate in a fair and balanced manner based on
principles of fair dealing and good faith.
---------------------------------------------------------------------------
\477\ Without commenting on the findings of the Senate Report,
the Commission notes that the Senate Report included descriptions of
certain conduct relating to marks where dealers purportedly refused
to explain the basis and methodology for the mark. See Senate
Report, at 509-510.
---------------------------------------------------------------------------
One commenter asked the Commission to confirm that the daily mark
received by counterparties is to be determined by reference to the same
mid-market valuations used in connection with the definition of
``Exposure'' under the 1994 ISDA Credit Support Annex. The Commission
declines to endorse any particular methodology given the principles
based nature of the rule.
Further, the Commission is providing guidance that the term ``mid-
market mark'' can be determined through mark-to-model calculations when
a liquid market does not exist. In addition, swap dealers and major
swap participants can delegate daily mark responsibilities to third
party vendors. However, swap dealers and major swap participants will
remain responsible for compliance with the rule.
E. Section Sec. 23.432--Clearing Disclosures
1. Proposed Sec. 23.432
The Commission's proposed rule required certain disclosures
regarding the counterparty's right to select a DCO and to clear swaps
that are not otherwise required to be cleared. For swaps where clearing
is mandatory,\478\ proposed Sec. 23.432(a) required a swap dealer or
major swap participant to notify the counterparty of its right to
select the DCO that would clear the swap. For swaps that are not
required to be cleared, under proposed Sec. 23.432(b), a swap dealer
or major swap participant was required to notify a counterparty that
the counterparty may elect to require the swap to be cleared and that
it has the sole right to select the DCO for clearing the swap.\479\
Neither of
[[Page 9769]]
these notification provisions applied where the counterparty was a
registered swap dealer, major swap participant, security-based swap
dealer or major security-based swap participant.\480\
---------------------------------------------------------------------------
\478\ See Section 2(h) of the CEA. (7 U.S.C. 2(h)).
\479\ With respect to these proposed disclosure requirements,
the Commission noted that, as between the parties, the counterparty
is entitled to choose whether and where to clear, but that no DCM or
SEF is required to make clearing available through any DCO. In other
words, it is up to the parties to take the swap to a DCM or SEF that
provides for clearing through the counterparty's preferred DCO. See
proposing release, 75 FR at 80646.
\480\ Proposing release, 75 FR at 80646.
---------------------------------------------------------------------------
2. Comments
The comments submitted on proposed Sec. 23.432 were directed at
issues related to the substantive rules for swaps not required to be
cleared and, as such, were beyond the scope of this rulemaking.\481\
The only commenters on the disclosure requirement itself stated that
they did not object to the proposed rule.\482\
---------------------------------------------------------------------------
\481\ See Barclays Jan. 11 Letter, at 8 (clearing requirement
should not apply to foreign swap transactions); SIFMA/ISDA Feb. 17
Letter, at 24-25; CEF Feb. 22 Letter, at 22 (the Commission should
clarify that the election to clear a swap is meant to be exercised
at the swap's inception); id. (supporting the proposed clearing
disclosure rule, but recommended that the election of the
counterparty regarding where to clear that is made at the outset of
the transaction should be binding unless both parties agree; to do
otherwise might require the swap dealer or major swap participant to
transfer a swap from bilateral clearing to central clearing at an
economically disadvantageous moment); MetLife Feb. 22 Letter, at 5
(major swap participants should be treated like other customers of a
swap dealer, and receive the same rights as other counterparties,
including the right to elect where to clear trades).
\482\ See COPE Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 22.
---------------------------------------------------------------------------
3. Final Sec. 23.432
The Commission has determined to adopt Sec. 23.432 as proposed.
F. Section 23.433--Communications--Fair Dealing
1. Proposed Sec. 23.433
The Dodd-Frank Act requires that the Commission establish a duty
for swap dealers and major swap participants to communicate in a fair
and balanced manner based on principles of fair dealing and good faith.
Proposed Sec. 23.433 established a duty that, consistent with the
statutory language, applies to all swap dealer and major swap
participant communications with counterparties. As the Commission noted
in the proposing release,\483\ these principles are well established in
the futures and securities markets, particularly through SRO
rules.\484\ The duty to communicate in a fair and balanced manner is
one of the primary requirements of the NFA customer communications rule
\485\ and is designed to ensure a balanced treatment of potential
benefits and risks. In determining whether a communication with a
counterparty is fair and balanced, the Commission stated that it
expects a swap dealer or major swap participant to consider factors
such as whether the communication: (1) Provides a sound basis for
evaluating the facts with respect to any swap; \486\ (2) avoids making
exaggerated or unwarranted claims, opinions or forecasts; \487\ and (3)
balances any statement that refers to the potential opportunities or
advantages presented by a swap with statements of corresponding
risks.\488\ The Commission also stated its expectation that to deal
fairly requires the swap dealer or major swap participant to treat
counterparties in such a way so as not to unfairly advantage a
counterparty or group of counterparties over another. Additionally,
communications are subject to the anti-fraud provisions of the CEA and
Commission Regulations, as well as any applicable SRO rules.\489\
---------------------------------------------------------------------------
\483\ Proposing release, 75 FR at 80646.
\484\ See, e.g., 17 CFR 170.5 (``A futures association must
establish and maintain a program for * * * the adoption of rules * *
* to promote fair dealing with the public.''); NFA Compliance Rule
2-29--Communications with the Public and Promotional Material; NFA
Interpretative Notice 9041--Obligations to Customers and Other
Market Participants.
\485\ See, e.g., NFA Compliance Rule 2-29(b)(2) and (5); see
also NFA Interpretive Notice 9043--NFA Compliance Rule 2-29: Use of
Past or Projected Performance; Disclosing Conflicts of Interest for
Security Futures Products (performance must be presented in a
balanced manner).
\486\ See, e.g., NFA Interpretive Notice 9041, Obligations to
Customers and Other Market Participants (``Members * * * and their
Associates should provide a sound basis for evaluating the facts
regarding any particular security futures product * * *.'').
\487\ See, e.g., NFA Compliance Rule 2-29(b)(4)-(5).
\488\ Proposing release, 75 FR at 80646.
\489\ Id.
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2. Comments
The Commission received several letters from commenters regarding
proposed Sec. 23.433. One commenter found the principles based
approach to the rule more appropriate than a prescriptive
approach.\490\ However, a different commenter expressed concern
regarding the rule's lack of detail, stating that it could create
uncertainty and risk for swap dealers and major swap participants.\491\
That commenter recommended that the Commission consider using safe
harbors containing objective standards as a means to satisfy the
statutory requirements.\492\ Another commenter urged the Commission to
clarify the communications standards by reference to currently
prevailing standards, such as FINRA and NFA standards, subject to
appropriate modifications to reflect standards for participation in the
swaps market.\493\ Another commenter requested that major swap
participants not be subject to a good faith and fair dealing rule when
transacting with swap dealers.\494\ It asserted that major swap
participants in this particular context are customers of swap dealers
and should not be treated as a dealer or quasi-dealer. Others had
little or no concern regarding the fair dealing requirement.\495\
---------------------------------------------------------------------------
\490\ CFA/AFR Feb. 22 Letter, at 12. In addition, the commenter
recognized the need for future guidance, if necessary, after
implementation.
\491\ NY City Bar Feb. 22 Letter, at 3.
\492\ Id.
\493\ FHLBanks Feb. 22 Letter, at 6.
\494\ MetLife Feb. 22 Letter, at 4-5.
\495\ See COPE Feb. 22 Letter, at 4. Accord, Exelon Feb. 22
Letter, at 3-4 (agreeing that holding swap dealers and major swap
participants to standards that require fair dealing is appropriate
as long as these principles are properly applied to commodity swap
market).
---------------------------------------------------------------------------
3. Final Sec. 23.433
The Commission has determined to adopt Sec. 23.433 as proposed. In
addition, the Commission is providing the following guidance regarding
the final fair dealing rule. As discussed above regarding Sec.
23.431--Disclosures, the fair dealing rule works in tandem with both
the material disclosure and anti-fraud rules to ensure that
counterparties receive material information that is balanced and fair
at all times.\496\ The Commission intends these rules to address the
concerns raised by commenters \497\ regarding transactions similar to
those profiled in the Senate Report.\498\ The Senate Report concludes
that those transactions, which involved structured CDOs, were
problematic because they were designed to fail and the disclosures
omitted and/or misrepresented the material risks, characteristics,
incentives and conflicts of interest. Under all circumstances, and
particularly those akin to the Senate Report involving complex swaps,
the Commission's fair dealing rule will apply and operate as an
independent basis for enforcement proceedings.
---------------------------------------------------------------------------
\496\ The fair dealing communications rule applies to all
communications between a counterparty and a swap dealer or major
swap participant, including the daily mark and termination. See
Section III.D. of this adopting release for a discussion of Sec.
23.431.
\497\ See CFA/AFR Feb. 22 Letter, at 12; Sen. Levin Aug. 29
Letter, at 10-11.
\498\ Senate Report, at 376-636.
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The fair dealing rule, like the disclosure rules, is principles
based and applies flexibly based on the facts and circumstances of a
particular swap. For example, when addressing the risks and
characteristics of a swap with features including, but not limited to,
caps, collars, floors, knock-ins, knock-outs and range accrual features
that increase its complexity, the fair dealing rule
[[Page 9770]]
requires the swap dealer or major swap participant to provide a sound
basis for the counterparty to assess how those features would impact
the value of the swap under various market conditions during the life
of the swap. In a complex swap, where the risks and characteristics
associated with an underlying asset are not readily discoverable by the
counterparty upon the exercise of reasonable diligence, the swap dealer
or major swap participant is expected, under both the disclosure rule
and fair dealing rule, to provide a sound basis for the counterparty to
assess the swap by providing information about the risks and
characteristics of the underlying asset.\499\ The fair dealing rule
also will supplement requirements to inform counterparties of material
incentives and conflicts of interest that would tend to be adverse to
the interests of a counterparty in connection with a swap, particularly
in situations like those referenced in the Senate Report. In this
regard, a swap dealer or major swap participant will have to follow
policies and procedures reasonably designed to ensure that the content
and context of its disclosures are fair and complete to allow the
counterparty to protect itself and make an informed decision.
---------------------------------------------------------------------------
\499\ Such a requirement is not intended to create, and does not
create, any general trading prohibition or general disclosure
requirement concerning ``inside information.'' See discussion at fn.
370; see also fn. 452.
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In addition, in response to the comments it received, the
Commission is confirming that it will look to NFA guidance when
interpreting Sec. 23.433 and, as appropriate, will consider providing
further guidance, if necessary, after implementation.\500\ The
Commission concludes that the futures and securities industry
familiarity with these precedents considerably mitigates concerns about
legal certainty as a result of the principles based rule. Also, in the
absence of fraud, the Commission will consider good faith compliance
with policies and procedures reasonably designed to comply with the
business conduct standards rules as a mitigating factor when exercising
its prosecutorial discretion in connection with a violation of the
rules. Lastly, the Commission is not exempting major swap participants
from the fair communication requirement when they transact with swap
dealers. Such an exemption would undermine congressional intent to
improve transparency and raise the business conduct standards
applicable to the market.
---------------------------------------------------------------------------
\500\ See, e.g., NFA Compliance Rule 2-29--Communications with
the Public and Promotional Material; NFA Interpretative Notice
9041--Obligations to Customers and Other Market Participants; NFA
Interpretive Notice 9043--NFA Compliance Rule 2-29: Use of Past or
Projected Performance; Disclosing Conflicts of Interest for Security
Futures Products.
---------------------------------------------------------------------------
G. Section 23.434--Recommendations to Counterparties--Institutional
Suitability
1. Proposed Sec. 23.434
In proposed Sec. 23.434, the Commission exercised its
discretionary authority under new Section 4s(h) by proposing an
institutional suitability obligation for any recommendation a swap
dealer or major swap participant makes to a counterparty in connection
with a swap or swap trading strategy.\501\ More precisely, proposed
Sec. 23.434 required a swap dealer or major swap participant to have a
reasonable basis to believe that any swap or trading strategy involving
swaps that it recommends to a counterparty is suitable for such
counterparty.\502\ A swap dealer or major swap participant would be
required to make this determination based on reasonable due diligence
that would include obtaining information regarding the counterparty's
financial situation and needs, objectives, tax status, ability to
evaluate the recommendation, liquidity needs, risk tolerance, ability
to absorb potential losses related to the recommended swap or trading
strategy, and any other information known by the swap dealer or major
swap participant.\503\
---------------------------------------------------------------------------
\501\ Proposing release, 75 FR at 80647.
\502\ The proposed rule was proposed based on suitability duties
for banks and broker dealers dealing with institutional clients. As
such, the proposed rule also implied a general suitability duty such
that a swap dealer would have to have a reasonable basis to believe
that the recommended swap or swap trading strategy is suitable for
at least some counterparties.
\503\ Proposing release, 75 FR at 80659.
---------------------------------------------------------------------------
Proposed Sec. 23.434 provided that a swap dealer or major swap
participant could fulfill its obligations if the following conditions
were satisfied: (1) The swap dealer or major swap participant had a
reasonable basis to believe that the counterparty (or a party to whom
discretionary authority has been delegated) was capable of evaluating,
independently, the risks related to the particular swap or trading
strategy recommended; (2) the counterparty (or its discretionary
advisor) affirmatively indicated that it was exercising independent
judgment in evaluating the recommendations; and (3) the swap dealer or
major swap participant had a reasonable basis to believe that the
counterparty had the capacity to absorb any potential losses.\504\
---------------------------------------------------------------------------
\504\ Id.
---------------------------------------------------------------------------
Proposed Sec. 23.434 made clear that it would not apply: To any
recommendations made to another swap dealer, major swap participant,
security-based swap dealer, or major security-based swap participant;
where a swap dealer or major swap participant provides information that
is general transaction, financial, or market information; or to swap
terms in response to a competitive bid request from the counterparty.
In proposing Sec. 23.434, the Commission explained that whether a swap
dealer or major swap participant has made a recommendation and thus
triggered its suitability obligation would depend on the facts and
circumstances of the particular case. A recommendation would include
any communication by which a swap dealer or major swap participant
provides information to a counterparty about a particular swap or
trading strategy that is tailored to the needs or characteristics of
the counterparty.\505\
---------------------------------------------------------------------------
\505\ Id., at 80647.
---------------------------------------------------------------------------
While recognizing that futures market professionals have not been
subject to an explicit suitability obligation, the Commission stated
that such professionals have long been required to meet a variety of
related requirements as part of their NFA-imposed obligations.\506\
Further, in proposing Sec. 23.434, the Commission considered that a
suitability obligation is a common requirement for professionals in
other markets and in other jurisdictions, including the banking and
securities markets. Thus, to promote regulatory consistency, the
Commission proposed to adopt a suitability obligation for swap dealers
and major swap participants, modeled, in part, on existing obligations
for banks and broker-dealers dealing with institutional clients.\507\
---------------------------------------------------------------------------
\506\ See, e.g., NFA Compliance Rule 2-30(c) and (j); see also
NFA Interpretive Notice 9004.
\507\ Proposing release, 75 FR at 80647.
---------------------------------------------------------------------------
2. Comments
The Commission received several comments representing a diversity
of views on proposed Sec. 23.434. As a general matter, some commenters
strongly supported the proposal as an important feature of the system
of business conduct standards and directly responsive to the concerns
raised by members of Congress regarding conflicts of interest,
particularly as between investment banks and their customers.\508\ For
example, one
[[Page 9771]]
commenter stated that, for both swap dealers and swap advisors, there
should be some suitability standards in place so that those entities
with the appropriate expertise and capabilities to engage knowledgeably
in these transactions are able to do so, while protecting those
entities that should not be engaged in these types of
transactions.\509\ Other commenters, however, believed that the
institutional suitability requirement is unnecessary and inappropriate
for the swaps market, which is comprised of institutional market
participants, not retail investors, and should remain an SRO rule, if
at all.\510\
---------------------------------------------------------------------------
\508\ See, e.g., CFA/AFR Feb. 22 Letter, at 12-13; Better
Markets Feb. 22 Letter, at 4-5; CFA/AFR Nov. 3 Letter, at 6-7.
\509\ GFOA Feb. 22 Letter, at 2.
\510\ See, e.g., Exelon Feb. 22 Letter, at 3; HETCO Feb. 22
Letter, at 1-4; CEF Feb. 22 Letter, at 8-9; SIFMA/ISDA Feb. 17
Letter, at 25; contra CFA/AFR Nov. 3 Letter, at 7.
---------------------------------------------------------------------------
Of specific concern to some commenters was the proposal's inclusion
of major swap participants. These commenters stated that, regardless of
size, major swap participants cannot be presumed to possess a level of
market or product information equal to that of swap dealers. Further,
they expressed concern that proposed Sec. 23.434 would force major
swap participants into a position of trust and confidence when, in
fact, they are transacting with their counterparties on an arm's length
basis.\511\ These commenters urged the Commission to treat major swap
participants like any other customer of a swap dealer.\512\
---------------------------------------------------------------------------
\511\ See, e.g., MFA Feb. 22 Letter, at 2 and 4; MetLife Feb. 22
Letter, at 4-5.
\512\ See, e.g., MFA Feb. 22 Letter, at 3; MetLife Feb. 22
Letter, at 4-5; contra CFA/AFR Nov. 3 Letter, at 7.
---------------------------------------------------------------------------
Several commenters expressed concern with the use of the term
``recommendation'' in proposed Sec. 23.434.\513\ One commenter opined
that the term is not defined and, therefore, could be overly
broad.\514\ Another commenter was concerned that general marketing
materials could qualify as a recommendation within the meaning of the
proposal.\515\ That commenter requested the Commission clarify that
such materials, as opposed to the recommendation of specific swaps to a
customer based on the individual customer's particular circumstances
and needs, does not trigger the requirements of proposed Sec.
23.434.\516\ Other commenters stated that unless swaps are disclosed in
an understandable, disaggregated form, they cannot be suitable.\517\
Similarly, a commenter suggested the Commission strengthen or clarify
protections against swap dealers recommending swaps that expose the
hedger to risks that are greater than those they seek to hedge, either
by identifying this as a violation of fraud standards or clarifying
that it would be a violation of the suitability and best interests
standards.\518\ In contrast, one commenter believed that the complexity
associated with collective investment vehicles would make it
impracticable to carry out suitability and diligence requirements under
proposed Sec. 23.434.\519\ Similarly, another commenter stated that,
without details of the customer's business, staff, or other risks, it
would be difficult for the swap dealer or counterparty to make a
suitability determination.\520\
---------------------------------------------------------------------------
\513\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 26 (``The
Commission's proposal appears to assume that every `recommendation'
is, in essence, a recommendation to the counterparty that the
identified transaction is a transaction that the counterparty should
execute based on its circumstances. This is far from accurate.'').
\514\ MFA Feb. 22 Letter, at 3.
\515\ FHLBanks Feb. 22 Letter, at 5.
\516\ Id.
\517\ See, e.g., CFA/AFR Feb. 22 Letter, at 12; Better Markets
Feb. 22 Letter, at 4-5.
\518\ CFA/AFR Feb. 22 Letter, at 20.
\519\ AMG-SIFMA Feb. 22 Letter, at 12.
\520\ HOOPP Feb. 22 Letter, at 2.
---------------------------------------------------------------------------
Related to the comments regarding the term ``recommendation'' was
the more general concern that proposed Sec. 23.434 would increase
costs to, and chill communications and transactions between, swaps
market participants.\521\ The concern was that the proposal would cut
the flow of information and transactional alternatives that fall short
of advice and that non-swap dealer and non-major swap participants find
beneficial.\522\ A related concern was that the term ``recommendation''
would encompass ordinary interactions, and, therefore, swap dealers
would always be subject to an explicit fiduciary duty.\523\ According
to some commenters, imposing such a fiduciary duty on swap dealers
would result in either a blanket prohibition on swap dealers
transacting with ERISA plans or place such plans at a negotiating
disadvantage with swap dealers by operation of other requirements that
would require the plans to provide their counterparty with financial
information to enter into a swap.\524\ Regarding costs, some commenters
believed that a suitability determination may be challenged in
litigation as a possible defense against enforcement of a swap by a
swap dealer, and the costs associated with defending such litigation
would be passed on to counterparties and would be disproportionate to
the benefits expected from proposed Sec. 23.434.\525\
---------------------------------------------------------------------------
\521\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 26-27; HOOPP Feb.
22 Letter, at 2; Exelon Feb. 22 Letter, at 3.
\522\ SIFMA/ISDA Feb. 17 Letter, at 27.
\523\ Id.
\524\ Id.; ABC/CIEBA Feb. 22 Letter, at 7.
\525\ See, e.g., FHLBanks June 3 Letter, at 7; VRS Feb. 22
Letter, at 3; HETCO Feb. 22 Letter, at 2; COPE Feb. 22 Letter, at 4.
---------------------------------------------------------------------------
Several commenters suggested that, if the Commission were to adopt
a suitability requirement, it could ameliorate some of the costs
associated with such a requirement by permitting swap dealers and major
swap participants to rely, absent notice of countervailing facts, upon
a counterparty's written representations rather than imposing an
independent diligence requirement.\526\ These commenters contend that
such an approach would prevent any suitability requirement from
triggering fiduciary or other advisory status except in circumstances
where that status reflects the reality of the parties'
relationship.\527\ In contrast, at least one commenter expressed
reservation about the utility of representations because it could
subvert the intent of the suitability standard.\528\ This commenter
believed there was no value in permitting swap dealers and major swap
participants to recommend swaps known to be unsuitable just because the
customer is willing to enter into the transaction.\529\ For this and
other reasons, the commenter urged the Commission to require a
suitability analysis, properly documented, whenever the swap dealer or
major swap participant is the initiator in recommending the transaction
or whenever the swap dealer or major swap participant recommends a
customized swap or trading strategy that involves a customized
swap.\530\
---------------------------------------------------------------------------
\526\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 27; ABC/CIEBA
Feb. 22 Letter, at 7; but see CFA/AFR Nov. 3 Letter, at 7.
\527\ See SIFMA/ISDA Feb. 17 Letter, at 27 fn. 59.
\528\ CFA/AFR Feb. 22 Letter, at 13; CFA/AFR Nov. 3 Letter, at
7.
\529\ CFA/AFR Feb. 22 Letter, at 13.
\530\ Id.
---------------------------------------------------------------------------
3. Final Sec. 23.434
The Commission has determined to adopt Sec. 23.434. The final rule
text has been changed to harmonize with the SEC's proposed rule and
FINRA's final institutional suitability rule.\531\ Through these
changes, the Commission achieves its proposed regulatory objectives
while reducing the cost of compliance associated with reconciliation of
the suitability duties imposed by the Commission, the SEC and FINRA.
---------------------------------------------------------------------------
\531\ See proposed 17 CFR 240.15Fh-3(f), SEC's proposed rules,
76 FR at 42455; FINRA Rule 2111 (Suitability), 75 FR 71479, Nov. 23,
2010 (Order Approving Proposed Rule Change; File No. SR-FINRA-2010-
039).
---------------------------------------------------------------------------
There are two principal changes from proposed Sec. 23.434. First,
major swap
[[Page 9772]]
participants are excluded from the institutional suitability
requirement. Second, the final rule clarifies that the suitability duty
requires a swap dealer to (1) understand the swap that it is
recommending, and (2) make a determination that the recommended swap is
suitable for the specific counterparty. Consistent with the
institutional suitability requirements of the proposed rule, however,
the swap dealer will still be able to satisfy the counterparty-specific
suitability duty by complying with the safe harbor in Sec. 23.434(b)
through the exchange of written representations. The Commission also
deleted paragraph (c)(2), which excluded from the scope of the rule:
(1) Information that is general transaction, financial, or market
information; and (2) swap terms in response to a competitive bid
request from the counterparty. The Commission has determined that, if a
swap dealer were to communicate such information to a counterparty,
without more, such communication would not be considered making a
``recommendation.'' As a result, such exclusion in proposed Sec.
23.434 was unnecessary and potentially confusing to the extent that it
could be read to contain the only types of information that would be
outside the scope of the suitability rule. The Commission agrees with
the commenters that stated that major swap participants are unlikely,
in the normal course of arm's length transactions, to be making
recommendations to counterparties and has removed major swap
participants from the final rule. This determination is consistent with
Section 4s(h)(4), which does not impose on major swap participants the
same ``acts as an advisor'' to a Special Entity duty as it does on swap
dealers.\532\
---------------------------------------------------------------------------
\532\ One commenter disagreed with removing major swap
participants from the suitability requirement. The commenter
reasoned that, if a major swap participant makes a recommendation,
the rule would provide protection for counterparties, but would not
otherwise be burdensome if they do not make recommendations. See
CFA/AFR Aug. 29 Letter, at 21-25. Notwithstanding the commenter's
view, the Commission has determined, in light of the definition of
major swap participant and the nature of its business, to remove
major swap participants from the suitability requirement.
---------------------------------------------------------------------------
In response to the comments it received, the Commission is
providing additional guidance as to the meaning of the term
``recommendation'' in the final suitability rule and adding Appendix A
to subpart H, which clarifies the term and provides guidance as to
compliance with the final rule.\533\ Final Sec. 23.434 requires a swap
dealer that makes a ``recommendation'' to a counterparty to have a
reasonable basis for believing that the recommended swap or trading
strategy involving swaps is suitable for the counterparty. While the
determination of whether a swap dealer has made a recommendation that
triggers a suitability obligation will turn on the facts and
circumstances of the particular situation, there are certain factors
the Commission will consider in reaching such a determination. The
facts and circumstances determination of whether a communication is a
``recommendation'' requires an analysis of the content, context, and
presentation of the particular communication or set of communications.
The determination of whether a ``recommendation'' has been made,
moreover, is an objective rather than a subjective inquiry. An
important factor in this regard is whether, given its content, context,
and manner of presentation, a particular communication from a swap
dealer to a counterparty reasonably would be viewed as a ``call to
action,'' or suggestion that the counterparty enter into a swap.\534\
An analysis of the content, context, and manner of presentation of a
communication requires examination of the underlying substantive
information transmitted to the counterparty and consideration of any
other facts and circumstances, such as any accompanying explanatory
message from the swap dealer.\535\
---------------------------------------------------------------------------
\533\ Appendix A to subpart H provides guidance as to the
meaning of the term recommendation as used in Sec. 23.434 and Sec.
23.440(a)--Acts as an Advisor to a Special Entity. The appendix also
provides guidance related to the safe harbors for compliance with
each final rule.
\534\ Cf. proposing release, 75 FR at 80647 fn. 81 (citing NASD
Notice to Members 01-23 (April 2001) and FINRA Proposed Suitability
Rule, 75 FR 52562, 52564-69, Aug. 26, 2010).
\535\ For example, if a swap dealer transmitted a research
report to a counterparty at the counterparty's request, that
communication would not be subject to the suitability obligation;
whereas, if the same swap dealer transmitted the very same research
report with an accompanying message, either oral or written, that
the counterparty should act on the report, the analysis would be
different.
---------------------------------------------------------------------------
Additionally, the more individually tailored the communication to a
specific counterparty or a targeted group of counterparties about a
swap, group of swaps or trading strategy involving the use of a swap,
the greater the likelihood that the communication may be viewed as a
``recommendation.'' For example, a ``flip book'' or ``pitch book'' that
sets out a customized transaction tailored to the needs or
characteristics of a specific counterparty will likely be a
recommendation. In contrast, general marketing materials, without more,
are unlikely to constitute a recommendation. Further, simply complying
with the requirements of the business conduct standards (e.g.,
verification of ECP or Special Entity status, disclosures of material
information, scenario analysis, disclosure of the daily mark, etc.),
without more, would not cause a swap dealer to be deemed to have made a
recommendation.
This formulation of ``recommendation'' is consistent with the
institutional suitability obligation imposed on federally regulated
banks acting as broker-dealers and making recommendations for
government securities to institutional customers, FINRA guidance on
determining whether a recommendation has been made in the suitability
context for broker-dealers recommending securities, and the SEC's
proposed rules and the federal securities laws on suitability
requirements.\536\ Further, DOL confirms that it does not view
compliance with the Commission's business conduct standards rules,
including the suitability requirement, to cause swap dealers
transacting with ERISA plans to become fiduciaries to those plans.\537\
The Commission also confirms that compliance with the suitability duty
would not cause a swap dealer to owe fiduciary duties to its
counterparty, including a Special Entity.
---------------------------------------------------------------------------
\536\ See, e.g., 12 CFR 13.4 (Office of the Comptroller of the
Currency regulation for banks recommending government securities to
customers); FINRA Rule 2111 (Suitability), 75 FR 71479; SEC's
proposed rules, 76 FR at 42455.
\537\ See Section II.B. of this adopting release for a
discussion of ``Regulatory Intersections--Department of Labor ERISA
Fiduciary Regulations.''
---------------------------------------------------------------------------
The Commission has considered commenters' statements about the
potential costs of proposed Sec. 23.434. With respect to concerns that
the suitability requirement could chill communications or spawn
vexatious litigation, the Commission notes that the final rule aims to
minimize costs by allowing swap dealers to satisfy their due diligence
duty ``to have or obtain information about the counterparty'' including
its investment profile, trading objectives, and ability to absorb
potential losses by relying on the representations from such
counterparty consistent with final Sec. 23.402(d).\538\
[[Page 9773]]
Furthermore, the Commission is clarifying in this adopting release and
in Appendix A to subpart H that, final Sec. 23.434(b) establishes a
safe harbor whereby a swap dealer will satisfy its counterparty-
specific duty under Sec. 23.434(a)(2) through the exchange of certain
written representations between the swap dealer and the counterparty as
provided in Sec. 23.434(c). The Commission further clarifies the types
of representations that would satisfy the requirements of final Sec.
23.402(d) (Reasonable Reliance on Representations) in the context of
the final suitability rule in Sec. 23.434.
---------------------------------------------------------------------------
\538\ The Commission notes, regarding counterparty-specific
suitability, that reasonable diligence would include, for example,
assessing whether a recommendation would expose a hedger to risks
that are greater than those they seek to hedge. See CFA/AFR Feb. 22
Letter, at 20. Reasonable diligence to determine suitability of a
bespoke swap might include, as suggested by commenters and depending
on the facts and circumstances, consideration of hedge equivalents,
evaluations of liquidity, or added price for embedded lines of
credit. See Better Markets Feb. 22 Letter, at 4-7; Better Markets
June 3 Letter, at 13. Depending on the facts and circumstances, a
violation of the suitability duty may also violate other rules,
including the anti-fraud and fair dealing rules.
---------------------------------------------------------------------------
A swap dealer may rely on representations to obtain information
about the counterparty when complying with the counterparty-specific
suitability obligation in Sec. 23.434(a)(2). For example, to obtain
information about the counterparty's ``ability to absorb potential
losses associated with the recommended swap or trading strategy,'' the
swap dealer could rely on the counterparty's representation that it has
a risk management program and/or hedging policy to manage and monitor
its ability to absorb potential losses, and that it has complied in
good faith with its policies and procedures for diligent review of and
compliance with its risk management program and/or hedging policy.
Alternatively, a swap dealer could satisfy the safe harbor
requirements in Sec. 23.434(b) to satisfy the counterparty-specific
suitability obligation. Final Sec. 23.434(b)(1) requires the swap
dealer to assess whether the counterparty is capable of evaluating,
independently, the risks related to a particular swap or swap trading
strategy. To make its assessment, the swap dealer may rely on a
counterparty's representations as provided in Sec. 23.434(c). Final
Sec. 23.434(c)(1) describes the types of representations a swap dealer
may rely on with respect to any counterparty other than a Special
Entity, and Sec. 23.434(c)(2) describes the types of representations a
swap dealer may rely on with respect to a Special Entity. Final Sec.
23.434(c)(1) provides that a swap dealer will satisfy Sec.
23.434(b)(1)'s requirement with respect to a counterparty other than a
Special Entity if it receives representations that the counterparty has
complied in good faith with its policies and procedures that are
reasonably designed to ensure that the persons responsible for
evaluating the recommendation and making trading decisions on behalf of
the counterparty are capable of doing so. Final Sec. 23.434(c)(2)
provides that a swap dealer will satisfy Sec. 23.434(b)(1)'s
requirement with respect to a Special Entity if it receives
representations that satisfy the terms of Sec. 23.450(d) regarding a
Special Entity's qualified independent representative.\539\
---------------------------------------------------------------------------
\539\ See Section IV.C.3.e. at fn. 867 and accompanying text for
a discussion of Sec. 23.450(d).
---------------------------------------------------------------------------
To satisfy the safe harbor in Sec. 23.434(b), the final rule
provides that the swap dealer and counterparty must exchange
representations that: (1) The counterparty is capable of independently
evaluating investment risks with regard to the recommended swap, (2)
the counterparty is exercising independent judgment and is not relying
on the recommendation of the swap dealer, (3) the swap dealer is acting
as a counterparty and is not undertaking to assess the suitability of
the swap or trading strategy involving a swap for the customer, and (4)
in the case of a counterparty that is a Special Entity, the swap dealer
complies with Sec. 23.440 where the recommendation would cause the
swap dealer to act as an advisor to a Special Entity within the meaning
of Sec. 23.440(a).\540\
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\540\ Prong (4) of the safe harbor clarifies that Sec. 23.434's
application is broader than Sec. 23.440--Requirements for swap
dealers acting as advisors to Special Entities. Final Sec. 23.434
is triggered when a swap dealer recommends any swap or trading
strategy that involves a swap to any counterparty. However, Sec.
23.440 is limited to a swap dealer's recommendations (1) to a
Special Entity (2) of swaps that are tailored to the particular
needs or characteristics of the Special Entity. See Section
IV.B.3.a. at fn. 697 and accompanying text. Thus, a swap dealer that
recommends a swap to a Special Entity that is tailored to the
particular needs or characteristics of the Special Entity may comply
with its suitability obligation by satisfying the safe harbor in
Sec. 23.434(b); however, the swap dealer must also comply with
Sec. 23.440 in such circumstances.
---------------------------------------------------------------------------
The Commission believes that this approach will lower the costs of
compliance that would result from a requirement that a swap dealer must
always conduct counterparty-specific due diligence while encouraging
counterparties that choose to make representations consistent with the
final rule to have policies and procedures to ensure that they have
their own advisors that are able to assess recommendations and make
appropriate determinations as to suitability. To further address
commenters' concerns about the potential burden of compliance on swap
dealers, the Commission clarifies that there is no duty to look behind
such representations in the absence of ``red flags.'' In this context,
the Commission interprets ``red flags'' to mean information known by
the swap dealer that would cause a reasonable person to question the
accuracy of the representation.
Commenters requested that the Commission allow swap dealers to rely
on representations made on a relationship basis (i.e., written
representations in counterparty relationship documentation) rather than
requiring a representation be made on a transaction-by-transaction
basis. The Commission agrees and believes this approach addresses the
needs that some market participants have to enter into recommended
transactions in short time frames. Where such representations are made
in counterparty relationship documentation, the documentation must
comply with final Sec. 23.402(d) and may be deemed renewed with each
recommendation.
The Commission has determined not to adopt suggestions from
commenters that it exclude certain classes of ``sophisticated''
counterparties from the protection of final Sec. 23.434. Nevertheless,
with respect to the counterparty-specific suitability duty, the swap
dealer will be able to rely on appropriate representations from
``sophisticated'' counterparties to satisfy the duty. The Commission
stresses that the representations relied upon by the swap dealer in all
cases must be documented in a manner that allows the Commission to
assess compliance with the final suitability rule.
In all cases, to meet the requirements of final Sec. 23.434, a
swap dealer must undertake reasonable diligence to understand the swap
that it is recommending. In general, what constitutes reasonable
diligence will vary depending on, among other things, the complexity
of, and risks associated with, the swap or swap trading strategy and
the swap dealer's familiarity with the swap or swap trading strategy.
At a minimum, a swap dealer's reasonable diligence must provide it with
an understanding of the potential risks and rewards associated with the
recommended swap or swap trading strategy. A swap dealer that lacks
this understanding would not be able to meet its obligations under
Sec. 23.434(a)(1).
These clarifications regarding how the Commission intends to apply
the suitability requirement are designed to address many of commenters'
statements, including that the Commission should ensure consistency
with the approach proposed by the SEC and the long-standing guidance
provided by FINRA.\541\ In so doing, the Commission states its
intention to be
[[Page 9774]]
guided, but not controlled, by precedent arising under analogous SRO
rules.\542\
---------------------------------------------------------------------------
\541\ See SEC's proposed rules, 76 FR at 42415 fn. 133.
\542\ See, e.g., NASD Notice to Members 01-23 (April 2001)
(discussing what constitutes a ``recommendation); see also FINRA
Rule 2111 (suitability).
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IV. Final Rules for Swap Dealers and Major Swap Participants Dealing
With Special Entities
Swap dealers and major swap participants are also subject to
certain business conduct standards rules when dealing with particular
counterparties that are defined as Special Entities. This section of
the adopting release discusses Sec. 23.401(c)-Definition of the term
Special Entity; Sec. 23.440-Requirements for swap dealers acting as
advisors to Special Entities; Sec. 23.450-Requirements for swap
dealers and major swap participants acting as counterparties to Special
Entities; and Sec. 23.451-Political contributions by certain swap
dealers.
A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)
1. Section 23.401--Proposed Definition of ``Special Entity''
Section 4s(h)(2)(C) and proposed Sec. 23.401 defined a ``Special
Entity'' as: (i) A Federal agency; (ii) a State, State agency, city,
county, municipality, or other political subdivision of a State; (iii)
any employee benefit plan, as defined in Section 3 of ERISA; (iv) any
governmental plan, as defined in Section 3 of ERISA; or (v) any
endowment, including an endowment that is an organization described in
Section 501(c)(3) of the Internal Revenue Code of 1986.\543\
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\543\ Proposing release, 75 FR at 80649 and 80657.
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2. Comments
a. State and Municipal Special Entities
One commenter requested the Commission clarify whether the proposed
definition was intended to include instrumentalities of a State or
municipality or a public corporation.\544\ The commenter noted that
proposed Sec. 23.450(b) (Requirements for a Special Entity's
representative) and proposed Sec. 23.451 (Political contributions by
certain swap dealers and major swap participants) referenced
``municipal entities,'' which included any agency, authority or
instrumentality of a State or political subdivision of a State.\545\
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\544\ APGA Feb. 22 Letter, at 2.
\545\ Id.; see proposed Sec. Sec. 23.450(b)(8) and
23.451(a)(3), proposing release, 75 FR at 80660-61.
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b. Employee Benefit Plans and Governmental Plans
Section 4s(h)(2)(C)(iii) refers to any employee benefit plan ``as
defined in'' Section 3 of ERISA. Section 3 of ERISA, however, defines
``employee benefit plan'' broadly and also defines several
subcategories of employee benefit plans that are excluded from
regulation under Title I of ERISA, including ``governmental plans,''
which are referenced in Section 4s(h)(2)(C)(iv).
Some commenters requested that the final rule clarify that prong
(iii) of the Special Entity definition only include employee benefit
plans that are ``subject to,'' i.e., regulated under, Title I of
ERISA.\546\ Commenters stated that the ``employee benefit plan'' prong
should be read narrowly and only include those plans ``subject to''
ERISA because Congress included a separate prong (iv) for
``governmental plans'' that are ``defined in'' Section 3 of ERISA, but
not ``subject to'' ERISA.\547\ Commenters also asserted that the
Commission should exclude foreign pension plans from the Special Entity
definition\548\ and that such an exclusion would be consistent with
congressional intent and would avoid conflicts with foreign law.\549\
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\546\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 30 fn. 70
(asserting that other than U.S. governmental plans, the Special
Entity definition should exclude (1) unfunded plans for highly
compensated employees, (2) foreign pension plans, (3) church plans
that have elected not to be subject to ERISA, and (4) Section 403(b)
plans that accept only employee contributions).
\547\ SIFMA/ISDA Feb. 17 Letter, at 30; CPPIB Feb. 22 Letter, at
3; OTPP Feb. 22 Letter, at 2.
\548\ See SIFMA/ISDA Feb. 17 Letter, at 30; ASF Feb. 22 Letter,
at 2-3; OTPP Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22 Letter, at 13
fn. 44; see also Societe Generale Feb. 18 Letter, at 12; Barclays
Jan. 11 Letter, at 9 fn. 9.
\549\ CPPIB Feb. 22 Letter, at 3-4.
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Other commenters asserted that the Commission should not limit or
exclude any governmental plans such as retirement and deferred
compensation plans.\550\ Another commenter stated that church plans and
church benefit boards that are ``defined in'' Section 3 of ERISA but
not ``subject to'' ERISA should be included within the Special Entity
definition.\551\ The commenter also asserted that the Commission should
avoid legal uncertainty for employee benefit plans that are ``defined
in'' but not ``subject to'' ERISA, such as church plans and church
benefit boards, and permitting such plans to opt in to the Special
Entities provisions of the business conduct standards rules would be a
preferable approach.\552\
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\550\ CFA/AFR Feb. 22 Letter, at 14-15; AFSCME Feb. 22 Letter,
at 5.
\551\ Church Alliance Feb. 22 Letter, at 4-5; Church Alliance
Aug. 29 Letter, at 3-4.
\552\ Church Alliance Oct. 4 Letter, at 2 (also asserting that a
``church benefit board'' is an organization described in Section
3(33)(C)(i) of ERISA).
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c. Master Trusts
Two commenters asserted that the Commission should clarify that the
definition of ``Special Entity'' should encompass master trusts holding
the assets of one or more employee benefit plans of a single
employer.\553\ Another commenter suggested that the definition apply to
any trust that holds the assets of employee benefit plans sponsored by
the same employer or related employers.\554\ These commenters assert
that employers that maintain multiple employee benefit plans often pool
their assets into a single trust called a ``master trust'' for
efficiency purposes.\555\ The commenters also assert that the Special
Entity provisions of the business conduct standards rules should apply
with respect to the master trust and not on a plan-by-plan basis, which
would be burdensome and negate some efficiencies achieved by a master
trust.\556\
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\553\ BlackRock Feb. 22 Letter, at 7; SIFMA/ISDA Feb. 17 Letter,
at 30; see also Church Alliance Feb. 22 Letter, at 5 (``Church
benefit boards may also be likened to a master trust that is
established by several multiple-employer pension plans.'').
\554\ ERIC Feb. 22 Letter, at 2 and 4-5 (asserting that the
assets of an employee benefit plan subject to ERISA generally must
be held in trust and, although the trust is a separate entity from
the plan, the trust exists solely to hold and invest the assets of
the plan).
\555\ See ERIC Feb. 22 Letter, at 4-5.
\556\ See, e.g., ERIC Feb. 22 Letter, at 5.
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d. Endowments
Section 4s(h)(2)(C)(v) refers to ``any endowment, including an
endowment that is an organization described in Section 501(c)(3)\557\
of the Internal Revenue Code of 1986.'' One commenter recommended the
Commission err on the side of inclusiveness and include charitable
organizations as Special Entities.\558\ Other commenters recommended
that the Commission clarify that the endowment prong of the Special
Entity definition is limited to when an endowment itself enters into
swaps, but does not include non-profit or charitable organizations that
enter into swaps, even where such an organization has an
endowment.\559\ One such commenter asserted that the
[[Page 9775]]
Commission should clarify that prong (v) does not include non-profit
organizations that enter into swaps to hedge operational risks, such as
interest rate risk in connection with a bond offering, that is
unrelated to its endowment's investment fund.\560\ Additionally, one
commenter stated that the Special Entity definition should not apply to
foreign endowments or foreign entities generally.\561\
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\557\ Section 501(c)(3) of the Internal Revenue Code of 1986
exempts from federal taxes: ``Corporations, and any community chest,
fund, or foundation, organized and operated exclusively for
religious, charitable, scientific, testing for public safety,
literary, or educational purposes, or to foster national or
international amateur sports competition * * * or for the prevention
of cruelty to children or animals, no part of the net earnings of
which inure to the benefit of any private shareholder or individual
* * *.'' 26 U.S.C. 501(c)(3).
\558\ CFA/AFR Feb. 22 Letter, at 14.
\559\ SFG Feb. 22 Letter, at 2-3; SIFMA/ISDA Feb. 17 Letter, at
30-31; NACUBO Feb. 22 Letter, at 1 fn. 2.
\560\ SFG Feb. 22 Letter, at 2-3.
\561\ Barclays Jan. 11 Letter, at 9 fn. 9.
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e. Collective Investment Vehicles: The ``Look Through'' Issue
DOL has a look through test for entities that have ERISA plan
investors, such as collective investment vehicles, to determine whether
the person operating the entity will be treated as an ERISA fiduciary
with respect to the invested plan assets.\562\ Collective investment
vehicles, such as commodity pools and hedge funds, typically include a
variety of investors and may include organizations that fall within the
Special Entity definition set forth in Section 4s(h)(2)(C). Because the
statutory definition of Special Entity uses ERISA's definition of
``employee benefit plan,'' commenters requested clarification of
whether the Commission will apply a ``look through'' test like DOL's to
collective investment vehicles for purposes of the business conduct
standards rules.
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\562\ 29 CFR 2510.3-101. If plans subject to ERISA own 25% or
more of the assets of a collective investment vehicle, any person
who exercises authority or control respecting the management or
disposition of the vehicle's underlying assets, and any person who
provides investment advice with respect to such assets for a fee, is
a fiduciary to the investing ERISA plans.
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The Commission also received several comments regarding collective
investment vehicles and whether they should be included within the
Special Entity definition.\563\ The majority of commenters who
addressed this issue were opposed to the Commission adopting a DOL-type
``look through'' test for collective investment vehicles.\564\ One
commenter asserted that investment vehicles that hold plan assets
should not be provided relief from the business conduct standards.\565\
Certain commenters asserted that the omission of collective investment
vehicles from the definition of Special Entity in the text of the Dodd-
Frank Act was determinative of congressional intent.\566\ Other
commenters pointed out that the statute addressed only direct
counterparty relationships and not the indirect collective investment
vehicle situation.\567\ In addition, it was argued that, because
collective investment vehicles include non-ERISA investors, extending
the definition would inappropriately cover investors who do not want or
need Special Entity protection.\568\
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\563\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13; BlackRock
Feb. 22 Letter, at 7; ABC/CIEBA Feb. 22 Letter, at 14; ASF Feb. 22
Letter, at 3-6; MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17
Letter, at 29-30; AFSCME Feb. 22 Letter, at 5; Church Alliance Feb.
22 Letter, at 4-5. See also Church Alliance Oct. 4 Letter, at 3-6
(recommending that church benefit boards be allowed to opt in to
Special Entity status).
\564\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13; BlackRock
Feb. 22 Letter, at 7; ABC/CIEBA Feb. 22 Letter, at 14; ASF Feb. 22
Letter, at 3-6; MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17
Letter, at 29-30.
\565\ AFSCME Feb. 22 Letter, at 5.
\566\ See, e.g., AMG-SIFMA Letter, at 12; ASF Feb. 22 Letter, at
3-6; BlackRock Feb. 22 Letter, at 7.
\567\ MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17 Letter, at
29-30; BlackRock Feb. 22 Letter, at 7.
\568\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 30.
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Further, from a pragmatic standpoint, one commenter maintained that
it would be highly impractical to discharge heightened duties on the
broad range of investors that participate in such vehicles and
expressed concern that proposed suitability and diligence requirements
would be problematic under a ``look through'' regime.\569\ The
commenter suggested that heightened standards for collective investment
vehicles would inappropriately subject those vehicles and their
investors to increased costs, decreased efficiency and execution
delays, and a ``look through'' provision could limit Special Entities'
non-swap investment options.\570\ Other commenters believed collective
investment vehicle managers would either limit or prohibit investments
by Special Entities to avoid limitations on their swap trading
activities.\571\ Such managers may be concerned that other non-Special
Entity investors may redeem or not invest if they believe the fund may
be subject to restrictions on trading due to investments by Special
Entities.\572\
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\569\ AMG-SIFMA Feb. 22 Letter, at 12.
\570\ Id., at 13.
\571\ See, e.g., ASF Feb. 22 Letter, at 4; AMG-SIFMA Feb. 22
Letter, at 13; MFA Feb. 22 Letter, at 6-7.
\572\ See AMG-SIFMA Feb. 22 Letter, at 13.
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3. Final Sec. 23.401(c) Special Entity Definitions
The Commission has considered the comments and congressional
intent, and has determined to clarify the scope of the Special Entity
definitions and further refine prongs (ii) and (iii) of Section
4s(h)(2)(C).\573\ For prong (ii), the Commission has determined to
clarify that the definition of State and political subdivisions of a
State includes instrumentalities, agencies or departments of States or
political subdivisions of a State. For prong (iii), the Commission has
determined to interpret the statute to apply only to employee benefit
plans subject to ERISA rather than those defined in ERISA. For plans
defined in ERISA but not otherwise covered by the Special Entity
definition, the Commission has determined to permit such plans to opt
in to the Special Entity protections under subpart H of part 23.
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\573\ In addition to the Commission's discretionary rulemaking
authority in Section 4s(h), Section 721(b)(2) of the Dodd-Frank Act
provides the Commission discretionary rulemaking authority to define
terms included in an amendment to the CEA made by Title VII of the
Dodd-Frank Act.
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a. Federal Agency
The Commission did not receive any comments on the Federal agency
prong (i) of the Special Entity definition, and thus, the Commission is
adopting the definition as proposed (renumbered as Sec.
23.401(c)(1)).\574\
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\574\ The definition of ``swap'' excludes ``any agreement,
contract or transaction a counterparty of which is a Federal Reserve
bank, the Federal Government, or a Federal agency that is expressly
backed by the full faith and credit of the United States.'' Section
1a(47)(B)(ix) of the CEA. Accordingly, the Commission expects that
Special Entities that are Federal agencies will be a narrow category
for purposes of these rules.
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b. State and Municipal Special Entities
The Commission has determined to refine prong (ii) of Section
4s(h)(2)(C), State and municipal Special Entities, to clarify that it
also includes ``any instrumentality, agency, department, or a
corporation of or established by'' States or political subdivisions of
a State (renumbered as Sec. 23.401(c)(2)).\575\ This clarification is
consistent with the Commission's modifications to Sec. 23.450(b)
(requirements for a Special Entity's representative) and Sec. 23.451
(political contributions by certain swap dealers).\576\ The Commission
also determined that including instrumentalities, agencies, departments
or corporations of or established by States or political subdivisions
of a State is consistent with congressional intent to provide
heightened protections for institutions backed by taxpayers.\577\ In
[[Page 9776]]
considering commenters' request for clarity on this issue, the
Commission views Sec. 23.401(c)(2) to apply broadly to State and local
governmental entities that are entrusted with public funds, including
public corporations.
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\575\ In refining prong (ii), the Commission has considered
other provisions of the CEA such as the ECP definition for
governmental entities, which includes ``an instrumentality, agency,
or department'' of a State or political subdivision of a State. See
Section 1a(18)(A)(vii)(III) of the CEA.
\576\ See Sections IV.C. and IV.D. of this adopting release for
a discussion of Sec. Sec. 23.450(b)(1)(vii) and 23.451(a)(3),
respectively.
\577\ See Senator Lincoln floor colloquy stating that the
Special Entity provisions in the Dodd-Frank Act ``should help
protect both tax payers and plan beneficiaries.'' 156 Cong. Rec.
S5923 (daily ed. Jul. 15, 2010) (statement of Sen. Lincoln).
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c. Employee Benefit Plans and Governmental Plans
As a matter of statutory interpretation, Sections 4s(h)(2)(C)(iii)
(employee benefit plans defined in Section 3 of ERISA) and
4s(h)(2)(C)(iv) (governmental plans defined in Section 3 of ERISA)
should be construed ``to avoid rendering superfluous'' the statutory
language.\578\ Section 3(3) of ERISA defines ``employee benefit plan''
broadly to encompass plans, funds, or programs established or
maintained by an employer or employee organization for the purpose of
providing medical benefits or retirement income.\579\ Section 3 of
ERISA (the definitional section) also defines specific types of
employee benefit plans, including governmental plans, which are
excluded from regulation under ERISA by Section 4(b) (the coverage
section of ERISA).\580\ Therefore, Section 4s(h)(2)(C)(iii) read
literally as any employee benefit plan ``defined in'' Section 3 of
ERISA would render Section 4s(h)(2)(C)(iv) superfluous because a
``governmental plan defined in section 3 of [ERISA]'' is subsumed by
the definition of ``employee benefit plan defined in section 3 of
[ERISA].''
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\578\ Astoria Fed. Sav. & Loan Assn. v. Solimino, 501 U.S. 104,
112 (1991).
\579\ See generally 29 U.S.C. 1002(3) (``employee benefit plan''
means an employee welfare benefit plan or an employee pension
benefit plan); 29 U.S.C. 1002(1) (``employee welfare benefit plan''
means a plan, fund, or program established or maintained by an
employer or by an employee organization, for the purpose of
providing for its participants or their beneficiaries medical,
surgical, or hospital care or benefits in the event of sickness,
accident, disability, death or unemployment); 29 U.S.C. 1002(2)
(``employee pension benefit plan'' means any plan, fund, or program
established or maintained by an employer or by an employee
organization that provides retirement income to employees).
\580\ Section 4(b) of ERISA (29 U.S.C. 1003(b)) states that
ERISA shall not apply to any employee benefit plan that is (1) a
governmental plan (as defined in Section 3(32) of ERISA (29 U.S.C.
1002(32)); (2) a church plan (as defined in Section 3(33) of ERISA
(29 U.S.C. 1002(33)) with respect to which no election has been made
to be subject to ERISA under 26 U.S.C. 410(d); (3) plans maintained
solely to comply with workmen's compensation, unemployment
compensation, or disability insurance laws; (4) plans maintained
outside the United States primarily for the benefit of persons
substantially all of whom are nonresident aliens (i.e., foreign
pension plans); or (5) excess benefit plans (as defined in Section
3(36) of ERISA (29 U.S.C. 1002(36)) that are unfunded.
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To resolve this ambiguity, the Commission is refining the
definition of ``any employee benefit plan defined in section 3 of
[ERISA]'' in proposed Sec. 23.401 as ``any employee benefit plan
subject to Title I of [ERISA]'' (renumbered as Sec. 23.401(c)(3)).
This clarifies that employee benefit plans listed in Section 4(b) of
ERISA (29 U.S.C. 1003(b)) are not Special Entities within the meaning
of 4s(h)(2)(C)(iii) or Sec. 23.401(c)(3). However, any employee
benefit plan that is a governmental plan as defined in Section 3 of
ERISA is a Special Entity within the meaning of Section 4s(h)(2)(C)(iv)
and Sec. 23.401(c)(4).
This refinement of the definition of ``employee benefit plan,''
however, also excludes other types of employee benefit plans described
in Section 4(b) of ERISA, including church plans and public and private
foreign pension plans. In response to commenters who support providing
protections broadly, including those commenters who assert that ``a
church plan should be treated as a Special Entity,'' \581\ the
Commission has determined to add a sixth prong to the Special Entity
definition. Under the new prong in Sec. 23.401(c)(6), any employee
benefit plan defined in Section 3 of ERISA, not otherwise defined as a
Special Entity, may elect to be defined as a Special Entity by
notifying its swap dealer or major swap participant of its election
prior to entering into a swap with the particular swap dealer or major
swap participant.\582\ Therefore, for example, under Sec.
23.401(c)(6), any church plan defined in Section 3(33) of ERISA,
including any plan described in Section 3(33)(C)(i), such as a church
benefit board, could elect to be defined as a Special Entity.
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\581\ Church Alliance Feb. 22 Letter, at 4.
\582\ This construction is similar to that of Section 4(b)(2) of
ERISA, which excludes church plans unless the church plan has
elected to be subject to ERISA. (29 U.S.C. 1003(b)(2)).
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The Commission has also considered the comments regarding the
treatment of a master trust where the master trust holds the assets of
more than one ERISA plan, as defined in Sec. 23.401(c)(3), sponsored
by a single employer or by a group of employers under common
control.\583\ In this regard, the Commission clarifies that it would
not find a swap dealer or major swap participant to have failed to
comply with the requirements of subpart H of part 23 of the
Commission's Regulations with respect to an ERISA plan, if it otherwise
complied with such requirements with respect to a master trust that
holds the assets of such ERISA plan. The Commission understands that a
single employer or a group of employers under common control may
sponsor multiple ERISA plans that are combined into a master trust to
achieve economies of scale and other efficiencies. In such cases, the
Commission does not believe that any individual ERISA plan within the
master trust would receive any additional protection if the swap dealer
or major swap participant had to separately comply with requirements of
subpart H of part 23 with respect to each ERISA plan whose assets are
held in the master trust.
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\583\ See generally Section 403(a) of ERISA (in general,
``assets of an employee benefit plan shall be held in trust by one
or more trustees'') (29 U.S.C. 1103(a)); see also DOL Regulation 29
CFR 2520.103-1(e) (requiring the plan administrator of a Plan which
participates in a master trust to file an annual report on IRS Form
5500 in accordance with the instructions for the form relating to
master trusts); see also IRS Form 5500 Instructions, at 9 (``For
reporting purposes, a `master trust' is a trust * * * in which the
assets of more than one plan sponsored by a single employer or by a
group of employers under common control are held.'').
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d. Endowment
The Commission agrees with commenters that the Special Entity prong
with respect to endowments is limited to the endowment itself.
Therefore, the endowment prong of the Special Entity definition under
Section 4s(h)(2)(C)(v) and Sec. 23.401(c)(5) applies with respect to
an endowment that is the counterparty to a swap with respect to its
investment funds. The definition would not extend to counterparties
that are charitable organizations generally. Additionally, where a
charitable organization enters into a swap as a counterparty, the
Special Entity definition would not apply where the organization's
endowment is contractually or otherwise legally obligated to make
payments on the swap. The Commission believes that this determination
is consistent with a plain reading of the statute and is consistent
with the Commission's determination regarding Special Entities and
collective investment vehicles. Finally, the statute does not
distinguish between foreign and domestic counterparties in Section
4s(h). Therefore, the Commission has determined that prong (v) of
Section 4s(h)(2)(C) and Sec. 23.401(c)(5) will apply to any endowment,
whether foreign or domestic.
e. Collective Investment Vehicles: The ``Look Through'' Issue
The Commission has determined as a matter of statutory
interpretation of Section 4s(h) that the definition of Special Entity
does not include collective investment vehicles that have Special
Entity participants. While DOL rules ``look through'' collective
investment vehicles to determine
[[Page 9777]]
whether the managers and advisors of those vehicles that received plan
assets should be subject to ERISA's fiduciary rules, there is no
indication that Congress intended the Commission to ``look through''
collective investment vehicles to apply the Dodd-Frank Act Special
Entity protections.\584\ Given that the statutory definition of Special
Entity does not mention collective investment vehicles, the Commission
is not convinced that extending the Dodd-Frank Act definition of
Special Entities to collective investment vehicles based on a DOL-type
look through test is appropriate or necessary.\585\
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\584\ However, nothing in the Dodd-Frank Act or the business
conduct standards rules would affect the application of the ERISA
look-through requirements.
\585\ The Commission clarifies, however, that this analysis is
not intended to apply with respect to a master trust that holds the
assets of more than one ERISA plan, as defined in Sec.
23.401(c)(3), which includes a master trust in which the assets of
more than one plan sponsored by a single employer or by a group of
employers under common control are held. This determination is based
on the language of Section 4s(h) of the CEA and ERISA's treatment of
master trusts as subject to regulation under ERISA, and is
consistent with the unanimous position of the comments received.
Thus, the Commission would consider such a master trust to be a
Special Entity within the meaning of Sec. 23.401(c)(3).
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Moreover, collective investment vehicles that trade swaps, known as
commodity pools,\586\ generally are operated by CPOs and traded by
CTAs, which some courts have held owe a fiduciary duty to the pool and
pool participants.\587\ Therefore, treating collective investment
vehicles as Special Entities if they receive investment funds from
Special Entities would not materially enhance the protections afforded
to such pool participants, but likely would create administrative
burdens for swap dealers and major swap participants seeking to
determine those pool participants' Special Entity status.
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\586\ Section 1a(10) of the CEA (7 U.S.C. 1a(10)).
\587\ See, e.g., Commodity Trend Serv., Inc. v. CFTC, 233 F.3d
981 (7th Cir. 2000); Savage v. CFTC, 548 F.2d 192 (7th Cir. 1977).
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B. Section 23.440--Requirements for Swap Dealers Acting as Advisors to
Special Entities
1. Proposed Sec. 23.440
Proposed Sec. 23.440 follows the statutory framework in Section
4s(h)(4)(B) of the CEA, which imposes a duty on any swap dealer that
``acts as an advisor to a Special Entity'' to ``act in the best
interests of the Special Entity.'' Section 4s(h)(4)(C) also requires
any swap dealer that ``acts as an advisor to a Special Entity'' to
``make reasonable efforts to obtain such information as is necessary to
make a reasonable determination that any swap recommended by the swap
dealer is in the best interests of the Special Entity * * *.'' The
terms ``act as an advisor to a Special Entity,'' ``best interests,''
``make reasonable efforts'' and ``recommended'' are not defined in the
statute.
Proposed Sec. 23.440(a) defined the term ``acts as an advisor to a
Special Entity'' and stated the term ``shall include where a swap
dealer recommends a swap or trading strategy that involves the use of
swaps to a Special Entity.'' \588\ Under proposed Sec. 23.440(a)(1)-
(2), the term does not include where a swap dealer provides (1)
information to a Special Entity that is general transaction, financial
or market information, or (2) swap terms in response to a competitive
bid request from a Special Entity.\589\ The Commission also discussed
the meaning of the term ``recommendation'' in the preamble to proposed
Sec. 23.434--Recommendations to counterparties--institutional
suitability.\590\
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\588\ Proposing release, 75 FR at 80650 and 80659.
\589\ The exclusions in proposed Sec. 23.440(a)(1)-(2) for
general transaction, financial or market information and swap terms
in response to a competitive bid request are consistent with the
exclusions in proposed Sec. 23.434(c)(2)-Recommendations to
counterparties-institutional suitability. Proposing release, 75 FR
at 80647-48 and 80659.
\590\ In the proposing release, the Commission stated that
whether a recommendation has been made depends on the facts and
circumstances of the particular case, and includes any communication
by which a swap dealer provides information to a counterparty about
a particular swap or trading strategy that is tailored to the needs
or characteristics of the counterparty, but would not include
information that is general transaction, financial, or market
information, swap terms in response to a competitive bid request
from the counterparty. Proposing release, 75 FR at 80647. See id. at
80647 and fn. 81 (citing SRO guidance--NASD Notice to Members 01-23
(April 2001)--interpreting the meaning of the term
``recommendation'' in the context of a securities suitability
obligation). See Sections III.G. and IV.B. of this adopting release
for a discussion of final Sec. Sec. 23.434 and 23.440,
respectively, and Appendix A to subpart H of part 23 for
clarification of the term ``recommendation.''
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Proposed Sec. 23.440(b)(1) restated the statutory duty to ``act in
the best interests'' but did not define the term ``best interests.''
\591\ The proposing release clarified that the meaning of the term
would be informed by ``established principles in case law under the CEA
with respect to the duties of advisors, which will inform the meaning
of the term on a case-by-case basis.'' The ``best interests''
principles, in the context of a recommended swap or swap trading
strategy, would impose affirmative duties to act in good faith and make
full and fair disclosure of all material facts and conflicts of
interest * * *.'' \592\ The proposing release also stated that best
interests principles would impose affirmative duties ``to employ
reasonable care that any recommendation made to a Special Entity is
designed to further the purposes of the Special Entity.''\593\
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\591\ Proposing release, 75 FR at 80650 and 80659.
\592\ Id., at 80650 fn. 98 (citing similar language in SEC v.
Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-94 (1963)).
\593\ Id.
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The proposing release explained that the statutory language in
Sections 4s(h)(4) and (5) and congressional intent guided the proposal.
The proposal would permit a swap dealer to both recommend a swap to a
Special Entity, prompting the duty to act in the best interests, and
then enter into the same swap with the Special Entity as a counterparty
if the Special Entity had a representative independent of the swap
dealer on which it could rely.\594\ Finally, the proposing release
stated that Sections 4s(h)(4) and (5) of the CEA and proposed rules
Sec. Sec. 23.440 and 23.450, together, were ``intended to allow
existing business relationships to continue, albeit subject to the new,
higher statutory standards of care.'' \595\
---------------------------------------------------------------------------
\594\ Id., at 80650 fn. 99 (citing 156 Cong. Rec. S5923 (daily
ed. Jul. 15, 2010) (statement of Sen. Lincoln)).
\595\ Id., at 80650.
---------------------------------------------------------------------------
The proposed rule restated the duty in Section 4s(h)(4)(C) that
``any swap dealer that acts as an advisor to a Special Entity shall
make reasonable efforts to obtain such information as is necessary to
make a reasonable determination that any swap recommended by the swap
dealer is in the best interests of the Special Entity.'' \596\ The
statute also states that ``such information'' includes information
relating to (1) the financial status, (2) the tax status, and (3) the
investment or financing objectives of the Special Entity.\597\ The
statute also grants the Commission discretionary authority to prescribe
additional types of information to satisfy the ``reasonable efforts''
and ``best interests'' standards.\598\ As a result, the Commission
proposed that the swap dealer also be required to make reasonable
efforts to obtain the following information: (1) The authority of the
Special Entity to enter into a swap; (2) the experience of the Special
Entity with respect to entering into swaps; (3) whether the Special
Entity has a representative as provided in
[[Page 9778]]
proposed Sec. 23.450(b); (4) whether the Special Entity has the
financial capability to withstand potential market-related changes in
the value of the swap; and (5) such other information as is relevant to
the particular facts and circumstances of the Special Entity.\599\
---------------------------------------------------------------------------
\596\ Proposed Sec. 23.440(b)(2); proposing release, 75 FR at
80659-60.
\597\ Section 4s(h)(4)(C)(i)-(iii) of the CEA.
\598\ Section 4s(h)(4)(C)(iv) of the CEA.
\599\ Proposing release, 75 FR at 80650.
---------------------------------------------------------------------------
Proposed Sec. 23.440(c) allowed a swap dealer to rely on the
Special Entity's written representations to satisfy its duty to ``make
reasonable efforts to obtain information'' under proposed Sec.
23.440(b). The proposed rule required a swap dealer to have a
reasonable basis to believe that the representations are reliable
taking into consideration the facts and circumstances of a particular
swap dealer-Special Entity relationship, assessed in the context of a
particular transaction.\600\ The representations had to be sufficiently
detailed.\601\
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\600\ Id., at 80660.
\601\ See proposed Sec. 23.440(c)(2) requiring representations
to be sufficiently detailed for the swap dealer to reasonably
conclude that the Special Entity is (1) capable of evaluating
independently the material risk inherent in the recommendation, (2)
exercising independent judgment in evaluating the recommendation,
and (3) capable of absorbing potential losses related to the
recommended swap. Proposing release, 75 FR at 80660. The criteria in
paragraph (c)(2) parallel and were modeled on the three criteria in
Sec. 23.434(b)(1)--Recommendations to counterparties--institutional
suitability. Id., at 80659.
---------------------------------------------------------------------------
2. Comments
The Commission received a significant number of comments regarding
proposed Sec. 23.440. The commenters raised a range of issues,
including: What types of activities should fall within the scope of the
rule; the definitions of the terms ``act as an advisor to a Special
Entity'' and ``best interests''; whether Special Entities should be
allowed to opt out of the protections; safe harbors for compliance;
intersections with the CTA, ERISA fiduciary, investment adviser, and
municipal advisor statutory and regulatory provisions; and the
potential costs and benefits to swap dealers and Special Entities. The
Commission also received late-filed comments comparing its proposed
approach with the SEC's proposed approach to ``acts as an advisor to a
Special Entity'' for SBS Dealers.
A few commenters supported the Commission's proposed interpretation
of Section 4s(h)(4)(B)-(C) and proposed Sec. 23.440.\602\ The
overwhelming majority of commenters, however, raised concerns with the
proposed rule and requested that the Commission further clarify the
meaning of ``acts as an advisor to a Special Entity.'' \603\
---------------------------------------------------------------------------
\602\ See, e.g., CFA/AFR Feb. 22 Letter, at 15-16; AFSCME Feb.
22 Letter, at 2-5; CFA/AFR Nov. 3 Letter, at 1.
\603\ See, e.g., APGA Feb. 22 Letter, at 3-5; APPA/LPPC Feb. 22
Letter, at 3; CalSTRS Feb. 28 Letter, at 3-5; CEF Feb. 22 Letter, at
16; GFOA Feb. 22 Letter, at 1-2; HOOPP Feb. 22 Letter, at 2-3;
NACUBO Feb. 22 Letter, at 2-4; Ropes & Gray Feb. 22 Letter, at 2-3;
Russell Feb. 18 Letter, at 1; SIFMA/ISDA Feb. 17 Letter, at 31-35;
ERIC Feb. 22 Letter, at 13-16; SWIB Feb. 22 Letter, at 2-4; Texas
VLB Feb. 22 Letter, at 1-2; and U. Tex. System Feb. 22 Letter, at 1-
3.
---------------------------------------------------------------------------
a. Scope of the Proposed ``Acts as an Advisor to a Special Entity'' and
``Recommendation'' Definitions
Commenters generally discussed the following issues: (1)
Congressional intent regarding the meaning of ``acts as an advisor to a
Special Entity''; (2) the definition of ``advice'' or
``recommendation''; (3) whether activities other than advice or
recommendations would trigger application of proposed Sec. 23.440; (4)
whether compliance with other business conduct standards would trigger
proposed Sec. 23.440; and (5) whether to permit an opt out or create a
safe harbor for swap dealers dealing with Special Entities that meet
certain criteria.
The Commission received several comments discussing whether
proposed Sec. 23.440 was consistent with congressional intent and
Section 4s(h)(4). Some commenters stated that ``recommendations'' were
an appropriate trigger for proposed Sec. 23.440 and consistent with
congressional intent.\604\ Other commenters stated that proposed Sec.
23.440 was inconsistent with or went beyond congressional intent.\605\
One commenter stated that Congress sought to establish a clear, bright
line between swap dealers that are advisors under Section 4s(h)(4) and
those that are merely counterparties under Section 4s(h)(5).\606\ Other
commenters asserted that the proposed rule imposed a fiduciary status
on swap dealers, a result that Congress expressly rejected in the
legislative history of the Dodd-Frank Act.\607\
---------------------------------------------------------------------------
\604\ See, e.g., AFSCME Feb. 22 Letter, at 2-3; CFA/AFR Feb. 22
Letter, at 14-15 and 19 (the goal of the statute was to ensure that
swap dealers would act in the best interest of more vulnerable
counterparties when providing advice and making recommendations).
\605\ See, e.g., VRS Feb. 22 Letter, at 5 (Congress did not
intend for the Commission to impose duties on a relationship that is
potentially principal-to-principal); SIFMA/ISDA Feb. 17 Letter, at 4
(Congress intended parties to a swap to clarify the nature of their
relationship, and not to transform the nature of their relationship,
noting the provision in 4s(h)(5)(A)(ii) that requires a swap dealer
that offers to enter or enters into a swap with a Special Entity to
disclose its capacity before initiation of the transaction); APPA/
LPPC Feb. 22 Letter, at 3 (the Dodd-Frank Act does not mandate a
``recommendation'' standard for the acts as an advisor provision);
Ropes & Gray Feb. 22 Letter, at 2 (the statute should be triggered
when the dealer assumes a status, rather than simply performing a
single act, and the phrase ``acts as an advisor'' intends a more
formal relationship than providing advice); CalSTRS Feb. 28 Letter,
at 4 (impairing Special Entities' access to derivatives markets was
contrary to congressional intent).
\606\ SIFMA/ISDA Feb. 17 Letter, at 4 fn. 11.
\607\ See BlackRock Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22
Letter, at 6 fn. 16.
---------------------------------------------------------------------------
Several commenters stated that the Commission's description of
``recommendation'' in the proposed rule was too broad and would
inappropriately limit communications between swap dealers and Special
Entities.\608\ Similarly, some commenters stated that the rule creates
a very low bar for tripping the ``best interests'' standard and would
often apply in the normal course of interactions between swap dealers
and Special Entities.\609\ Commenters asserted that a swap dealer that
prepares a term sheet and recommends a swap for consideration is not
necessarily providing advice as to whether or not to enter into the
transaction.\610\ Another commenter asserted that the term
``recommends'' has the potential to be vastly expansive and should not
extend to marketing activities.\611\ A number of commenters asserted
that the enumerated exclusions from the term ``acts as an advisor to a
Special Entity'' are too narrow and overlook circumstances that should
not give rise to an advisory relationship.\612\
---------------------------------------------------------------------------
\608\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 2; SWIB Feb. 22
Letter, at 2-4; NACUBO Feb. 22 Letter, at 2; U. Tex. System Feb. 22
Letter, at 1-2.
\609\ See, e.g., U. Tex. System Feb. 22 Letter, at 2; Russell
Feb. 18 Letter, at 1; GFOA Feb. 22 Letter, at 1-2; AMG-SIFMA Feb. 22
Letter, at 3; ERIC Feb. 22 Letter, at 15; ABC/CIEBA Feb. 22 Letter,
at 7; SIFMA/ISDA Feb. 17 Letter, at 33 (providing specific
information while negotiating a swap should not constitute advising
others); cf. CFA/AFR Feb. 22 Letter, at 19-20.
\610\ SIFMA/ISDA Feb. 17 Letter, at 33; cf. Russell Feb. 18
Letter, at 1.
\611\ Ropes & Gray Feb. 22 Letter, at 2-3.
\612\ See, e.g., AFSCME Feb. 22 Letter, at 3; NACUBO Feb. 22
Letter, at 2; U. Tex. System Feb. 22 Letter, at 2; Ropes & Gray Feb.
22 Letter, at 2-3; cf. SWIB Feb. 22 Letter, at 2-3 (the exclusion is
too narrow because Special Entities do not always issue competitive
bid requests); Texas VLB Feb. 22 Letter, at 2.
---------------------------------------------------------------------------
Several commenters have stated that the Commission should clearly
define activities that are recommendations or provide an alternative
that clearly establishes when a swap dealer acts as an advisor to a
Special Entity.\613\ Commenters stated the Commission should issue
guidance to clearly define when a swap dealer will be classified as an
``advisor'' to avoid inadvertently
[[Page 9779]]
triggering that status.\614\ Other commenters stated that the proposed
rule uses subjective criteria and is unworkable.\615\
---------------------------------------------------------------------------
\613\ See ERIC Feb. 22 Letter, at 2; CEF Feb. 22 Letter, at 17;
AGPA Feb. 22 Letter, at 4; Ropes & Gray Feb. 22 Letter, at 3;
Russell Feb. 18 Letter, at 1.
\614\ See ERIC Feb. 22 Letter, at 15; CEF Feb. 22 Letter, at 17.
\615\ See Russell Feb. 18 Letter, at 1; VRS Feb. 22 Letter, at
5; cf. Ropes & Gray Feb. 22 Letter, at 3 (a bright line test would
be more appropriate than a facts-and-circumstances approach to a
rule focused on the existence of a specific relationship).
---------------------------------------------------------------------------
Commenters also suggested that the definition of ``advice'' or
``recommendations'' should be limited to communications that are
individualized or tailored to the recipient. One commenter suggested
that the ``acts as an advisor to a Special Entity'' definition should
be limited to individualized advice based on the particular needs of
the Special Entity.\616\ Another commenter suggested the Commission
adopt a definition of advice as ``recommendations related to a swap or
a swap trading strategy that are made to meet the objectives or needs
of a specific counterparty after taking into account the counterparty's
specific circumstances.'' \617\ Another commenter stated that the
definition of ``recommendation'' should turn on whether the swap dealer
suggested or indicated a particular preferred course of action.\618\
---------------------------------------------------------------------------
\616\ SIFMA/ISDA Feb. 17 Letter, at 31-32.
\617\ CFA/AFR Feb. 22 Letter, at 19-20; cf. SWIB Feb. 22 Letter,
at 2-3 (a swap dealer should not be acting as an advisor where it
provides research and recommendations that are not specifically
designed for the specific Special Entity).
\618\ APGA Feb. 22 Letter, at 4 (a ``recommendation'' should
mean a firm indication by the swap dealer of a particular preferred
transaction, swap or market strategy).
---------------------------------------------------------------------------
Commenters also proposed alternatives to determining when a swap
dealer ``acts as an advisor to a Special Entity.'' Some commenters
requested the Commission specifically exclude certain activities from
the meaning of ``advice'' or ``recommendation.'' \619\ Commenters also
suggested the Commission should look to principles of agency to
determine whether a swap dealer is acting as an advisor.\620\
---------------------------------------------------------------------------
\619\ See CEF Feb. 22 Letter, at 17 (``recommending'' a swap
should not apply to the negotiation or the marketing of a swap);
APGA Feb. 22 Letter, at 5 (providing market color and alerting a
Special Entity to a possible strategy or to new products that are
being offered, even when based upon knowledge of the Special
Entity's hedge positions or market strategy, should not constitute
making a recommendation that causes a swap dealer to be deemed an
advisor to a Special Entity); SIFMA/ISDA Feb. 17 Letter, at 33-34.
\620\ See CEF Feb. 22 Letter, at 16; Ropes & Gray Feb. 22
Letter, at 2 (providing advice is a narrower category than making a
mere recommendation; therefore, ``acting as an advisor'' should
require acknowledged agency, in which the Special Entity places
trust, confidence, or reliance on the swap dealer); but cf. AFSCME
Feb. 22 Letter, at 3 (many non-swap dealer market participants often
assume that the swap dealer is a trusted advisor and is accountable
for its advice).
---------------------------------------------------------------------------
Commenters asserted that broad application of the term
``recommends'' in proposed Sec. 23.440, which imposes a best interests
duty on a swap dealer, will chill normal commercial communications,
restrict customary commercial interactions, and generally reduce market
information shared between swap dealers and Special Entities.\621\
Commenters asserted that swap dealers will decline to propose
transactions, provide term sheets or transaction-specific information
tailored to the Special Entity, and will be discouraged from providing
education, suggestions, or other information with respect to a current
or potential transaction that is customarily provided in the normal
course of the business relationship.\622\
---------------------------------------------------------------------------
\621\ See SIFMA/ISDA Feb. 17 Letter, at 22; APGA Feb. 22 Letter,
at 3; APPA/LPPC Feb. 22 Letter, at 3; NACUBO Feb. 22 Letter, at 2;
COPE Feb. 22 Letter, at 2; U. Tex. System Feb. 22 Letter, at 2; VRS
Feb. 22 Letter, at 5; Ohio STRS Feb. 18 Letter, at 2-3; MHFA Feb. 22
Letter, at 2; Russell Feb. 18 Letter, at 1; BlackRock Feb. 22
Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3.
\622\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 6 and 33; VRS
Feb. 22 Letter, at 5; U. Tex. System Feb. 22 Letter, at 2; MHFA Feb.
22 Letter, at 2; Russell Feb. 18 Letter, at 1; APPA/LPPC Feb. 22
Letter, at 3; Ohio STRS Feb. 18 Letter, at 2-3; BlackRock Feb. 22
Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3; Texas VLB Feb. 22
Letter, at 1; NACUBO Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22 Letter,
at 3.
---------------------------------------------------------------------------
Commenters asserted that swap dealers provide valuable information,
but the broad application of the term ``recommends'' will preclude
Special Entities from receiving this information. One commenter
asserted that such communications serve an important informational
function; even where the prospective counterparty's last inclination
would be to follow guidance from the swap dealer, such communications
can indicate where the dealer might be willing to execute before
negotiation and the types of trades that are being circulated in the
marketplace.\623\ Other commenters added that swap dealers provide
valuable information that could not easily be obtained elsewhere, and
informal and course-of-business communications where market ideas and
structures are presented and discussed is invaluable.\624\ Other
commenters asserted that the broad application of the term
``recommends'' will make compliance burdensome for swap dealers and
will increase costs.\625\ Commenters requested the Commission clarify
whether activities or conduct other than making a recommendation would
cause a swap dealer to ``act as an advisor to a Special Entity'' within
the meaning of Sec. 23.440, because language in the proposing release
was ambiguous.\626\ Several commenters raised concerns that compliance
with other business conduct rules could cause a swap dealer to act as
an advisor. Commenters identified the following examples: Providing
tailored disclosures, scenario analyses, daily marks, assessing the
qualifications of a Special Entity's independent representative, the
general provisions of proposed Sec. 23.402, and verification of
counterparty eligibility.\627\
---------------------------------------------------------------------------
\623\ Ropes & Gray Feb. 22 Letter, at 3.
\624\ U. Tex. System Feb. 22 Letter, at 2; APPA/LPPC Feb. 22
Letter, at 3, APGA Feb. 22 Letter, at 4; SWIB Feb. 22 Letter, at 3;
Texas VLB Feb. 22 Letter, at 3; SFG Feb. 22 Letter, at 3; MHFA Feb.
22 Letter, at 3; ERIC Feb. 22 Letter, at 15.
\625\ COPE Feb. 22 Letter, at 2-3 (swap dealers may be forced to
require personnel to read from an approved script to avoid
violations; such compliance will require more compliance personnel
and raise swap dealer costs); Ropes & Gray Feb. 22 Letter, at 3
(compliance with the proposed rule would require the swap dealer to
make difficult distinctions between general information and specific
trade data).
\626\ CalSTRS Feb. 28 Letter, at 3 and 5; ERIC Feb. 22 Letter,
at 3, 14 and 16; see proposing release, 75 FR at 80650 (``The
proposed definition does not address what it means to act as an
advisor in connection with any other dealings between a swap dealer
and a Special Entity.'').
\627\ See SIFMA/ISDA Feb. 17 Letter, at 4 and 32; AFSCME Feb. 22
Letter, at 3; NACUBO Feb. 22 Letter, at 3; U. Tex. System Feb. 22
Letter, at 2-3; SWIB Feb. 22 Letter, at 3; CalPERS Feb. 18 Letter,
at 3 fn. 4; BlackRock Feb. 22 Letter, at 6; ERIC Feb. 22 Letter, at
15-16; ABC/CIEBA Feb. 22 Letter, at 7.
---------------------------------------------------------------------------
Several commenters discussed whether the Commission should permit
the intention of the parties, rather than a functional test, to
determine whether a swap dealer ``acts as an advisor to a Special
Entity.'' \628\ One commenter asserted that it would be impossible
under the proposed rules for a swap dealer to confirm to a Special
Entity counterparty that it was acting only as a counterparty and not
acting as an advisor.\629\ Several commenters supported an approach to
permit the Special Entity and swap dealer to agree that the swap dealer
is not acting as an advisor, and, therefore, not subject to proposed
Sec. 23.440.\630\ Another
[[Page 9780]]
commenter stated that permitting the swap dealer and Special Entity to
determine whether the swap dealer ``acts as an advisor to the Special
Entity'' is consistent with the business conduct standards requirement
for a swap dealer to ``disclose to the Special Entity in writing the
capacity in which the swap dealer is acting.'' \631\ By contrast,
however, one commenter opposed an approach that would permit a swap
dealer to avoid any obligation for giving advice where it discloses
that it is not impartial and has an interest in the transaction being
recommended.\632\
---------------------------------------------------------------------------
\628\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 5; Ropes & Gray
Feb. 22 Letter, at 2; NACUBO Feb. 22 Letter, at 2-3; U. Tex. System
Feb. 22 Letter, at 2 and 3; CEF Feb. 22 Letter, at 16; VRS Feb. 22
Letter, at 5; CalSTRS Feb. 28 Letter, at 3; MHFA Feb. 22 Letter, at
2; Russell Feb. 18 Letter, at 1; ERIC Feb. 22 Letter, at 2; ABC/
CIEBA Feb. 22 Letter, at 7; ABA/ABC Feb. 22 Letter, at 2; Davis &
Harman Mar. 25 Letter, at 4; Rep. Smith July 25 Letter, at 2.
\629\ SIFMA/ISDA Feb. 17 Letter, at 5.
\630\ See Ropes & Gray Feb. 22 Letter, at 2; NACUBO Feb. 22
Letter, at 2-3; CEF Feb. 22 Letter, at 16; VRS Feb. 22 Letter, at 5;
CalSTRS Feb. 28 Letter, at 3; MHFA Feb. 22 Letter, at 2; Russell
Feb. 18 Letter, at 1; ERIC Feb. 22 Letter, at 2; ABC/CIEBA Feb. 22
Letter, at 7; ABA/ABC Feb. 22 Letter, at 2; Davis & Harman Mar. 25
Letter, at 4; Rep. Smith July 25 Letter, at 2; cf. U. Tex. System
Feb. 22 Letter, at 2-3 (a swap dealer should not be an advisor if
(1) any swap dealer communications that would otherwise be deemed a
recommendation were only made in response to the Special Entity's
solicitation for information, and (2) the Special Entity certifies
to the swap dealer that an advisory relationship does not arise).
\631\ VRS Feb. 22 Letter, at 5; see Section 4s(h)(5)(A)(ii) of
the CEA; proposing release, proposed Sec. 23.450(f), 75 FR at
80661.
\632\ AFSCME Feb. 22 Letter, at 4.
---------------------------------------------------------------------------
Many commenters suggested that the Commission consider whether the
Special Entity relied or depended on the swap dealer's advice or
recommendations to determine whether a swap dealer ``acts as an advisor
to a Special Entity.'' \633\ Commenters suggested a swap dealer should
be deemed to ``act as an advisor to a Special Entity'' only where the
advice will serve as a primary basis for the Special Entity's decision
to take or refrain from taking a particular action.\634\ One commenter
asserted that ``[i]mposing a `best interests' duty based only on
recommendations in the context of particular transactions would
effectively overturn * * * longstanding [Commission] precedent.'' \635\
---------------------------------------------------------------------------
\633\ Ropes & Gray Feb. 22 Letter, at 2 (the definition of
``acts as an advisor'' should require acknowledged agency in which
the Special Entity places trust, confidence, or reliance on the swap
dealer); SIFMA/ISDA Feb. 17 Letter, at 31-32 fn. 76; APGA Feb. 22
Letter, at 4; ATA Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at
3; ERIC Feb. 22 Letter, at 16.
\634\ SIFMA/ISDA Feb. 17 Letter, at 31-32; APGA Feb. 22 Letter,
at 4; ATA Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3; cf.
DOL's current fiduciary regulation, which deems a person that
renders investment advice to an ERISA plan a ``fiduciary'' where
``the advice will serve as a primary basis for investment decisions
with respect to plan assets.'' 29 CFR 2510.3-21(c); supra fn. 34.
\635\ SIFMA/ISDA Feb. 17 Letter, at 32 fn. 76 (asserting that
Commission precedent recognized ``the nature of the overall
relationship between the customer and advisor--and the customer's
dependence on the advisor--that gives rise to a fiduciary
relationship'') citing In re Jack Savage, [1975-1977 Transfer
Binder] Comm. Fut. L. Rep. (CCH) ] 20,139 (CFTC Mar. 1, 1976).
---------------------------------------------------------------------------
Commenters suggested that the Commission permit Special Entities of
a certain size or sophistication be exempted or permitted to opt out of
the protections under Section 4s(h)(4)(B)-(C) and proposed Sec.
23.440. Commenters suggested that Special Entities be permitted to
represent to a swap dealer that an advisory relationship is not
intended if the Special Entity meets a minimum threshold of assets
under management, net financial assets, debt outstanding, or frequency
of executing swaps.\636\ Commenters also asserted that the business
conduct standards protections generally, and proposed Sec. 23.440 in
particular, do not provide any benefit to sophisticated Special
Entities.\637\ Additionally, one commenter suggested that the final
rule should provide that a swap dealer is never an advisor to an ERISA
plan.\638\
---------------------------------------------------------------------------
\636\ NACUBO Feb. 22 Letter, at 2-4; U. Tex. System Feb. 22
Letter, at 3; cf. VRS Feb. 22 Letter, at 4 (the Commission should
exempt transactions between swap dealers and Special Entities that
qualify as ``qualified institutional buyers'' as defined in Rule
144A under the Securities Act); CEF Feb. 22 Letter, at 5; SIFMA/ISDA
Feb. 17 Letter, at 3 fn. 17. (17 CFR 230.144A). Rule 144A exempts
from certain federal securities law protections certain entities
that own and invest on a discretionary basis at least $100 million
in securities of issuers that are not affiliated with the entity.
\637\ See, e.g., CEF Feb. 22 Letter, at 16; VRS Feb. 22 Letter,
at 4.
\638\ ERIC Feb. 22 Letter, at 2.
---------------------------------------------------------------------------
Many commenters suggested that the Commission create a safe harbor
for compliance with proposed Sec. 23.440 if the Special Entity is
separately represented by a qualified independent representative as
prescribed under Section 4s(h)(5) and proposed Sec. 23.450.\639\
Several commenters suggested different refinements for such a safe
harbor, for example, if (1) the communications are in response to the
advisor's standing solicitation for information, and (2) the advisor
certifies to the swap dealer that no advisory relationship is
intended.\640\ Other commenters suggested the safe harbor should apply
if the Special Entity is represented by a sophisticated, professional
advisor such as a bank, registered investment adviser, insurance
company, qualified professional asset manager \641\ (``QPAM''), or in-
house asset manager \642\ (``INHAM'').\643\ Alternatively, the Special
Entity's fiduciary could agree to the safe harbor if it is in the
Special Entity's best interests, for example, where the Special Entity
has the ability to solicit bids and trade with multiple
counterparties.\644\
---------------------------------------------------------------------------
\639\ SIFMA/ISDA Feb. 17 Letter, at 31; Ropes & Gray Feb. 22
Letter, at 2; NACUBO Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at
16; APPA/LPPC Feb. 22 Letter, at 3; APGA Feb. 22 Letter, at 5; SWIB
Feb. 22 Letter, at 5; CalPERS Feb. 18 Letter, at 4; CalSTRS Feb. 28
Letter, at 3; SFG Feb. 22 Letter, at 1; BlackRock Feb. 22 Letter, at
5; AMG-SIFMA Feb. 22 Letter, at 2 and 5; ERIC Feb. 22 Letter, at 3
and 15; ABC/CIEBA Feb. 22 Letter, at 7; contra CFA/AFR Nov. 3
Letter, at 3.
\640\ NACUBO Feb. 22 Letter, at 4.
\641\ A qualified professional asset manager is defined in DOL
prohibited transaction exemption 84-14 as a bank, insurance company,
or registered investment adviser that meets certain capital, net
worth, or assets under management tests. DOL QPAM PTE 84-14, 75 FR
38837.
\642\ An in-house asset manager is defined in DOL prohibited
transaction exemption 96-23, 61 FR 15975, Apr. 10, 1996 (``DOL In-
House Asset Manager PTE 96-23''), as a wholly-owned subsidiary of an
ERISA plan sponsor that is a registered investment adviser that
meets certain assets under management tests.
\643\ SIFMA/ISDA Feb. 17 Letter, at 31; BlackRock Feb. 22
Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 7.
\644\ CalSTRS Feb. 28 Letter, at 4.
---------------------------------------------------------------------------
Following the release of SEC's proposed business conduct standards
for SBS Entities, the Commission received several comment letters
addressing, among other things, a comparison of SEC's proposed Sec.
240.15Fh-2(a) and Sec. 240.15Fh-4,\645\ Special Requirements for SBS
Dealers Acting as Advisors to Special Entities, and the Commission's
proposed Sec. 23.440,\646\ Requirements for Swap Dealers Acting as
Advisors to Special Entities.
---------------------------------------------------------------------------
\645\ SEC's proposed rules, 76 FR at 42423-25, 42454, and 42456-
57.
\646\ Proposing release, 75 FR at 80650-51 and 80659-60.
---------------------------------------------------------------------------
The Commission's proposed Sec. 23.440(a) and the SEC's proposed
Sec. 240.15Fh-2(a) both define a swap dealer or SBS Dealer,
respectively, that recommends a swap, security-based swap or a trading
strategy that uses a swap or security-based swap to a Special Entity to
be ``acting as an advisor to a Special Entity.'' Under the Commission's
proposed Sec. 23.440, a swap dealer that meets the definition of
``acts as an advisor to a Special Entity'' then has a duty to act in
the best interests of the Special Entity. Under the SEC's proposed
Sec. 240.15h-2(a), a SBS Dealer that recommends a security-based swap
or trading strategy involving the use of a security-based swap meets
the definition of ``acts as an advisor to a Special Entity,'' unless
(1) the Special Entity represents in writing that: (i) It will not rely
on recommendations provided by the SBS Dealer; and (ii) it will rely on
advice from a qualified independent representative as defined in Sec.
240.15Fh-5(a); \647\ (2) the SBS
[[Page 9781]]
dealer has a reasonable basis to believe that the Special Entity is
advised by a qualified independent representative as defined in Sec.
240.15Fh-5(a); and (3) the SBS Dealer discloses that it is not
undertaking to act in the best interests of the Special Entity. Under
the proposal, an SBS Dealer that exchanges the required representations
with the Special Entity would not have a duty to act in the best
interests of the Special Entity when making a recommendation.
---------------------------------------------------------------------------
\647\ SEC's proposed rules, 76 FR at 42425-27 and 42457. SEC
proposed Sec. 240.15Fh-5(a) is the parallel rule to the
Commission's proposed Sec. 23.450-Requirements for swap dealers and
major swap participants acting as counterparties to Special
Entities. Both proposed rules further describe the duty for a swap
dealer, major swap participant, or SBS Entity to have a reasonable
basis to believe that a Special Entity has a qualified independent
representative that meets certain statutory criteria described in
Section 4s(h)(5) of the CEA or Section 15F(h)(5) of the Exchange
Act.
---------------------------------------------------------------------------
The Commission received comment letters in support of \648\ and
against \649\ the SEC approach. The supporters generally asserted that
the SEC's proposed rules represent workable solutions to some of the
industry's concerns over the adverse consequences of the Commission's
proposed rules.\650\ Commenters opposed to the SEC's approach generally
asserted that it was inconsistent with congressional intent and would
permit an SBS Entity to provide advice that may not be in the best
interests of the Special Entity without accountability.\651\ Another
commenter asserted that the SEC's approach would result in Special
Entities signing away their right to the ``best interests'' protection
as a condition of doing business.\652\
---------------------------------------------------------------------------
\648\ See, e.g., FIA/ISDA/SIFMA Aug. 26 Letter, at 4-5;
BlackRock Aug. 29 Letter, at 2 and 7; ABC Aug. 29 Letter, at 2 and
6-8.
\649\ Better Markets Aug. 29 Letter, at 2 and 14-15; CFA/AFR
Aug. 29 Letter, at 1-2, 9, 13 and 26-29.
\650\ See, e.g., BlackRock Aug. 29 Letter, at 2.
\651\ Better Markets Aug. 29 Letter, at 15; see also CFA/AFR
Aug. 29 Letter, at 26-29.
\652\ CFA/AFR Aug. 29 Letter, at 26; CFA/AFR Nov. 3 Letter, at
2.
---------------------------------------------------------------------------
b. Meaning of ``Best Interests''
Several commenters raised issues concerning the duty to act in the
best interests of the Special Entity imposed under Section 4s(h)(4) and
Sec. 23.440. Issues raised by commenters generally include: (1)
Whether a ``best interests'' duty imposes a fiduciary duty; (2) whether
imposing a ``best interests'' duty will improperly encourage Special
Entities to rely on the swap dealer; (3) the meaning of the term ``best
interests''; (4) whether a ``best interests'' duty also imposes
specific disclosure obligations; and (5) whether swap dealers will
continue to transact with Special Entities if they are subject to a
``best interests'' duty.
The Commission sought comment on a number of questions regarding
proposed Sec. 23.440, including whether swap dealers should be subject
to an explicit fiduciary duty when acting as an advisor to a Special
Entity.\653\ Some commenters cited the legislative history to support
the view that Congress rejected an express fiduciary duty for swap
dealers entering into a swap with a Special Entity.\654\ A number of
commenters assert that a ``best interests'' duty creates a fiduciary
relationship,\655\ or could give rise to fiduciary duties under other
bodies of law including the common law, state pension laws, the CEA,
the Advisers Act, and ERISA.\656\ Commenters also asserted that the
inherent conflicts of interest in a counterparty relationship are
incompatible with a fiduciary duty.\657\ Similarly, another commenter
asked the Commission to clarify that complying with Sec. Sec. 23.440
and 23.450 do not cause a swap dealer to be a fiduciary under any other
body of law, including the securities laws or common law.\658\
---------------------------------------------------------------------------
\653\ Proposing release, 75 FR at 80651.
\654\ SIFMA/ISDA Feb. 17 Letter, at 4 (citing a Senate version
of H.R. 4173); but cf. CFA/AFR Feb. 22 Letter, at 15 (asserting that
the original Senate version imposed a fiduciary duty on all
interactions between swap dealers and Special Entities that was
ultimately an unworkable approach. However, the legislative history
provides an insight into congressional intent that the ``best
interests'' standard of care should be broadly applied).
\655\ Ohio STRS Feb. 18 Letter, at 2; CPPIB Feb. 22 Letter, at
3; AMG-SIFMA Feb. 22 Letter, at 4 and 6; SIFMA/ISDA Feb. 17 Letter,
at 6; NACUBO Feb. 22 Letter, at 2; Calhoun Feb. 22 Letter, at 2-3.
\656\ SIFMA/ISDA Feb. 17 Letter, at 6; CalSTRS Feb. 28 Letter,
at 3; AMG-SIFMA Feb. 22 Letter, at 4; Comm. Cap. Mkts. May 3 Letter,
at 3.
\657\ SIFMA/ISDA Feb. 17 Letter, at 6; CalSTRS Feb. 28 Letter,
at 4.
\658\ ERIC Feb. 22 Letter, at 4; cf. BlackRock Feb. 22 Letter,
at 5 (recommending the Commission should specify that proposed Sec.
23.440 is not intended to cause a swap dealer to be considered an
ERISA fiduciary).
---------------------------------------------------------------------------
The Commission also sought comment in the proposing release on
whether to define ``best interests,'' and if so, what should the
definition be.\659\ Some commenters stated that the best interests duty
should be removed from the final rules.\660\ One commenter suggested
that the Commission revise the ``best interests'' standard to require
only a duty of fair dealing and not import a fiduciary duty.\661\
Another commenter asserted that a ``best interests'' standard of care
is appropriate where a swap dealer provides advice tailored to the
Special Entity's position; however, the standard would be inappropriate
if the definition of ``advice'' was not sufficiently narrowed.\662\
---------------------------------------------------------------------------
\659\ Proposing release, 75 FR at 80651.
\660\ BlackRock Feb. 22 Letter, at 5; Calhoun Feb. 22 Letter, at
2-3; cf. CalSTRS Feb. 28 Letter, at 3 (asserting that the term
``best interests'' is vague).
\661\ AMG-SIFMA Feb. 22 Letter, at 6.
\662\ SWIB Feb. 22 Letter, at 3.
---------------------------------------------------------------------------
Other commenters supported the proposed ``best interests'' standard
and suggested that the Commission should clarify that a ``best
interests'' duty is a higher standard than a suitability
obligation.\663\ The commenter also requested that the Commission
clarify that certain practices should be identified as inherent
violations of the best interests standard, including (1) designing
swaps with features that expose the Special Entity to risks that are
greater than those it intends to hedge, and (2) recommending customized
swaps when the Special Entity could attain the same results at a lower
risk-adjusted cost using standardized swaps.\664\
---------------------------------------------------------------------------
\663\ CFA/AFR Feb. 22 Letter, at 15.
\664\ Id.
---------------------------------------------------------------------------
Other commenters discussed the scope of the duty. A commenter
asserted, in the context of trading with a municipality, a swap dealer
that demanded additional collateral could arguably violate its best
interests duty because obtaining collateral is in the interest of the
swap dealer and not the municipality.\665\ The commenter also stated
that the Commission should clarify the scope of the ``best interests''
standard and ``distinguish advice that is fiduciary in nature from
advice rendered in the context of soliciting, structuring or executing
a particular transaction.'' \666\ Conversely, another commenter
asserted that customization by its very nature implies that the swap
has been designed with the particular needs of the counterparty in
mind, and, therefore, there is no benefit to allowing swap dealers to
avoid regulatory duties when recommending customized swaps.\667\
---------------------------------------------------------------------------
\665\ SIFMA/ISDA Feb. 17 Letter, at 6 fn. 19.
\666\ SIFMA/ISDA Feb. 17 Letter, at 32 fn. 74 (asserting that
such a distinction exists in other legal contexts, for example, a
broker that provides advice on particular occasions does not trigger
an ongoing duty to advise in the future and monitor all data
potentially relevant to a customer's investment) (citing de
Kwiatkowski v. Bears Stearns & Co., Inc., 306 F.3d 1293, 1302 (2d
Cir. 2003); see id. (asserting that the Advisers Act generally does
not apply to a person whose only advice consists of advising an
issuer how to structure its financing) (citing SEC Staff Legal
Bulletin No. 11 (Sept. 2000) and SEC no-action letter to David A.
Kekich, The Arkad Company, 1992 WL 75601 (available Mar. 19, 1992)).
\667\ CFA/AFR Feb. 22 Letter, at 13 (discussing customized swaps
with respect to a suitability duty).
---------------------------------------------------------------------------
Some commenters raised concerns that the ``best interests'' duty
will inappropriately encourage a Special Entity to rely on a swap
dealer. Commenters claim that reliance could create confusion regarding
the parties' respective responsibilities and could inappropriately
increase dependence on
[[Page 9782]]
the swap dealer and discourage counterparties from conducting their own
investigations and taking responsibility for their own decisions and
conduct.\668\ Conversely, other commenters stated that applying the
``best interests'' duty to recommendations would strike a reasonable
balance by limiting the duty to instances in which Special Entities
relied on the swap dealer and the standard should be scalable depending
on the degree of reliance.\669\
---------------------------------------------------------------------------
\668\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 2.
\669\ CFA/AFR Feb. 22 Letter, at 5 and 15; cf. AFSCME Feb. 22
Letter, at 3 (asserting that non-swap dealers will often assume that
a swap dealer that represents itself as a ``trusted advisor'' will
be accountable for the advice it provides).
---------------------------------------------------------------------------
The Commission listed three questions in the proposing release
requesting comment on whether a ``best interests'' duty should require
additional specific disclosures regarding (1) conflicts of interest,
(2) the profit the swap dealer expects to make on swaps it enters into
with the Special Entity, and (3) any positions the swap dealer holds
from which it may profit should the swap in question move against the
Special Entity.\670\ Most commenters discussed material incentives and
conflicts of interest generally in the context of proposed Sec.
23.431(a)(3); \671\ however, some commenters discussed the Commission's
request for comment in the context of a ``best interests'' duty.
---------------------------------------------------------------------------
\670\ Proposing release, 75 FR at 80651.
\671\ See Section III.D.3.d. of this adopting release for a
discussion of Sec. 23.431(a)(3).
---------------------------------------------------------------------------
One commenter asserted that a swap dealer should provide conflict
of interest disclosures that go beyond the issue of compensation and
third-party payments when dealing with a Special Entity and consider
the full range of conflicts that may exist that are relevant to a
particular recommendation.\672\ The commenter also stated that it is
not necessary to require a swap dealer in all instances to disclose its
pre-existing positions; however, disclosure should be required if those
positions create a material conflict of interest.\673\
---------------------------------------------------------------------------
\672\ CFA/AFR Feb. 22 Letter, at 16 (asserting a swap dealer
must disclose if a swap is designed so that the dealer will profit
if the transaction fails for the Special Entity); see id. (when
recommending customized swaps, a swap dealer should be required to
break out the pricing of the components of the swap, including the
profit).
\673\ CFA/AFR Feb. 22 Letter, at 7 (asserting that an example of
such a material conflict would be where the swap dealer was taking a
major short position in a type of swap that it was also recommending
a Special Entity take a long position, therefore the swap dealer
should be required to disclose that fact and its reasons for
believing the counter position is nonetheless in the best interests
of the Special Entity).
---------------------------------------------------------------------------
Some commenters opposed requiring a swap dealer to disclose their
profit or anticipated profit in connection with a particular swap.\674\
Commenters also opposed requirements for swap dealers to disclose pre-
existing positions to any counterparty because swap dealers may choose
not to enter into swaps with Special Entities if they are required to
disclose proprietary positions.\675\
---------------------------------------------------------------------------
\674\ SIFMA/ISDA Feb. 17 Letter, at 22 (asserting that such
disclosure is not required by the statute and is inconsistent with
congressional intent as Congress rejected such a requirement when
enacting the Dodd-Frank Act); CEF Feb. 22 Letter, at 21.
\675\ See SWIB Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter,
at 14-15 (opposing the disclosure of pre-existing positions because
it could allow a counterparty to discern confidential information of
the swap dealer's other clients, the disclosure is potentially
misleading, the requirement would discourage swap dealers from
providing liquidity, and compliance would be difficult when
considering whether disclosure is required for non-standardized
swaps whose relation to a pre-existing position of a recommended
swap is a matter of degree).
---------------------------------------------------------------------------
The Commission also requested comment on whether proposed Sec.
23.440 would preclude swap dealers from continuing their current
practice of both recommending and entering into swaps with Special
Entities.\676\ One commenter asserted that Special Entities would
retain their ability to engage in transactions with swap dealers as
counterparties.\677\ Conversely, several commenters asserted that a
duty to act in the ``best interests'' is incompatible with a
counterparty relationship.\678\ These commenters asserted that there
are several problems for a swap dealer that both acts as a counterparty
and is required to act in the best interests of its counterparty in the
same transaction, including that: (1) The duty of care is fundamentally
at odds with an arm's length counterparty relationship, (2) it would
result in an unresolvable conflict, and (3) the parties' interests are
by definition adverse.\679\
---------------------------------------------------------------------------
\676\ Proposing release, 75 FR at 80651.
\677\ CFA/AFR Feb. 22 Letter, at 17; CFA/AFR Nov. 3 Letter, at
3.
\678\ SWIB Feb. 22 Letter, at 4; GFOA Feb. 22 Letter, at 2;
Calhoun Feb. 22 Letter, at 2; ABC/CIEBA Feb. 22 Letter, at 7; ABA/
ABC Feb. 22 Letter, at 2.
\679\ SWIB Feb. 22 Letter, at 4; GFOA Feb. 22 Letter, at 2; ABC/
CIEBA Feb. 22 Letter, at 7; contra CFA/AFR Nov. 3 Letter, at 3.
---------------------------------------------------------------------------
Several commenters asserted that a ``best interests'' duty will
discourage or prevent swap dealers from transacting with Special
Entities.\680\ Commenters also asserted that a duty to act in the
``best interests'' of a Special Entity will increase burdens,
compliance costs and liability exposure to swap dealers, and the
additional costs and risks will be passed on to Special Entities
through increased pricing.\681\ Thus, several commenters asserted that
the proposed rules could increase costs for Special Entities, preclude
them from hedging their risks, and do not provide corresponding
benefits to Special Entities.\682\
---------------------------------------------------------------------------
\680\ See SIFMA/ISDA Feb. 17 Letter, at 5-6; Ohio STRS Feb. 18
Letter, at 2; CalSTRS Feb. 28 Letter, at 4; AMG-SIFMA Feb. 22
Letter, at 4; SWIB Feb. 22 Letter, at 4; CalPERS Feb. 18 Letter, at
3-4; VRS Feb. 22 Letter, at 3; OTPP Feb. 22 Letter, at 3; GFOA Feb.
22 Letter, at 2; BlackRock Feb. 22 Letter, at 5; ERIC Feb. 22
Letter, at 2; ABC/CIEBA Feb. 22 Letter, at 2; Texas VLB Feb. 22
Letter, at 1; NACUBO Feb. 22 Letter, at 2-3; HOOPP Feb. 22 Letter,
at 2.
\681\ See, e.g., CEF Feb. 22 Letter, at 16; CalPERS Feb. 18
Letter, at 4; Ropes & Gray Feb. 22 Letter, at 2; COPE Feb. 22
Letter, at 2; VRS Feb. 22 Letter, at 3; BDA Feb. 22 Letter, at 2;
AMG-SIFMA Feb. 22 Letter, at 4.
\682\ See CEF Feb. 22 Letter, at 16; APGA Feb. 22 Letter, at 1;
ETA May 4 Letter, at 8; CalPERS Feb. 18 Letter, at 4; SWIB Feb. 22
Letter, at 3; VRS Feb. 22 Letter, at 4; CalSTRS Feb. 28 Letter, at 2
and 4; OTPP Feb. 22 Letter, at 3; ERIC Feb. 22 Letter, at 2.
---------------------------------------------------------------------------
c. Comments on Sec. 23.440(b)(2)--Duty to Make Reasonable Efforts
The Commission sought comment in the proposing release on whether
to prescribe additional information that would be relevant to a swap
dealer's ``reasonable efforts'' and ``best interests'' duties under the
proposed rule.\683\ One commenter suggested that the Commission should
clarify whether there is certain information without which the swap
dealer could not make a recommendation. The commenter also suggested
that where a swap dealer makes a recommendation based on limited
information, any disclosures about the limitations should be made to
the board of the Special Entity and not simply to the investment
officer.\684\ The commenter agreed that there should be a mechanism to
allow a Special Entity to discuss various options with a swap dealer
without divulging confidential information.\685\ The commenter warned,
however, that an overly broad interpretation of proposed Sec.
23.440(c) could undercut the protections of the best interests
duty.\686\
---------------------------------------------------------------------------
\683\ Proposing release, 75 FR at 80651.
\684\ CFA/AFR Feb. 22 Letter, at 17.
\685\ Id., at 16.
\686\ Id. (asserting that some Special Entities may have
incentives to evade the restrictions of their charters to hide the
extent to which they are underfunded and, therefore, the Commission
should ensure that the regulation does not provide a means for
Special Entities to use swaps to assume unreasonably high investment
risks to seek higher returns).
---------------------------------------------------------------------------
Another commenter opposed requirements for swap dealers to seek
extensive information about a Special Entity, including information for
the swap dealer to reasonably conclude that the Special Entity has the
financial capability to withstand potential market-related changes in
the value of
[[Page 9783]]
the swap.\687\ The commenter asserted that if the Special Entity had to
provide financial information as a prerequisite to enter into a swap,
such a requirement would disadvantage the Special Entity and give swap
dealers an informational advantage in negotiations.\688\
---------------------------------------------------------------------------
\687\ ABC/CIEBA Feb. 22 Letter, at 7-8.
\688\ Id.
---------------------------------------------------------------------------
Other commenters asserted that the pre-execution duties to make
reasonable efforts would require a swap dealer to undertake extensive
diligence and obtain detailed representations.\689\ One commenter added
that such requirements would significantly increase costs, delay
execution, and leave Special Entities to pay more for swaps and expose
them to extended periods of market risk.\690\ The commenter also
requested that the Commission permit a swap dealer to rely on
representations of the Special Entity to meet both its duty to act in
the best interests and its obligation to make reasonable efforts to
obtain necessary information.\691\ Other commenters asked the
Commission to provide greater clarity as to what constitutes ``a
reasonable basis to believe that the representations are reliable.''
\692\ The commenters suggest that representations from the Special
Entity's authorized employee or independent representative should be
conclusive unless the swap dealer has actual knowledge that such
representations are untrue.\693\ Other commenters stated that the
proposing release did not provide estimates of the costs of the
proposed rule to Special Entities, and that the additional costs and
burdens do not have corresponding benefits.\694\
---------------------------------------------------------------------------
\689\ SIFMA/ISDA Feb. 17 Letter, at 6-7; Ohio STRS Feb. 18
Letter, at 2; BlackRock Feb. 22 Letter, at 5-6; ETA May 4 Letter, at
8.
\690\ SIFMA/ISDA Feb. 17 Letter, at 6-7 (asserting such
requirements would reduce or eliminate swap transactions for Special
Entities if the information gathering is required on a trade-by-
trade basis).
\691\ Id., at 35.
\692\ APPA/LPPC Feb. 22 Letter, at 3; APGA Feb. 22 Letter, at 5.
\693\ Id.
\694\ BlackRock Feb. 22 Letter, at 5-6; ETA May 4 Letter, at 8.
---------------------------------------------------------------------------
3. Final Sec. 23.440
Considering the comments, statutory construction and legislative
history, the Commission has determined to adopt Sec. 23.440 with
certain modifications. Final Sec. 23.440(a) defines the term ``acts as
an advisor to a Special Entity'' to mean ``when the swap dealer
recommends a swap or trading strategy involving a swap that is tailored
to the particular needs or characteristics of the Special Entity.''
Final Sec. 23.440(b) provides two safe harbors from the definition of
``acts as an advisor to a Special Entity'' for particular types of
conduct: (1) Communications between a swap dealer and an ERISA plan
that has an ERISA fiduciary; \695\ and (2) communications to any
Special Entity (including a Special Entity that is an ERISA plan) or
its representative that do not express an opinion as to whether the
Special Entity should enter into a recommended swap or trading strategy
involving a swap that is tailored to the particular needs or
characteristics of the Special Entity.\696\ Qualifying for either safe
harbor requires an exchange of specified representations in writing by
the swap dealer and Special Entity.
---------------------------------------------------------------------------
\695\ An ERISA ``fiduciary'' is defined in Section 3(21) of
ERISA (29 U.S.C. 1002(21)) and DOL Regulations at 29 CFR 2510.3-21.
\696\ Swap dealers that choose to operate within the safe harbor
would be permitted to recommend tailored swaps to a Special Entity,
provided that the swap dealer does not express an opinion as to
whether the Special Entity should enter into the particular swap or
swap trading strategy. Therefore, the safe harbor carves out from
the term ``acts as an advisor to a Special Entity'' recommendations
that are trade ideas or alternatives, but does not carve out
subjective opinions as to whether the Special Entity should enter
into a particular bespoke swap or swap trading strategy.
---------------------------------------------------------------------------
The final rule adopts the statutory ``best interests'' duty for
swap dealers acting as advisors to Special Entities and ``reasonable
efforts'' duty for swap dealers to make a determination that any swap
or swap trading strategy is in the best interests of the Special
Entity. The final rule allows a swap dealer to rely on the written
representations of the Special Entity to satisfy its ``reasonable
efforts'' duty. Such representations can be made on a relationship
basis in counterparty relationship documentation rather than on a
transaction basis, where appropriate. This adopting release and
Appendix A to subpart H provide guidance for compliance with the second
safe harbor in Sec. 23.440(b)(2).
a. Acts as an Advisor to a Special Entity
The Commission has determined that a swap dealer will act as an
advisor to a Special Entity when it recommends a swap or swap trading
strategy that is tailored to the particular needs or characteristics of
the Special Entity. This approach differs from proposed Sec. 23.440 in
two significant ways. First, the type of recommendation that will
prompt the ``best interests'' duty in the final rule is limited to
recommendations of bespoke swaps,\697\ i.e., swaps that are tailored to
the particular needs or characteristics of the Special Entity.\698\
---------------------------------------------------------------------------
\697\ Unlike Sec. 23.440, the suitability rule Sec. 23.434
covers recommendations regarding any type of swap or trading
strategy involving a swap and is not limited to recommendations of
bespoke swaps.
\698\ Whether a swap is tailored to the particular needs or
characteristics of the Special Entity will depend on the particular
facts and circumstances. Swaps with terms that are tailored or
customized to a specific Special Entity's needs or objectives, or
swaps with terms that are designed for a targeted group of Special
Entities that share common characteristics, e.g., school districts,
are likely to be viewed as tailored to the particular needs or
characteristics of the Special Entity. Generally, however, the
Commission would not view a swap that is ``made available for
trading'' on a DCM or SEF, as provided in Section 2(h)(8) of the
CEA, as tailored to the particular needs or characteristics of the
Special Entity. See Section III.D.3.b. at fn. 394 for a discussion
of final Sec. 23.431(b)'s requirement to provide scenario analysis
when requested by the counterparty for any swap not ``made available
for trading'' on a DCM or SEF; see also Proposed Rules, Trade
Execution Requirements, 76 FR at 58191; Proposed Rules, Process to
Make a Swap Available to Trade, 76 FR 77728.
---------------------------------------------------------------------------
Second, in response to commenters' concerns, the Commission
clarified in the discussion of the institutional suitability rule,
Sec. 23.434, the types of communications that will be considered
recommendations.\699\ These two changes clarify the circumstances that
would cause a swap dealer to act as an advisor to a Special Entity,
consistent with the statutory framework and considering the
comments.\700\
---------------------------------------------------------------------------
\699\ The facts and circumstances determination of whether a
communication is a ``recommendation'' requires an analysis of the
content, context, and presentation of the particular communication
or set of communications. The determination of whether a
``recommendation'' has been made is an objective rather than a
subjective inquiry. An important factor in this regard is whether,
given its content, context, and manner of presentation, a particular
communication from a swap dealer to a counterparty reasonably would
be viewed as a ``call to action,'' or suggestion that the
counterparty enter into a swap. An analysis of the content, context,
and manner of presentation of a communication requires examination
of the underlying substantive information transmitted to the
counterparty and consideration of any other facts and circumstances,
such as any accompanying explanatory message from the swap dealer.
Additionally, the more individually tailored the communication to a
specific counterparty or a targeted group of counterparties about a
swap, group of swaps or trading strategy involving the use of a
swap, the greater the likelihood that the communication may be
viewed as a ``recommendation.'' See Section III.G. of this adopting
release for a discussion of the suitability obligation under Sec.
23.434.
\700\ See, e.g., CFA/AFR Feb. 22 Letter, at 20 (``an appropriate
definition of advice might be: `recommendations related to a swap or
a swap trading strategy that are made to meet the objectives or
needs of a specific counterparty after taking into account the
counterparty's specific circumstances' ''); CFA/AFR Nov. 3 Letter,
at 2; SIFMA/ISDA Feb. 17 Letter, at 32 (advice is ``individualized
based on the particular needs of the Special Entity''); cf. SWIB
Feb. 22 Letter, at 2-3; see also APGA Feb. 22 Letter, at 4 (``a
`recommendation' which would trigger the advisor obligations should
mean a firm indication by the swap dealer of a particular preferred
transaction, swap, or market strategy''); id. (A presentation
offering information concerning new products or services or new
market strategies, without advancing a particular course of action,
should not be considered advice); SIFMA/ISDA Feb. 17 Letter, at 33
(``in preparing a term sheet, recommending a swap for consideration
by a counterparty, and in other similar conduct, [a swap dealer] may
well not be providing advice as to the advisability of entering into
the relevant swap transaction'').
---------------------------------------------------------------------------
[[Page 9784]]
In addition, the Commission has determined to provide two safe
harbors to the rule--one that will apply only to ERISA plans and
another that would apply to all Special Entities (including a Special
Entity that is an ERISA plan). These safe harbors reflect several
considerations, including comments describing the benefits of a free
flow of information between a swap dealer and Special Entity, clear
congressional intent to raise the standard of care for swap dealers
that transact with Special Entities, and the implications of the ``best
interests'' duty for swap dealers and Special Entities.
First, under Sec. 23.440(b)(1), a swap dealer will not be acting
as an advisor to a Special Entity that is an ERISA plan if: (1) The
ERISA plan represents in writing that it has an ERISA fiduciary; (2)
the ERISA fiduciary represents in writing that it will not rely on
recommendations provided by the swap dealer; and (3) the ERISA plan
represents in writing that (A) it will comply in good faith with
written policies and procedures reasonably designed to ensure that any
recommendation the Special Entity receives from the swap dealer
materially affecting a swap transaction is evaluated by a fiduciary
before the transaction occurs, or (B) any recommendation the Special
Entity receives from the swap dealer materially affecting a swap
transaction will be evaluated by a fiduciary before that transaction
occurs. In reaching this determination, the Commission has considered
the comments, the comprehensive federal regulatory scheme that applies
to ERISA fiduciaries, and the importance of harmonizing the Dodd-Frank
Act requirements with ERISA to avoid unintended consequences.\701\
Therefore, Sec. 23.440(b)(1) both harmonizes the federal regulatory
regimes and ensures appropriate protections for ERISA plans.
---------------------------------------------------------------------------
\701\ The Commission has considered commenters' suggestions that
different categories of Special Entities should not be treated
differently. See, e.g., CalSTRS Feb. 28 Letter, at 2 fn. 1. The
Commission disagrees. Congress has established a comprehensive
federal regulatory framework for ERISA plans, but has not done so
for other Special Entities, which are subject to a wide range of
state and local laws. Therefore, the Commission believes it is
appropriate and consistent with congressional intent to harmonize
regulation under the Dodd-Frank Act and CEA with ERISA requirements.
Such harmonization avoids unintended consequences while maintaining
protections for ERISA plans. With respect to other Special Entities,
the Commission has considered commenters concerns and has provided
compliance mechanisms under the final rules to address potential
costs without undermining the benefits Congress intended.
---------------------------------------------------------------------------
Second, under Sec. 23.440(b)(2), a swap dealer will not be
``acting as an advisor'' to any Special Entity (including a Special
Entity that is an ERISA plan) \702\ if: (1) The swap dealer does not
express an opinion as to whether the Special Entity should enter into a
recommended swap or swap trading strategy that is tailored to the
particular needs or characteristics of the Special Entity; (2) the
Special Entity represents in writing that it will not rely on the swap
dealer's recommendations and will rely on advice from a qualified
independent representative within the meaning of Sec. 23.450; and (3)
the swap dealer discloses that it is not undertaking to act in the best
interests of the Special Entity. The Commission believes that this will
provide greater clarity to the respective roles of the parties, and
because a swap dealer must refrain from making statements or otherwise
expressing an opinion to meet the safe harbor's requirements, the
provision also provides meaningful protections to Special Entities.
---------------------------------------------------------------------------
\702\ When dealing with an ERISA plan, a swap dealer may comply
with either or both safe harbors under Sec. 23.440(b)(1) and
(b)(2).
---------------------------------------------------------------------------
Appendix A to subpart H provides additional guidance to market
participants that choose to operate within the safe harbor. If a swap
dealer complies with the terms of the safe harbor, it can be assured
that the following types of communications, for example, would not be
subject to the best interests duty: (1) Providing information that is
general transaction, financial, educational, or market information; (2)
offering a swap or trading strategy involving a swap, including swaps
that are tailored to the needs or characteristics of a Special Entity;
(3) providing a term sheet, including terms for swaps that are tailored
to the needs or characteristics of a Special Entity; (4) responding to
a request for a quote from a Special Entity; (5) providing trading
ideas for swaps or swap trading strategies, including swaps that are
tailored to the needs or characteristics of a Special Entity; and (6)
providing marketing materials upon request or on an unsolicited basis
about swaps or swap trading strategies, including swaps that are
tailored to the needs or characteristics of a Special Entity. The list
is illustrative and not exhaustive. It is intended to provide guidance
to market participants. The safe harbor in Sec. 23.440(b)(2) allows a
wide range of communications and interactions between swap dealers and
Special Entities without invoking the ``best interests'' duty, provided
that the swap dealer does not express its own subjective opinion to the
Special Entity or its representative as to whether the Special Entity
should enter into the swap or trading strategy that is customized or
tailored to the Special Entity's needs or circumstances and the
appropriate representations and disclosures are exchanged. The
Commission notes, however, that depending on the facts and
circumstances, some of the examples on the list in Appendix A could be
a ``recommendation'' that would trigger a suitability obligation under
Sec. 23.434. However, the Commission has determined that such
activities would not, by themselves, prompt the ``best interests'' duty
in Sec. 23.440 provided that the parties comply with the other
requirements of Sec. 23.440(b)(2).
The safe harbor draws a clear distinction between the activities
that will and will not cause a swap dealer to be acting as an advisor
to a Special Entity. Thus, a swap dealer that wishes to avoid engaging
in activities that trigger a ``best interests'' duty must appropriately
manage its communications. To clarify the type of communications that
they will make under the safe harbor, the Commission expects that swap
dealers may specifically represent that they will not express an
opinion as to whether the Special Entity should enter into a
recommended swap or trading strategy, and that for such advice the
Special Entity should consult its own advisor. Nothing in the final
rule would preclude such a representation from being included in
counterparty relationship documentation. However, such a representation
would not act as a safe harbor under the rule where, contrary to the
representation, the swap dealer does express an opinion to the Special
Entity as to whether it should enter into a recommended swap or trading
strategy.
The safe harbor permits a swap dealer to engage in a wide variety
of discussions and communications with a Special Entity about
individually tailored swaps and trading strategies, including the
advantages or disadvantages of different swaps or trading strategies,
without invoking the ``best interests'' duty. All of the swap dealer's
communications, however, must be made in a fair and balanced manner
based on principles of fair dealing and good faith in compliance with
Sec. 23.433. Furthermore, where the communications are
``recommendations,'' the swap dealer
[[Page 9785]]
must comply with the suitability obligations under Sec. 23.434.
Some commenters requested that the Commission clarify whether
activities other than those described in Sec. 23.440 would cause a
swap dealer to act as an advisor to a Special Entity. The Commission
has determined that a swap dealer will only ``act as an advisor to a
Special Entity'' as provided in final Sec. 23.440(a). Similarly, in
response to commenters, the Commission confirms that compliance with
the requirements of Section 4s(h) and the Commission's business conduct
standards rules in subpart H of part 23, will not, by itself, cause a
swap dealer to ``act as an advisor to a Special Entity'' within the
meaning of Sec. 23.440.
b. Commenters' Alternative Approaches
The Commission considered comments asserting that Sections 4s(h)(4)
and 4s(h)(5) of the CEA are mutually exclusive provisions and 4s(h)(4)
should not apply where a swap dealer acts as a counterparty to a
Special Entity. Similarly, the Commission considered comments
requesting that the Commission provide a safe harbor to Sec. 23.440
that would allow a swap dealer to avoid ``acting as an advisor to a
Special Entity'' where the Special Entity is advised by a qualified
independent representative. The Commission disagrees with commenters'
statutory interpretation and declines to provide a safe harbor for all
communications between a swap dealer and Special Entity provided that
the Special Entity is advised by a qualified independent
representative. A plain reading of Section 4s(h) does not provide that
a swap dealer acting as a counterparty to a Special Entity may avoid
Section 4s(h)(4)'s provisions.\703\ The Commission also believes that
it would be inconsistent with the statutory language to allow a swap
dealer to avoid Section 4s(h)(4)'s requirements when it provides
subjective advice to a Special Entity, simply because the Special
Entity has a representative on which it is relying. Such an
interpretation of the statute would essentially render Section 4s(h)(4)
a nullity and grant swap dealers unfettered discretion to provide
subjective advice. Such a result would be inconsistent with
congressional intent to raise standards for the protection of Special
Entities.
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\703\ Legislative history supports that 4s(h)(4) and 4s(h)(5)
are not mutually exclusive. ``[N]othing in [CEA Section 4s(h)]
prohibits a swap dealer from entering into transactions with Special
Entities. Indeed, we believe it will be quite common that swap
dealers will both provide advice and offer to enter into or enter
into a swap with a special entity. However, unlike the status quo,
in this case, the swap dealer would be subject to both the acting as
advisor and business conduct requirements under subsections (h)(4)
and (h)(5).'' 156 Cong. Rec. S5923 (daily ed. Jul. 15, 2010)
(statement of Sen. Lincoln).
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Many commenters suggested that a swap dealer should only be deemed
to ``act as an advisor'' based on mutual agreement between the swap
dealer and Special Entity. The Commission declines to adopt such an
approach because it would be inconsistent with the statute. Section
4s(h)(4) is self-effectuating and by its terms does not delegate the
determination to the parties. The statute establishes an advisor test
based on conduct-``acting'' as an advisor-not agreement. If the parties
were permitted to agree that a swap dealer was not acting as an advisor
subject to a ``best interests'' duty, irrespective of the swap dealer's
conduct, the rule would essentially immunize swap dealers from
complying with the obligations imposed by the statute when acting as an
advisor. A statutory protection would not be meaningful if the default
position were that protection only applies where the entity regulated
by the provision, the swap dealer, agrees to be regulated.
Commenters also suggest that the Commission should look to whether
the Special Entity relied on the swap dealer's advice or
recommendations or whether such communications were the primary basis
for the Special Entity's trading decision to determine whether the swap
dealer acted as an advisor. The Commission declines to adopt such a
standard. Final Sec. 23.440 creates an objective test that analyzes
the swap dealer's communications. Such a standard is appropriate
considering that the business conduct standards rules regulate the swap
dealer's conduct. The commenters' suggestion would shift the inquiry
from an analysis of the swap dealer's conduct to an analysis of whether
the Special Entity actually relied on the swap dealer.\704\ Such a
shift would not achieve the purposes of the statue and would create
uncertainty.
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\704\ One commenter asserted that Commission precedent
recognizes that dependence or reliance is necessary to give rise to
an advisory relationship. SIFMA/ISDA Feb. 17 Letter, at 32 fn. 76
(citing In re Jack Savage, [1975-1977 Transfer Binder] Comm. Fut. L.
Rep. (CCH) ] 20,139 (CFTC Mar. 1, 1976)). The Commission disagrees
that Savage can be applied so broadly. In Savage, the Commission
denied a newsletter publisher's commodity trading advisor
registration application. Although the Commission acknowledges in
Savage that the duties attendant to an advisory relationship exist
where a customer may rely on a commodity trading advisor's advice,
reliance is not a required element for the creation of an advisory
status nor the duties that flow from it. The fact that a customer
does not rely would have no bearing on a regulatory action. An
advisory relationship and related duties do not arise by the
subjective understanding of the customer but by operation of law. A
person becomes a commodity trading advisor when advising others for
compensation or profit as to the value or advisability of trading in
a commodity for future delivery or swap, among others. Once the
advice is rendered for compensation or profit, regardless of the
customer's reliance, the advisor owes the duties attendant to such
advice.
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Commenters also suggested that the Commission adopt rules that
permit sophisticated Special Entities to opt out of the protections
provided in Section 4s(h)(4) and Sec. 23.440. Neither the statute nor
legislative history distinguishes between sophisticated and
unsophisticated Special Entities. Congress intended to provide
heightened protections to Special Entities, and the Commission is not
convinced that there is an objective proxy for sophistication with
respect to participants in the swaps markets.\705\ Therefore, the
Commission has determined not to permit Special Entities to opt out of
the protections of the statute and the rules. Instead, the Commission
has adopted clear, objective criteria for a swap dealer to determine
whether it is acting as an advisor to a Special Entity, subject to a
``best interests'' duty, or operating within the safe harbors provided
in the rule.
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\705\ See Section III.A.1. of this adopting release for a
discussion of ``Opt in or Opt out for Certain Classes of
Counterparties.''
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Those commenters that advocated an opt out regime, a qualified
independent representative safe harbor, or to limit application of the
rule were primarily concerned that a broad application of the
definition of ``acts as an advisor to a Special Entity'' and that
potential new costs or liability could chill communications between
swap dealers and Special Entities, raise hedging costs for Special
Entities, or reduce the number of swap dealers that would be willing
counterparties to Special Entities. The Commission believes that the
final rule appropriately addresses these concerns. Under the final rule
a swap dealer can appropriately manage its communications to its
counterparties and can take reasonable steps to avoid ``act[ing] as an
advisor to a Special Entity.'' Thus, the Commission believes that Sec.
23.440 is designed appropriately to mitigate costs associated with the
statutory requirements and the rule. The rule also achieves the
intended regulatory protections by either (1) limiting the types of
communications from the swap dealer that could have the greatest
potential to mislead a Special Entity, or (2) where the swap dealer
``acts as an advisor,'' subjecting such communications to the ``best
interests'' standard of care.
[[Page 9786]]
c. Best Interests
The final rule (renumbered as Sec. 23.440(c)(1)) adopts the
statutory ``best interests'' duty for swap dealers acting as advisors
to Special Entities and ``reasonable efforts'' duty for swap dealers
making a determination that the swap or swap trading strategy is in the
best interests of the Special Entity. The Commission has determined not
to define the term ``best interests,'' but rather to provide further
guidance as to the meaning of the term and the scope of the duty.
The Commission has considered commenters' views and the legislative
history \706\ in regard to whether Section 4s(h)(4) imposes a fiduciary
duty. The Commission has determined that the ``best interests'' duty
under Section 4s(h)(4) is not a fiduciary duty. Additionally, the
Commission does not view the business conduct standards statutory
provisions or rules in subpart H of part 23 to impose a fiduciary duty
on a swap dealer with respect to any other party.
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\706\ In the Senate bill, the business conduct standards
provision stated ``a swap dealer that provides advice regarding, or
offers to enter into, or enters into a swap with [a Special Entity]
shall have a fiduciary duty to the [Special Entity].'' Restoring
American Financial Stability Act of 2010, H.R. 4173, Section 731
(May 20, 2010) (Public Print version as passed in the Senate of the
United States May 27 (legislative day, May 26, 2010) (proposed
amendments to Section 4s(h)(2)(A) and (B) of the CEA), available at
http://www.gpo.gov). The House and Senate Conference Committee did
not adopt the fiduciary duty language and instead adopted the
following: ``Any swap dealer that acts as an advisor to a Special
Entity shall have a duty to act in the best interests of the Special
Entity.'' See Section 4s(h)(4)(B) of the CEA.
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Whether a recommended swap is in the ``best interests'' of the
Special Entity will turn on the facts and circumstances of the
particular recommendation and particular Special Entity. However, the
Commission will consider a swap dealer that ``acts as an advisor to a
Special Entity'' to have complied with its duty under final Sec.
23.440(c)(1) where the swap dealer (1) complies with final Sec.
23.440(c)(2) to make a reasonable effort to obtain necessary
information, (2) acts in good faith and makes full and fair disclosure
of all material facts and conflicts of interest with respect to the
recommended swap,\707\ and (3) employs reasonable care that any
recommendation made to a Special Entity is designed to further the
Special Entity's stated objectives.\708\
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\707\ Where a swap dealer ``acts as an advisor to a Special
Entity,'' the nature and content of the conflicts of interest
disclosures will depend on the facts and circumstances of the
particular swap dealer-Special Entity relationship and the
recommended swap or trading strategy. See Section III.D. of this
adopting release for a discussion of Sec. 23.431-Disclosures of
material information, including whether a swap dealer is required to
disclose that it is trying to move a particular position off its
books at Section III.D.3.d.
\708\ A swap dealer would be expected to evaluate the ``best
interests'' in accordance with reasonably designed policies and
procedures and document how it arrived at a ``reasonable
determination'' that a recommended swap is in the best interests of
the Special Entity.
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For a recommendation of a swap to be in the best interests of the
Special Entity, the swap does not need to be the ``best'' of all
possible alternatives that might hypothetically exist, but should be
assessed in comparison to other swaps, such as swaps offered by the
swap dealer or ``made available for trading'' on a SEF or DCM.\709\ To
be in the best interests of a Special Entity, the recommended bespoke
swap would have to further the Special Entity's hedging, investing or
other stated objectives. Additionally, whether a recommended swap is in
the best interests of the Special Entity will be analyzed based on
information known to the swap dealer (after it has employed its
reasonable efforts required under Section 4s(h)(4)(C) and final Sec.
23.440(c)(2)) at the time the recommendation is made. The ``best
interests'' duty does not prohibit a swap dealer from negotiating swap
terms in its own interests,\710\ nor does it prohibit a swap dealer
from making a reasonable profit from a recommended transaction.\711\
Depending on the facts and circumstances, the ``best interests'' duty
also does not require an ongoing obligation to act in the best
interests of the Special Entity.\712\ For example, a swap dealer would
be able to exercise its rights under the terms and conditions of the
swap when determining whether to make additional collateral calls in
response to the Special Entity's deteriorating credit rating, whether
or not such collateral calls would be, from the Special Entity's
perspective, in the Special Entity's ``best interests.''
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\709\ See Section IV.B.3.a. at fn. 698 for a discussion of
Section 2(h)(8) and swaps ``made available for trading'' on a DCM or
SEF; see also Section III.D.3.b. for a related discussion of swaps
``made available for trading'' for scenario analysis disclosures
under final Sec. 23.431(b) at fn. 394 and accompanying text at fn.
405.
\710\ For example, the swap dealer may negotiate appropriate
provisions relating to collateral calls and termination rights to
manage its risks related to the swap.
\711\ Some commenters suggested that a swap dealer that ``acts
as an advisor to a Special Entity'' should be required to break out
the pricing components of the swap, including the profit. See, e.g.,
CFA/AFR Feb. 22 Letter, at 16. The Commission declines to require
any particular disclosures under this principles based standard.
Whether such disclosure would be required to comply with the duty to
act in the best interests of the Special Entity will depend on the
facts and circumstances of the particular recommended swap or
trading strategy.
\712\ However, whenever the swap dealer engages in activity that
would cause it to be acting as an advisor to the Special Entity, the
best interests duty would be prompted. For example, if a swap dealer
acted as an advisor in connection with a material amendment to, or
termination of, a swap, the ``best interests'' duty would apply.
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d. Commenters' Alternative ``Best Interests'' Approaches
The Commission declines some commenters' suggestions that the
Commission delete the best interests duty or interpret best interests
to be a fair dealing standard. Such an approach is inconsistent with
the statute which uses the terms, ``fair dealing'' and ``best
interests,'' in different provisions, indicating that they impose
different duties.\713\ Another commenter requested that the Commission
identify certain practices as inherent violations of the ``best
interests'' duty including where a swap dealer designs a swap with
features that expose the Special Entity to risks that are greater than
those they intend to hedge. In the Commission's view, a swap dealer
that ``acts as an advisor to a Special Entity'' could not recommend a
swap or trading strategy that is inconsistent with the Special Entity's
stated objectives. Where a swap dealer that is acting as an advisor
concludes that the stated objectives are inconsistent with the Special
Entity's best interests, the swap dealer would be expected to so inform
the Special Entity and its independent representative.
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\713\ Compare Section 4s(h)(3)(C) (``duty for a swap dealer * *
* to communicate in a fair and balanced manner based on principles
of fair dealing and good faith'') with Section 4s(h)(4)(B) (``a duty
to act in the best interests'').
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The Commission has considered commenters' assertions that a Special
Entity may be less likely to undertake its own due diligence when
dealing with a swap dealer that is subject to the ``best interests''
duty. The Commission, however, believes that final Sec. 23.440
appropriately clarifies the duties and roles of the parties consistent
with congressional intent. The Commission also notes that prior to
entering into any swap with a swap dealer, a Special Entity will have a
qualified independent representative that will evaluate the swap
dealer's advice in light of the Special Entity's ``best interests.''
e. Final Sec. 23.440(c)(2)--Duty to Make Reasonable Efforts
Consistent with Section 4s(h)(4)(C), proposed Sec. 23.440(b)(2)
(renumbered as Sec. 23.440(c)(2)) required a swap dealer that ``acts
as an advisor to a Special Entity'' to make reasonable efforts to
obtain information necessary to make a reasonable determination that
any recommended swap or trading strategy
[[Page 9787]]
involving a swap is in the best interests of the Special Entity.\714\
The proposed rule listed eight specific types of information that the
swap dealer must make reasonable efforts to obtain and consider when
making a determination that a recommendation is in the best interests
of the Special Entity.\715\ The Commission has determined to delete two
of the listed types of information, proposed Sec. 23.440(b)(2)(i)
\716\ and (vi).\717\ Additionally, the Commission is refining the
criteria in proposed Sec. 23.440(b)(2)(iv) \718\ and (vii) \719\
(renumbered as Sec. 23.440(c)(2)(iii) and (v)). These changes are for
clarification only and do not substantively change the rule.
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\714\ Proposing release, 75 FR at 80650 and 80659-60.
\715\ Id., at 80659-60.
\716\ Under proposed Sec. 23.440(b)(2)(i), a swap dealer would
have to make reasonable efforts to obtain such information regarding
``the authority of the Special Entity to enter into a swap.'' Id.,
at 80660. The Commission has determined that the regulatory
objective intended by this provision is already achieved in final
Sec. 23.402(b)--Know your counterparty.
\717\ Under proposed Sec. 23.440(b)(2)(vi), a swap dealer would
have to make reasonable efforts to obtain such information regarding
``whether the Special Entity has an independent representative that
meets the criteria enumerated in [proposed] Sec. 23.450(b).'' Id.,
at 80660. The Commission has determined that this would be
duplicative of the requirements in Sec. 23.450.
\718\ Id., at 80660. The provision as adopted clarifies that a
Special Entity's objectives in using swaps may be broader than
investment or financing needs.
\719\ Id., at 80660. The provision as adopted clarifies that the
intent of the provision concerns changes in market conditions.
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The Commission also clarifies how a swap dealer can satisfy its
best interests duty where a Special Entity does not provide complete
information with respect to the criteria in final Sec. 23.440(c)(2).
Commenters have asserted that Special Entities may be reluctant to
provide complete information to swap dealers about their investment
portfolio or other information that might be relevant to the
appropriateness of a particular recommendation. Nothing in the rule is
intended to disadvantage a Special Entity in its negotiations with a
swap dealer or require it to disclose proprietary information.
However, to comply with its ``best interests'' duty where the
Special Entity does not provide complete information, the swap dealer
must make clear to the Special Entity that the recommendation is based
on the limited information known to the swap dealer and that the
recommendation might be different if the swap dealer had more complete
information. The Commission has also considered comments suggesting
that disclosures about a recommendation's limitations should be made to
the board of the Special Entity and not to the investment officer.\720\
The Commission agrees that the best practice for a swap dealer that
``acts as an advisor to a Special Entity'' within the meaning of Sec.
23.440(a) would be to ensure that disclosures about the limitations of
its recommendation are communicated to the governing board or to a
person or persons occupying a similar status or performing similar
functions.
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\720\ See CFA/AFR Feb. 22 Letter, at 17.
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Furthermore, where a swap dealer's reasonable efforts to obtain
necessary information results in limited or incomplete information, the
swap dealer must assess whether it is able to make a reasonable
determination that a particular recommendation is in the ``best
interests'' of the Special Entity. For example, a fundamental
requirement to making a determination that a recommendation is in the
best interests is to understand the objectives of the Special Entity
with respect to the swap. If, after the swap dealer makes reasonable
efforts to obtain information about the Special Entity's objectives,
the Special Entity does not provide sufficient information to the swap
dealer, then the swap dealer would be unable to make a determination
that a recommendation is in the best interests of the Special Entity.
Therefore, a swap dealer that ``acts as an advisor to a Special
Entity'' would have to refrain from making a recommendation to the
Special Entity in such circumstances.
A commenter asserted that any mechanism to allow a Special Entity
to avoid divulging confidential information should not be interpreted
so broadly as to undercut the protections of a best interests duty or
permit Special Entities to engage in swaps with unreasonably high
risk.\721\ The Commission has considered the comment and has determined
that the rule is designed to provide appropriate protections to Special
Entities.
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\721\ Id., at 16.
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f. Final Sec. 23.440(d)--Reasonable Reliance on Representations
Proposed Sec. 23.440(c) (renumbered as Sec. 23.440(d)) permitted
a swap dealer to rely on written representations of the Special Entity
to satisfy its obligation to ``make reasonable efforts'' to obtain
necessary information. However, the proposed rule listed additional
criteria that a swap dealer would have to consider to determine that
the representations were reliable.\722\ The Commission has determined
to delete from the final rule text the additional criteria that a swap
dealer would be expected to consider. Commenters found the proposed
rule text confusing and unworkable.\723\ In light of the comments, the
Commission has determined to provide additional guidance as to when a
swap dealer would not be able to rely on written representations.
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\722\ See proposed Sec. 23.440(c)(1)-(3), proposing release, 75
FR at 80660 (``(1) The swap dealer has a reasonable basis to believe
that the representations are reliable taking into consideration the
facts and circumstances of a particular swap dealer-Special Entity
relationship, assessed in the context of a particular transaction;
and (2) The representations include information sufficiently
detailed for the swap dealer to reasonably conclude that the Special
Entity is: (i) Capable of evaluating independently the material
risks inherent in the recommendation; (ii) Exercising independent
judgment in evaluating the recommendation; and (iii) Capable of
absorbing potential losses related to the recommended swap; and (3)
The swap dealer has a reasonable basis to believe that the Special
Entity has a representative that meets the criteria enumerated in
Sec. 23.450(b).'').
\723\ See, e.g., BlackRock Feb. 22 Letter, at 6.
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A swap dealer would be able to rely on representations unless it
had information that would cause a reasonable person to question the
accuracy of the representation.\724\ The Commission declines to adopt
other commenters' suggestion that a swap dealer or major swap
participant be permitted to rely on representations unless it had
actual knowledge that the representations were untrue. The Commission
has determined that an actual knowledge standard may inappropriately
encourage the swap dealer to ignore red flags. The Commission also
confirms that such representations, where appropriate, can be contained
in counterparty relationship documentation consistent
[[Page 9788]]
with Sec. 23.402(d) to avoid transaction-by-transaction
compliance.\725\
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\724\ The Commission's determination is consistent with several
commenters' suggestions. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36
(``[swap dealers] should be permitted to rely on a written
representation * * * that the counterparty and/or its representative
satisfies the standards * * * absent actual notice of countervailing
facts (or facts that reasonably should have put [a swap dealer] on
notice), which would trigger a consequent duty to inquire
further.''); ABC/CIEBA Feb. 22 Letter, at 10-11 fn. 3 (asserting the
Commission should adopt a standard used under Rule 144A of the
federal securities laws, which would not impose a duty to inquire
further ``unless circumstances existed giving reason to question the
veracity of a certification''); AMG-SIFMA Feb. 22 Letter, at 10-11
(``A swap dealer or [major swap participant] should be able to rely
on an investment adviser's representation unless the swap dealer or
[major swap participant] has information to the contrary.''); Comm.
Cap. Mkts. May 3 Letter, at 2 (``The dealer should be required to
probe beyond that representation only if it has reason to believe
that the Special Entity's representations with respect to its
independent representative are inaccurate.''); BlackRock Feb. 22
Letter, at 3 (``The CFTC should specifically permit the [swap
dealer] to rely, absent notice of facts that would require further
inquiry.'').
\725\ As the Commission stated in the proposing release, such
representations can be included in counterparty relationship
documentation or other written agreement between the parties and
that the representations can be deemed applicable or renewed, as
appropriate, to subsequent swaps between the parties if the
representations continue to be accurate and relevant with respect to
the subsequent swaps. Proposing release, 75 FR at 80641-42.
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C. Section 23.450--Requirements for Swap Dealers and Major Swap
Participants Acting as Counterparties to Special Entities
1. Proposed Sec. 23.450
Proposed Sec. 23.450 followed the statutory language in Section
4s(h)(5) of the CEA, which requires swap dealers and major swap
participants \726\ that offer to enter or enter into swaps with Special
Entities \727\ to comply with any duty established by the Commission
that they have a reasonable basis to believe that the Special Entity
has an independent representative that meets certain enumerated
criteria. The enumerated criteria include that a Special Entity
representative: (1) Has sufficient knowledge to evaluate the
transaction and risks; (2) is not subject to a statutory
disqualification; \728\ (3) is independent of the swap dealer or major
swap participant; \729\ (4) undertakes a duty to act in the best
interests of the Special Entity it represents; \730\ (5) makes
appropriate and timely disclosures to the Special Entity; \731\ (6)
evaluates, consistent with any guidelines provided by the Special
Entity, fair pricing and the appropriateness of the swap; \732\ (7) in
the case of employee benefit plans subject to ERISA, is a fiduciary as
defined in Section 3 of ERISA (29 U.S.C. 1002); \733\ and (8) in the
case of a municipal entity as defined in proposed Sec. 23.451, is
subject to restrictions on certain political contributions imposed by
the Commission, the SEC or an SRO subject to the jurisdiction of the
Commission or the SEC.\734\
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\726\ Although the title of Section 4s(h)(5) refers only to swap
dealers, the specific requirements in Section 4s(h)(5)(A) are
imposed on both swap dealers and major swap participants that offer
to or enter into a swap with a Special Entity. Accordingly, the
Commission proposed to apply the counterparty requirements to major
swap participants as well as to swap dealers. Proposing release, 75
FR at 80651 fn. 104.
\727\ The Commission interpreted the statute as imposing this
duty on swap dealers and major swap participants in connection with
swaps entered into with all categories of Special Entities. The
statutory language is ambiguous as to whether the duty is intended
to apply with respect to all types of Special Entity counterparties,
or just a sub-group. The ambiguities arise, in part, from the
reference to subclauses (I) and (II) of Section 1a(18)(A)(vii) of
the CEA, which include certain governmental entities and
multinational or supranational government entities. Yet,
multinational and supranational government entities do not fall
within the definition of Special Entity in Section 4s(h)(2)(C), and
State agencies, which are defined as Special Entities, are not
included in Section 1a(18)(A)(vii)(I) and (II) but are included in
(III). The Commission's interpretation is consistent with
legislative history. See H.R. Rep. No. 111-517, at 869 (June 29,
2010) (Conf. Rep.) (``When acting as counterparties to a pension
fund, endowment fund, or state or local government, dealers are to
have a reasonable basis to believe that the fund or governmental
entity has an independent representative advising them.'').
Proposing release, 75 FR at 80651 fn. 106 and 108.
\728\ To guide swap dealers and major swap participants, the
proposed rule defined ``statutory disqualification'' as grounds for
refusal to register or to revoke, condition or restrict the
registration of any registrant or applicant for registration as set
forth in Sections 8a(2) and 8a(3) of the CEA. Proposing release, 75
FR at 80651.
\729\ The proposed rule clarified that ``independent'' as it
relates to a representative of a Special Entity means independent of
the swap dealer or major swap participant, not independent of the
Special Entity. Proposing release, 75 FR at 80652 fn. 113 and 115.
\730\ The Commission did not define ``best interests'' in this
context, but noted the scope of the duty would be related to the
nature of the relationship between the independent representative
and the Special Entity, and established principles in case law would
inform the meaning of the term on a case-by-case basis. At a
minimum, the swap dealer or major swap participant would have a
reasonable basis for believing that the representative could assess:
(1) How the proposed swap fits within the Special Entity's
investment policy; (2) what role the particular swap plays in the
Special Entity's portfolio; and (3) the Special Entity's potential
exposure to losses. The swap dealer or major swap participant would
also need to have a reasonable basis for believing that the
representative has sufficient information to understand and assess
the appropriateness of the swap prior to the Special Entity entering
into the transaction. Proposing release, 75 FR at 80652.
\731\ The proposed rule refined the criterion under Section
4s(h)(5)(A)(i)(V), ``appropriate disclosures'' to mean ``appropriate
and timely disclosures.'' Proposing release, 75 FR at 80652.
\732\ The proposed rule refined the statutory language to
provide that the representative ``evaluate[], consistent with any
guidelines provided by the Special Entity, [the] fair pricing and *
* * appropriateness of the swap.'' Swap dealers and major swap
participants could rely on appropriate legal arrangements between
Special Entities and their independent representatives in applying
this criterion. For example, where a pension plan has a plan
fiduciary that by contract has discretionary authority to carry out
the investment guidelines of the plan, the swap dealer or major swap
participant would be able to rely, absent red flags, on the Special
Entity's representations regarding the legal obligations of the
fiduciary. Evidence of the legal relationship between the plan and
its fiduciary would enable the swap dealer or major swap participant
to conclude that the fiduciary is evaluating fair pricing and the
appropriateness of all transactions prior to entering into such
transactions on behalf of the plan. To comply with this criterion,
the swap dealer or major swap participant also would consider
whether the independent representative is documenting its decisions
about appropriateness and pricing of all swap transactions and that
such documentation is being retained in accordance with any
regulatory requirements that might apply to the independent
representative. This approach was applied to in-house independent
representatives as well. Proposing release, 75 FR at 80652-53.
\733\ Notwithstanding comments from ERISA plans and their
fiduciaries, the Commission determined that independent
representatives of plans subject to ERISA would have to meet all the
independent representative criteria in Section 4s(h)(5)(A). The
Commission sought further comment on this interpretation of the
statute. Proposing release, 75 FR at 80653 fn. 122.
\734\ Criterion 8--restrictions on certain political
contributions--is not in the statutory text under Section
4s(h)(5)(A)(i)(I)-(VII). The Commission proposed this criterion
using its discretionary authority under Section 4s(h)(5)(B). The
requirement would not apply to in-house independent representatives
of a municipal entity following the definition of ``municipal
advisor'' in Section 15B of the Exchange Act (15 U.S.C. 78o-4),
which excludes employees of a municipal entity. For examples of pay-
to-play rules, see, e.g., SEC Rule 206(4)-5 under the Advisers Act
(17 CFR 275.206(4)-5) (``SEC Advisers Act Rule 206(4)-5''); MSRB
Rule G-37: Political Contributions and Prohibitions on Municipal
Securities Business. The Commission proposed to impose comparable
requirements on swap dealers and major swap participants that act as
counterparties to Special Entities in proposed Sec. 23.451. The
Commission stated in the proposing release that it would propose
comparable requirements on registered CTAs when they advise
municipal entities in a separate release. Proposing release, 75 FR
at 80653 fn. 125.
---------------------------------------------------------------------------
The proposed rule set out several factors to be considered by swap
dealers and major swap participants in determining whether the Special
Entity's representative satisfies the enumerated criteria, including
(1) the nature of the Special Entity-representative relationship; (2)
the representative's ability to make hedging or trading decisions; (3)
the use of consultants or, with respect to employee benefit plans
subject to ERISA, use of a Qualified Professional Asset Manager \735\
or In-House Asset Manager; \736\ (4) the representative's general level
of experience in the financial markets and particular experience with
the type of product under consideration; (5) the representative's
ability to understand the economic features of the swap; (6) the
representative's ability to evaluate how market developments would
affect the swap; and (7) the complexity of the swap.\737\
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\735\ See DOL QPAM PTE 84-14, 75 FR 38837.
\736\ See DOL In-House Asset Manager PTE 96-23, 61 FR 15975;
Proposed Amendment to PTE 96-23, 75 FR 33642, June 14, 2010.
\737\ Proposing release, 75 FR at 80651; see also id., at 80660-
61 (proposed Sec. 23.450(d)(2)).
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The proposed rule provided that a representative would be deemed to
be independent if: (1) It was not (with a one-year look back) an
associated person of the swap dealer or major swap participant within
the meaning of Section 1a(4) of the CEA; (2) there was no ``principal
relationship'' between the representative and the swap dealer or major
swap participant within the meaning of Sec. 3.1(a) \738\ of the
[[Page 9789]]
Commission's Regulations; and (3) the representative did not have a
material business relationship with the swap dealer or major swap
participant.\739\ However, if the representative received any
compensation from the swap dealer or major swap participant within one
year of an offer to enter into a swap, the swap dealer or major swap
participant would have to ensure that the Special Entity is informed of
the compensation and that the Special Entity agrees in writing, in
consultation with the representative, that the compensation does not
constitute a material business relationship between the representative
and the swap dealer or major swap participant.\740\ The proposed rule
defined a material business relationship as any relationship with a
swap dealer or major swap participant, whether compensatory or
otherwise, that reasonably could affect the independent judgment or
decision making of the representative.\741\
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\738\ 17 CFR 3.1(a).
\739\ Proposing release, 75 FR at 80652.
\740\ Id.
\741\ Id.
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To address concerns that the statute places undue influence in the
hands of the swap dealer or major swap participant by allowing it to
control who qualifies as an independent representative of a Special
Entity, the proposed rule provided that negative determinations be
reviewed by the swap dealer's or major swap participant's chief
compliance officer.\742\ Under the proposed rule, if a swap dealer or
major swap participant determined that an independent representative
did not meet the enumerated criteria, the swap dealer or major swap
participant would be required to make a written record of the basis for
such determination and submit such determination to its chief
compliance officer for review.\743\ Such review would ensure that the
swap dealer or major swap participant had a substantial, unbiased basis
for the determination.\744\
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\742\ Id., at 80653.
\743\ Id.
\744\ Id.
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Proposed Sec. 23.450(f) also required, as provided in Section
4s(h)(5)(A)(ii), that swap dealers and major swap participants disclose
in writing to Special Entities the capacity in which they are acting
before initiation of a swap transaction. In addition, if a swap dealer
or major swap participant were to engage in business with the Special
Entity in more than one capacity, the swap dealer or major swap
participant would have to disclose the material differences between the
capacities.\745\
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\745\ For example, the Commission stated that when the swap
dealer acts both as an advisor and a counterparty to the Special
Entity, or when firms act both as underwriters in a bond offering
and counterparties in swaps used to hedge such financing, a swap
dealer's duties to the Special Entity would vary depending on the
capacities in which it is operating. Id., at 80653.
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Finally proposed Sec. 23.450(g) stated that the rule would not
apply with respect to a swap that is initiated on a DCM or SEF where
the swap dealer or major swap participant does not know the Special
Entity's identity.\746\
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\746\ Proposed Sec. 23.450(g) is informed by the statutory
language in Section 4s(h)(7) of the CEA.
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2. Comments
The Commission received many comments on the various aspects of
proposed Sec. 23.450. The Commission has grouped the comments by the
following issues: (1) Types of Special Entities that should be included
in final Sec. 23.450; (2) duty to assess the qualifications of a
Special Entity's representative; (3) representative qualifications;
\747\ (4) reasonable reliance on representations; (5) unqualified
representatives; and (6) disclosure of capacity.
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\747\ The comments related to representative qualifications
address the following issues: (1) Regulated advisors; (2)
independence; (3) best interests, disclosures, fair pricing and
appropriateness; and (4) employee benefit plans subject to ERISA.
---------------------------------------------------------------------------
a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)
Several commenters asserted that Section 4s(h)(5)(A)(i) only
applies to the governmental Special Entities that are described in
Section 1a(18)(A)(vii)(I) and (II) of the CEA, contrary to the approach
taken in proposed Sec. 23.450.\748\ Commenters also asserted that it
is unclear whether the Commission has the authority to apply the rule
to swaps with ERISA plans, governmental plans, and endowments.\749\
Some commenters urged the Commission to resolve any ambiguity in the
statutory language by applying the final rule only to the State and
municipal Special Entities defined in Section 4s(h)(C)(2)(ii).\750\ One
commenter stated that if the final rule is applied to ERISA plans, then
such plans should only be subject to subclause (VII) of Section
4s(h)(5)(A)(i),\751\ which requires a Special Entity that is an
employee benefit plan subject to ERISA to have an independent
representative that ``is a fiduciary as defined in Section 3 of
[ERISA].'' \752\ Commenters asserted that requirements for ERISA
fiduciaries are comparable to those required in subclauses (I)-(VI) of
Section 4s(h)(5)(A)(i), rendering the protections of Section 4s(h)(5)
and proposed Sec. 23.450 unnecessary, and potentially harmful.\753\
Conversely, one commenter opposed any carve-outs for ERISA plans and
stated the Special Entity provisions are not served by deferring to
ERISA's regulatory regime.\754\
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\748\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS
Feb. 18 Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 2-3 and 8; ERIC
Feb. 22 Letter, at 6-7; Davis & Harman Mar. 25 Letter, at 2.
\749\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS
Feb. 18 Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 8.
\750\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS
Feb. 18 Letter, at 5; ERIC Feb. 22 Letter, at 6-7.
\751\ ABC/CIEBA Feb. 22 Letter, at 9 fn. 1; ABC Aug. 29 Letter,
at 9.
\752\ Section 4s(h)(5)(A)(i)(VII).
\753\ See, e.g., ERIC Feb. 22 Letter, at 6-9.
\754\ AFSCME Feb. 22 Letter, at 5.
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b. Duty To Assess the Qualifications of a Special Entity's
Representative
Commenters asserted that proposed Sec. 23.450 will allow a swap
dealer or major swap participant to veto a Special Entity's decision to
select a particular representative,\755\ and will unduly limit a
Special Entity's choice regarding its own advisor.\756\ Commenters also
assert that proposed Sec. 23.450 inappropriately gives additional
leverage to a swap dealer or major swap participant dealing with
Special Entities, undermines the representative's ability or
willingness to negotiate, and may be used to pressure Special Entities
to share otherwise confidential information.\757\ Furthermore,
commenters assert that the duty under the proposed rule is intrusive,
creates an inherent conflict of interest, and undermines the Special
Entity's own selection process.\758\ Other commenters asserted that
proposed Sec. 23.450 will not benefit Special Entities and will make
dealing with swap dealers more costly and problematic.\759\ Conversely,
one commenter asserted that proposed Sec. 23.450 created a reasonable
and workable approach that is consistent with congressional
intent.\760\
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\755\ ABA/ABC Feb. 22 Letter, at 2; Davis & Harman Mar. 25
Letter, at 2-3; Rep. Smith July 25 Letter, at 2; ABC/CIEBA June 3
Letter, at 5-6;
\756\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36; ABC/CIEBA
Feb. 22 Letter, at 9; CEF Feb. 22 Letter, at 23; Calhoun Feb. 22
Letter, at 5.
\757\ ABC/CIEBA Feb. 22 Letter, at 9; ABA/ABC Feb. 22 Letter, at
2; AMG-SIFMA Feb. 22 Letter, at 10.
\758\ See, e.g., BlackRock Feb. 22 Letter, at 3; CalPERS Feb. 18
Letter, at 3; Cityview Feb. 22 Submission; Texas VLB Feb. 22 Letter,
at 2; GFOA Feb. 22 Letter, at 1.
\759\ See, e.g., ASF Feb. 22 Letter, at 5; GFOA Feb. 22 Letter,
at 1.
\760\ CFA/AFR Feb. 22 Letter, at 17.
---------------------------------------------------------------------------
Commenters also asserted that proposed Sec. 23.450 may conflict
with current law under ERISA or with DOL's proposed fiduciary rule. The
commenters asserted that proposed Sec. 23.450 requires a swap dealer
or major
[[Page 9790]]
swap participant to review the qualifications of the Special Entity's
representative which could be considered providing advice as to the
selection of the Special Entity's advisor. Commenters asserted this
could make the swap dealer or major swap participant a fiduciary to an
ERISA plan under ERISA and DOL's existing regulations \761\ or under
DOL's proposed fiduciary rule.\762\
---------------------------------------------------------------------------
\761\ ABA/ABC Feb. 22 Letter, at 1; Davis & Harman Mar. 25
Letter, at 1; ERIC Feb. 22 Letter, at 9; MFA Feb. 22 Letter, at 6-7
fn. 13; ABC/CIEBA June 3 Letter, at 2.
\762\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA Feb. 22
Letter, at 5; ABA/ABC Feb. 22 Letter, at 1; Davis & Harman Mar. 25
Letter, at 1; ERIC Feb. 22 Letter, at 9; ABC/CIEBA June 3 Letter, at
2.
---------------------------------------------------------------------------
Commenters also asserted that proposed Sec. 23.450 may conflict
with DOL's QPAM prohibited transaction exemption.\763\ The QPAM
exemption sets out several conditions an ERISA fiduciary must satisfy
to be a ``qualified professional asset manager'' within the meaning of
the exemption. According to commenters, proposed Sec. 23.450 permits a
swap dealer or major swap participant to veto or implicitly cause the
Special Entity to replace its advisor which may render the QPAM
exemption unavailable to ERISA plans and their ERISA fiduciaries.\764\
---------------------------------------------------------------------------
\763\ See DOL QPAM PTE 84-14, 75 FR 38837.
\764\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA June 3 Letter,
at 5.
---------------------------------------------------------------------------
c. Representative Qualifications
i. Regulated Advisors
Several commenters recommended that the Commission deem
representatives that have a particular regulatory status to meet some
or all of independent representative criteria in proposed Sec.
23.450(b). Several commenters suggested that banks, investment
advisers, insurance companies, QPAMs, and INHAMs \765\ be deemed to
meet the statutory criteria.\766\ Commenters also stated that
requirements under ERISA should automatically qualify an ERISA plan's
fiduciary under the proposed criteria.\767\ Other commenters asserted
that municipal advisors,\768\ fiduciaries to governmental plans,\769\
and employees of a Special Entity should be deemed to satisfy the
enumerated criteria.\770\
---------------------------------------------------------------------------
\765\ Cf. DOL In-House Asset Manager PTE 96-23, 61 FR 15975.
\766\ See SIFMA/ISDA Feb. 17 Letter, at 36; ERIC Feb. 22 Letter,
at 2 and 12; AMG-SIFMA Feb. 22 Letter, at 2; BlackRock Feb. 22
Letter, at 3.
\767\ See, e.g., ERIC Feb. 22 Letter, at 6-9.
\768\ SIFMA/ISDA Feb. 17 Letter, at 36; Texas VLB Feb. 22
Letter, at 2.
\769\ CalSTRS Feb. 28 Letter, at 3.
\770\ APGA Feb. 22 Letter, at 6-7.
---------------------------------------------------------------------------
Several commenters requested that the Commission or an SRO develop
a voluntary certification and proficiency examination program for
independent representatives. The commenters proposed that the
Commission should permit a swap dealer or major swap participant to
conclude that any certified representative would automatically satisfy
the criteria in proposed Sec. 23.450(b).\771\ Conversely, one
commenter asserted that representations and warranties from the
representative should not amount to a waiver of compliance for a swap
dealer.\772\
---------------------------------------------------------------------------
\771\ See, e.g., CalPERS Feb. 18 Letter, at 5-6; CalPERS Aug. 29
Letter, 4-6; SWIB Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 23;
Cityview Feb. 22 Submission; Riverside Feb. 22 Letter, at 1-2; SFG
Feb. 22 Letter, at 1; CFA/AFR Aug. 29 Letter, at 23; CFA/AFR Nov. 3
Letter, at 5.
\772\ AFSCME Feb. 22 Letter, at 6.
---------------------------------------------------------------------------
ii. Independence
The proposing release clarified that the Special Entity's
representative must be ``independent'' of the swap dealer or major swap
participant; however, the representative does not have to be
independent of the Special Entity.\773\ Several commenters agreed with
the Commission's proposed interpretation.\774\ Commenters also
requested that the Commission clarify that an independent
representative may be an employee, officer, agent, associate, trustee,
director, subsidiary, or affiliate, such as an INHAM.\775\
---------------------------------------------------------------------------
\773\ Proposing release, 75 FR at 80652 fn. 113.
\774\ See CFA/AFR Feb. 22 Letter, at 17; ERIC Feb. 22 Letter, at
3 and 9; APPA/LPPC Feb. 22 Letter, at 2; NACUBO Feb. 22 Letter, at
4; U. Tex. System Feb. 22 Letter, at 3-4; APGA Feb. 22 Letter, at 6.
\775\ See, e.g., NACUBO Feb. 22 Letter, at 4; U. Tex. System
Feb. 22 Letter, at 3-4; ERIC Feb. 22 Letter, at 9. Cf. DOL In-House
Asset Manager PTE 96-23, 61 FR 15975.
---------------------------------------------------------------------------
The Commission received comments concerning the proposed
independence test in general and specifically regarding the ``material
business relationship'' prong. Some commenters recommended that the
Commission delete the ``material business relationship''
requirement.\776\ Alternatively, commenters suggested the Commission
consider other existing standards which, according to the commenters,
would be more workable such as ownership \777\ or affiliate tests.\778\
Commenters stated that the Commission's proposed standard was
unnecessarily duplicative of or not harmonized with other independence
standards under the federal securities laws and ERISA.\779\ Commenters
also asserted that the final regulation should permit a swap dealer or
major swap participant to conclude that a plan's representative is
``independent'' if the representative is an ERISA fiduciary,\780\ or at
a minimum, if the representative is an ERISA fiduciary that is also a
regulated entity such as a QPAM.\781\
---------------------------------------------------------------------------
\776\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 11-12; SIFMA/ISDA
Feb. 17 Letter, at 38; contra CFA/AFR Feb. 22 Letter, at 17 (``the
proposed standard generally provides the appropriate level of
independence'').
\777\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 11-12, fn. 38
(recommending the Commission consider ``standards of ownership''
such as those in DOL's QPAM exemption); see also DOL QPAM PTE 84-14,
75 FR 38837.
\778\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 37-38 (``the
Commission should adopt one of several other well-established and
workable tests of independence (such as excluding all `affiliates,'
as * * * defined under * * * the CEA)''); BlackRock Feb. 22 Letter,
at 4.
\779\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38; ABC/CIEBA
Feb. 22 Letter, at 11; ERIC Feb. 22 Letter, at 11-12; AMG-SIFMA Feb.
22 Letter, at 2; BlackRock Feb. 22 Letter, at 4.
\780\ ERIC Feb. 22 Letter, at 6 and 8; ABC/CIEBA Feb. 22 Letter,
at 11 (``we urge the CFTC to provide that a `major [sic] business
relationship' does not exist if the relationship between the dealer
or [major swap participant] and the [ERISA] Plan * * * would not
give rise to a prohibited transaction under ERISA''); ABC Aug. 29
Letter, at 14.
\781\ See, e.g., BlackRock Feb. 22 Letter, at 4; FIA/ISDA/SIFMA
Aug. 29 Letter, at 20; AMG-SIFMA Feb. 22 Letter, at 11-12 fn. 38;
see also DOL QPAM PTE 84-14, Part (VI)(a), 75 FR at 38843 (a QPAM
must be a bank, savings and loan association, insurance company, or
registered investment adviser).
---------------------------------------------------------------------------
Commenters also assert that the proposed ``material business
relationship'' standard is unclear, vague and overly broad, and swap
dealers will refrain from transacting with Special Entities without
further clarifications.\782\ These commenters stated that the
``material business relationship'' standard may inappropriately
preclude many qualified asset managers from acting as independent
representatives.\783\ According to the commenters, many asset managers
have multiple relationships with financial services firms that have
swap dealer affiliates, and a requirement to survey all business
relationships to determine whether and what compensation was paid would
be very burdensome, require the development of costly new recordkeeping
systems not currently in place, and provide little or no benefit to
Special Entities.\784\ The commenters
[[Page 9791]]
also assert that the ``material business relationship'' standard
reduces Special Entities' choices for qualified representatives and
increases costs for representatives and Special Entities.\785\ A number
of commenters also requested that the Commission clarify that the
disclosure requirement is limited to compensation received in
connection with the relevant swap transaction.\786\ Conversely, one
commenter asserted the rule should require disclosure of all business
relationships.\787\
---------------------------------------------------------------------------
\782\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38 (``the
proposing standard is so broad and vague that [swap dealers] wary of
the consequence of misinterpreting its requirements will likely
simply abstain from affected trades''); APPA/LPPC Feb. 22 Letter, at
5 (the ``standard is both broad and somewhat vague * * * and dealers
may be reluctant to take on the potential liability related to this
determination''); AMG-SIFMA Feb. 22 Letter, at 11; BlackRock Feb. 22
Letter, at 11.
\783\ SIFMA/ISDA Feb. 17 Letter, at 38; ABC/CIEBA Feb. 22
Letter, at 11; AMG-SIFMA Feb. 22 Letter, at 11; BlackRock Feb. 22
Letter, at 4 fn. 9, but see CFA/AFR Nov. 3 Letter, at 3-4.
\784\ BlackRock Feb. 22 Letter, at 4 (``an asset manager may
trade securities through the broker affiliate of the swap dealer;
use an affiliated broker dealer as distributor/underwriter for
mutual funds managed by the asset manager; or license an index from
an affiliate of the dealer''); SIFMA/ISDA Feb. 17 Letter, at 38 (a
swap dealer's ``affiliated broker-dealer [that] is the underwriter
for mutual funds managed by the investment adviser'' should not
constitute a ``material business relationship''); ABC/CIEBA Feb. 22
Letter, at 11 (requiring representatives to determine all
compensation received from a swap dealer in connection with all
other transactions worldwide would impose staggering administrative
burdens and is likely impracticable); AMG-SIFMA Feb. 22 Letter, at
11 (large investment advisers are affiliated with banks and broker-
dealers that would also be, or be affiliated with, swap dealers and
would be precluded from entering into trades with many swap dealers
on behalf of their customers).
\785\ SIFMA/ISDA Feb. 17 Letter, at 38; AMG-SIFMA Feb. 22
Letter, at 11; BlackRock Feb. 22 Letter, at 4; APPA/LPPC Feb. 22
Letter, at 5.
\786\ ABC/CIEBA Feb. 22 Letter, at 11; SIFMA/ISDA Feb. 17
Letter, at 38 (disclosure should not be required where a swap dealer
in its capacity as broker provided soft dollar research unrelated to
any swap transaction to a Special Entity's investment adviser);
BlackRock Feb. 22 Letter, at 4; APPA/LPPC Feb. 22 Letter, at 5; CEF
Feb. 22 Letter, at 23.
\787\ Better Markets Feb. 22 Letter, at 8 (asserting swap
dealers have provided advantageous allocations of securities in
public offerings to influence advisors that should be disclosed).
---------------------------------------------------------------------------
The proposed definition of ``material business relationship'' also
excluded payment of fees by the swap dealer or major swap participant
to the Special Entity's representative at the written direction of the
Special Entity for services provided in connection with the swap.\788\
Some commenters expressed concerns that the exclusion could be used for
abuse or would undermine the independence of their advice.\789\ These
commenters stated the exclusion should be deleted and such practices
should be prohibited.\790\
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\788\ Proposing release, 75 FR at 80652 and 80660.
\789\ CFA/AFR Feb. 22 Letter, at 17; Better Markets Feb. 22
Letter, at 4 and 8; Calhoun Feb. 22 Letter, at 2; see also CFA/AFR
Nov. 3 Letter, at 4; but cf. APPA/LPPC Feb. 22 Letter, at 5
(limiting such arrangements may make it difficult for governmental
entities to find qualified swap advisors).
\790\ Better Markets Feb. 22 Letter, at 7-8; Better Markets June
3 Letter, at 13; Calhoun Feb. 22 Letter, at 3.
---------------------------------------------------------------------------
The proposed definition of ``material business relationship'' also
stated that the term is subject to a one-year look back, including any
compensation received within one year of an offer to enter into the
swap.\791\ Some commenters recommended that the Commission extend the
relevant time period.\792\ Conversely, another commenter stated that a
one-year look back would be problematic in instances where corporate
identities change through corporate transactions or
consolidations.\793\
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\791\ Proposed Sec. 23.450(a)(3), proposing release, 75 FR at
80652 and 80660.
\792\ CFA/AFR Aug. 29 Letter, at 33; Better Markets Feb. 22
Letter, at 8.
\793\ BlackRock Aug. 29 Letter, at 6 (asserting that DOL
eliminated a one-year look back rule in the QPAM Exemption in
response to industry concerns regarding the workability in light of
consolidation and changes in the financial services industry).
---------------------------------------------------------------------------
Under proposed Sec. 23.450(c)(3), the Special Entity may agree in
writing that any compensation the representative received from the swap
dealer or major swap participant does not constitute a ``material
business relationship.'' \794\ One commenter requested that the
Commission clarify that the disclosure of any such compensation is made
to the Special Entity's board and the written agreement comes from the
board.\795\ Other commenters asserted that a Special Entity may be
reluctant to make a determination that a relationship was not a
``material business relationship'' because the Special Entity could be
held liable if the determination is later deemed inaccurate.\796\
---------------------------------------------------------------------------
\794\ Proposing release, 75 FR at 80660.
\795\ CFA/AFR Feb. 22 Letter, at 17; CFA/AFR Nov. 3 Letter, at
4.
\796\ APPA/LPPC Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter,
at 4.
---------------------------------------------------------------------------
Following the release of the SEC's proposed business conduct
standards for SBS Entities, the Commission received comment letters
addressing harmonization of the agencies' independence tests.\797\ Some
commenters requested that both agencies adopt the Commission's proposed
approach with ``minor adjustments.'' \798\ Other commenters supported
the SEC's associated person and gross revenue tests \799\ and requested
that the agencies coordinate the independence tests.\800\
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\797\ The SEC proposed that a Special Entity's representative
would be ``independent'' of an SBS Entity if the representative does
not have a relationship with the SBS Entity, whether compensatory or
otherwise, that reasonably could affect the independent judgment or
decision-making of the representative. The SEC's proposal, however,
would consider a representative deemed to be independent of the SBS
Entity if, within one year, the representative was not an associated
person of the SBS Entity and had not received more than ten percent
of its gross revenues from the SBS Entity. SEC's proposed rules, 76
FR at 42426.
\798\ See, e.g., CFA/AFR Aug. 29 Letter, at 33.
\799\ See, e.g., FIA/ISDA/SIFMA Aug. 26 Letter, at 6.
\800\ See, e.g., FIA/ISDA/SIFMA Sept. 14 Letter, at passim; see
also SIFMA/ISDA Feb. 17 Letter, at 37-38.
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iii. Best Interests, Disclosures, Fair Pricing and Appropriateness
Section 4s(h)(5) and proposed Sec. 23.450(b) would require a swap
dealer or major swap participant to have a reasonable basis to believe
that a Special Entity's representative (1) undertakes a duty to act in
the Special Entity's ``best interests''; (2) makes appropriate
disclosures; and (3) will provide written representations regarding
fair pricing and appropriateness of the transaction.\801\ To assess the
``best interests'' criterion, the Commission proposed by example that a
swap dealer or major swap participant would be able to rely, absent red
flags, on duties established by appropriate legal arrangements between
Special Entities and their independent representatives.\802\ One
commenter requested that the Commission clarify that a swap dealer or
major swap participant could also rely on an employment relationship to
satisfy the ``best interests'' duty, disclosure obligation, and duty to
evaluate fair pricing and appropriateness of the swap.\803\ Other
commenters similarly stated that legal obligations under ERISA or state
law would require the fiduciary to an ERISA plan or governmental plan
to comply with a best interests duty, disclosure obligations, and a
duty to evaluate fair pricing and appropriateness.\804\
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\801\ Section 4s(h)(5)(A)(i)(IV)-(VI) of the CEA and proposed
Sec. 23.450(b)(4)-(6); proposing release, 75 FR at 80652-53 and
80660.
\802\ Proposing release, 75 FR at 80652-53. Such legal
arrangements could include, for example, a contract between a
pension plan and a plan fiduciary that required the fiduciary to
evaluate, consistent with any guidelines provided by the Special
Entity, fair pricing and the appropriateness of the swap.
\803\ APGA Feb. 22 Letter, at 6; cf. CFA/AFR Aug. 29 Letter, at
34 (asserting that a representative that is subject to separate
legal requirements, such as an investment adviser or ERISA
fiduciary, could be presumed to satisfy the ``best interests''
criterion).
\804\ See, e.g., ERIC Feb. 22 Letter, at 8-9; CalSTRS Feb. 28
Letter, at 3.
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iv. Employee Benefit Plans Subject to ERISA
The Commission sought comment on whether the statutory
representative criteria under Section 4s(h)(5)(A)(i)(I)-(VI) were
duplicative or inconsistent with ERISA's fiduciary requirements.\805\
Commenters asserted that ERISA imposes comparable requirements to the
statute and proposed Sec. 23.450(b)(1)-(6), and the rule adds
administrative costs without corresponding benefits.\806\
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\805\ Proposing release, 75 FR at 80653.
\806\ SIFMA/ISDA Feb. 17 Letter, at 36-37; ERIC Feb. 22 Letter,
at 2 and 6-9 (asserting that ERISA imposes ``duties that are
similar, but more exacting,'' with respect to the knowledge
requirement, statutory disqualification, independence, best
interests, disclosures, and fair pricing and appropriateness); ABC/
CIEBA June 3 Letter, at 6.
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[[Page 9792]]
Another commenter stated that it was unclear whether the criteria
in Section 4s(h)(5)(A)(i)(I)-(VI) apply to governmental plans that are
defined in but not subject to ERISA. The commenter requested that the
Commission clarify that a governmental plan's representative does not
need to satisfy the first six criteria if it is represented by a
fiduciary under state or local law.\807\
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\807\ CalSTRS Feb. 28 Letter, at 6.
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d. Reasonable Reliance on Representations
Proposed Sec. 23.450(d) permitted a swap dealer or major swap
participant \808\ to rely on Special Entity representations to satisfy
its duty to assess the qualifications of the Special Entity's
independent representative, if the representations were reliable and
sufficiently detailed.\809\ Several commenters expressed concern with
the language in proposed Sec. 23.450(d)(1) that would require the swap
dealer or major swap participant to ``consider the facts and
circumstances of a particular Special Entity-representative
relationship, assessed in the context of a particular transaction.''
\810\ Similarly, several commenters expressed concern with the language
in proposed Sec. 23.450(d)(2) that would require the representations
to be ``sufficiently detailed.'' \811\ Conversely, one commenter
supported the Commission's approach and requested that the Commission
require record retention that would permit the Commission to determine
compliance.\812\
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\808\ Two commenters noted that the rule text of proposed Sec.
23.450(d) provided that a swap dealer may rely on written
representations but was silent as to whether major swap participants
could rely. See SIFMA/ISDA Feb. 17 Letter, at 36 fn. 85; ABC/CIEBA
Feb. 22 Letter, at 9 fn. 2. The Commission intended this provision
to be available to both swap dealers and major swap participants and
expressly references both in final Sec. 23.450(e).
\809\ Proposing release, 75 FR at 80660.
\810\ SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA Feb. 22
Letter, at 9; BlackRock Feb. 22 Letter, at 3; proposing release, 75
FR at 80660.
\811\ Id.
\812\ CFA/AFR Feb. 22 Letter, at 6; CFA/AFR Nov. 3 Letter, at 5.
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A majority of commenters asserted that proposed Sec. 23.450(d)
would require extensive and burdensome transaction-by-transaction
diligence that would significantly delay execution and increase costs
for swap dealers, major swap participants and Special Entities.\813\
Commenters also asserted that the conditions for reliance, which
include a nonexclusive list of seven factors under proposed Sec.
23.450(d)(2), were unnecessarily complex and could cause swap dealers
or major swap participants to overreach in their requests for
information.\814\ Many commenters requested that the Commission permit
swap dealers and major swap participants to rely on representations
from the Special Entity or the independent representative that simply
repeat the enumerated criteria in proposed Sec. 23.450(b).\815\
Commenters also requested that the Commission permit representations to
be made on a relationship basis and only updated periodically \816\ or
upon a material change such as a change in the Special Entity's
representative.\817\ Another commenter stated that to avoid giving the
swap dealer or major swap participant unfair leverage when dealing with
Special Entities, the required representations must be unambiguous, and
determinations of accuracy must be within the sole judgment of the
Special Entity.\818\
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\813\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA
Feb. 22 Letter, at 9-10; BlackRock Feb. 22 Letter, at 3; ABA/ABC
Feb. 22 Letter, at 2-3; AMG-SIFMA Feb. 22 Letter, at 9; SWIB Feb. 22
Letter, at 4-5; Ropes & Gray Feb. 22 Letter, at 3-4; APPA/LPPC Feb.
22 Letter, at 4.
\814\ See, e.g., Ropes & Gray Feb. 22 Letter, at 3-4; APPA/LPPC
Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA
Feb. 22 Letter, at 9-10.
\815\ SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA Feb. 22
Letter, at 10; SWIB Feb. 22 Letter, at 4-5; CEF Feb. 22 Letter, at
16 and 23; VRS Feb. 22 Letter, at 5; APPA/LPPC Feb. 22 Letter, at 4;
Comm. Cap. Mkts. May 3 Letter, at 2; Comm. Cap. Mkts. Aug. 29
Letter, at 2-3.
\816\ Ropes & Gray Feb. 22 Letter, at 4.
\817\ APGA Feb. 22 Letter, at 6-7.
\818\ CalPERS Oct. 4 Letter, at 1.
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A number of commenters also discussed the circumstances in which a
swap dealer or major swap participant could rely on a representation
without further inquiry. Some commenters suggested the Commission
permit a swap dealer or major swap participant to rely if it did not
have actual knowledge that the representations were incorrect.\819\
Conversely, some commenters suggested the Commission permit reliance
unless the swap dealer or major swap participant knows of facts that
reasonably should put it on notice that would trigger a duty to inquire
further.\820\ Two commenters requested that the Commission clarify that
the exchange of representations will not give any party any additional
rescission, early termination, or monetary compensation rights.\821\
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\819\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 10-11; Davis &
Harman Mar. 25 Letter, at 5-6; APGA Feb. 22 Letter, at 6; SIFMA/ISDA
Feb. 17 Letter, at 36; contra CFA/AFR Nov. 3 Letter, at 5.
\820\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36 (``[swap
dealers] should be permitted to rely on a written representation * *
* that the counterparty and/or its representative satisfies the
standards * * * absent actual notice of countervailing facts (or
facts that reasonably should have put [a swap dealer] on notice),
which would trigger a consequent duty to inquire further.''); see
also supra fn. 724. Contra CFA/AFR Nov. 3 Letter, at 5.
\821\ ABC/CIEBA Feb. 22 Letter, at 12-13 (asserting that a swap
dealer faced with a highly volatile market and disadvantageous swap
position could claim that a Special Entity provided inaccurate
representations to avoid its obligations); AMG-SIFMA Feb. 22 Letter,
at 10.
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e. Unqualified Representatives
Proposed Sec. 23.450(e) provided that any swap dealer or major
swap participant that determines a Special Entity's representative does
not meet the relevant criteria must submit a written record of the
basis of its determination to the chief compliance officer for review
that the determination was unbiased. Two commenters asserted that the
proposed rule does not provide meaningful protection to Special
Entities from a swap dealer or major swap participant that abuses its
discretion.\822\ Another commenter recommended the Commission require
the swap dealer or major swap participant to submit the written record
to the Commission in addition to the chief compliance officer.\823\ A
commenter also asserted the Commission should require the written
determination be made to the trading supervisor rather than the chief
compliance officer.\824\
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\822\ ABC/CIEBA Feb. 22 Letter, at 9; CalPERS Feb. 18 Letter, at
3.
\823\ CFA/AFR Feb. 22 Letter, at 18.
\824\ SIFMA/ISDA Feb. 17 Letter, at 38-39.
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A commenter requested that the Commission confirm that the swap
dealer or major swap participant would not have any liability to the
Special Entity or its representative as a result of its good faith
determination that the representative was not qualified.\825\
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\825\ Id.
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f. Disclosure of Capacity
Proposed Sec. 23.450(f) requires a swap dealer or major swap
participant to disclose to the Special Entity the capacity in which it
is acting in connection with the swap and, if in more than one
capacity, to disclose the material differences between such capacities
in connection with the swap and any other financial transaction or
service involving the Special Entity. Two commenters requested that the
Commission clarify that required disclosures of other capacities be
limited only to those capacities in connection with the swap.\826\
[[Page 9793]]
Commenters also requested the Commission clarify the meaning of
``before the initiation of a swap'' and to confirm that such
disclosures could be made in a master agreement.\827\ One commenter
asserted that ERISA plans typically have many different types of
relationships with swap dealers, and listing all such relationships
prior to each transaction would impose significant burdens and not
provide meaningful information to an ERISA plan.\828\
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\826\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA Feb. 22
Letter, at 11-12.
\827\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA
Feb. 22 Letter, at 11-12; APGA Feb. 22 Letter, at 7.
\828\ ABC/CIEBA Feb. 22 Letter, at 12.
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g. Transaction Costs and Risks
Commenters asserted that compliance with proposed Sec. 23.450
would be burdensome, costly, or impractical.\829\ Commenters also
stated that the proposed rule may expose swap dealers and major swap
participants to new litigation risks from Special Entities and
representatives.\830\ Commenters asserted that swap dealers and major
swap participants will either pass additional risk and compliance costs
onto Special Entities or refuse to transact with Special Entities
altogether, and such results are ultimately harmful to Special Entities
and outweigh any benefits.\831\
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\829\ See, e.g., ABC/CIEA Feb. 22 Letter, at 3; ERIC Feb. 22
Letter, at 9; CalSTRS Feb. 28 Letter, at 2 and 6; MFA Feb. 22
Letter, at 2; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22 Letter, at
16; HOOPP Feb. 22 Letter, at 2.
\830\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; SIFMA/ISDA
Feb. 17 Letter, at 39; VRS Feb. 22 Letter, at 3; HOOPP Feb. 22
Letter, at 2; CEF Feb. 22 Letter, at 16.
\831\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; ERIC Feb. 22
Letter, at 9-10; CalSTRS Feb. 28 Letter, at 2 and 6; MFA Feb. 22
Letter, at 2; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22 Letter, at
16; HOOPP Feb. 22 Letter, at 2.
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3. Final Sec. 23.450
Based on consideration of the comments, the Commission has
determined to adopt proposed Sec. 23.450 with several changes. The
principal changes include, first, under Sec. 23.450(b)(2), a
representative of an ERISA plan will have to meet only one criterion to
qualify under the section: That it is a fiduciary as defined in Section
3 of ERISA (29 U.S.C. 1002).\832\ Second, under Sec. 23.450(d)(1)
certain counterparty representations will be deemed to provide a
reasonable basis for a swap dealer or major swap participant to believe
that a representative of a Special Entity, other than an ERISA plan,
meets the enumerated criteria in Sec. 23.450(b).\833\ Third, under
Sec. 23.450(c) compliance with certain criteria will be deemed to
establish that a representative is ``independent'' of the swap dealer
or major swap participant within the meaning of Sec.
23.450(b)(1)(iii).\834\ The following discussion addresses comments on
proposed Sec. 23.450 and the changes in final Sec. 23.450.
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\832\ Section 23.450(b)(2) provides: ``Any swap dealer or major
swap participant that offers to enter or enters into a swap with a
Special Entity as defined in Sec. 23.401(c)(3) shall have a
reasonable basis to believe that the Special Entity has a
representative that is a fiduciary as defined in Section 3 of
[ERISA] (29 U.S.C. 1002).'' A swap dealer or major swap participant
will have a reasonable basis to believe that an ERISA plan has a
qualified independent representative under Sec. 23.450(b)(2) if it
receives a representation in writing identifying the representative
and stating that the representative is a fiduciary as defined in
Section 3 of ERISA (29 U.S.C. 1002) as provided in Sec.
23.450(d)(2).
\833\ Section 23.450(d)(1) provides: Safe Harbor. (1) A swap
dealer or major swap participant shall be deemed to have a
reasonable basis to believe that the Special Entity, other than a
Special Entity defined in Sec. 23.401(c)(3), has a representative
that satisfies the applicable requirements of paragraph (b)(1) of
this section provided that: (i) The Special Entity represents in
writing to the swap dealer or major swap participant that it has
complied in good faith with written policies and procedures
reasonably designed to ensure that it has selected a representative
that satisfies the applicable requirements of paragraph (b) of this
section, and that such policies and procedures provide for ongoing
monitoring of the performance of such representative consistent with
the requirements of paragraph (b) of this section; and (ii) The
representative represents in writing to the Special Entity and swap
dealer or major swap participant that the representative: (A) Has
policies and procedures reasonably designed to ensure that it
satisfies the applicable requirements of paragraph (b) of this
section; (B) Meets the independence test in paragraph (c) of this
section; and (C) Is legally obligated to comply with the applicable
requirements of paragraph (b) of this section by agreement,
condition of employment, law, rule, regulation, or other enforceable
duty.
\834\ Section 23.450(c) provides: Independent. For purposes of
paragraph (b)(1)(iii) of this section, a represenative of a Special
Entity will be deemed to be independent of the swap dealer or major
swap participant if: (1) The representative is not and, within one
year of representing the Special Entity in connection with the swap,
was not an associated person of the swap dealer or major swap
participant within the meaning of Section 1a(4) of the Act; (2)
There is no principal relationship between the representative of the
Special Entity and the swap dealer or major swap participant; (3)
The representative: (i) Provides timely and effective disclosures to
the Special Entity of all material conflicts of interest that could
reasonably affect the judgment or decision making of the
representative with respect to its obligations to the Special
Entity; and(ii) Complies with policies and procedures reasonably
designed to manage and mitigate such material conflicts of interest;
(4) The representative is not directly or indirectly, through one or
more persons, controlled by, in control of, or under common control
with the swap dealer or major swap participant; and (5) The swap
dealer or major swap participant did not refer, recommend, or
introduce the representative to the Special Entity within one year
of the representative's representation of the Special Entity in
connection with the swap.
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a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)
The Commission has determined based on the statutory framework and
legislative intent that final Sec. 23.450, like the proposed rule,
shall apply to swaps offered or entered into with all types of Special
Entities. The Commission declines to adopt commenters' position that
the rule be limited to the entities described under Section
1a(18)(A)(vii)(I) and (II).\835\ The Commission also disagrees with
commenters' assertion that the Commission does not have the authority
to apply the rule to swaps with all types of Special Entities.
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\835\ The Commission is persuaded, however, that with respect to
ERISA plans, the swap dealer or major swap participant need only
assess whether the plan representative is a fiduciary as defined in
Section 3 of ERISA (29 U.S.C. 1002) as provided in Section
4s(h)(5)(A)(VII). See Section IV.C.3.d. for a discussion of
qualification criteria for independent representatives.
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Requiring swap dealers or major swap participants to comply with
Sec. 23.450 when dealing with all types of Special Entities resolves
the ambiguities in the statutory text.\836\ The determination is also
consistent with the legislative history \837\ and the clear statutory
intent to raise the standard of care for swap dealers and major swap
participants dealing with Special Entities, generally. Finally, Section
4s(h)(5)(B) provides the Commission with discretionary rulemaking
authority to establish such other standards and requirements as the
Commission may determine are appropriate in the public interest, for
the protection of investors, or otherwise in furtherance of the
purposes of the CEA. The Commission believes that ensuring all Special
Entities have a sufficiently knowledgeable and independent
representative that is capable of providing disinterested, expert
advice is an essential component of the statutory framework that
Congress established for Special Entities.\838\
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\836\ See fn. 727 discussing the ambiguities in Section 4s(h)(5)
of the CEA as to whether the duty is intended to apply with respect
to all types of Special Entity counterparties or just a sub-group.
\837\ See H.R. Rep. No. 111-517 at 869 (June 29, 2010) (Conf.
Rep.) (``When acting as counterparties to a pension fund, endowment
fund, or state or local government, dealers are to have a reasonable
basis to believe that the fund or governmental entity has an
independent representative advising them.'').
\838\ For ERISA plans, the Commission has determined that the
statute deems a fiduciary as defined in Section 3 of ERISA (29
U.S.C. 1002) to be a qualified independent representative within the
meaning of Section 4s(h)(5)(A).
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b. ERISA Plan Representatives That Are ERISA Fiduciaries
The Commission has considered the statutory language in Section
4s(h)(5)
[[Page 9794]]
and issues raised by commenters \839\ and is persuaded that, for
transactions with an ERISA plan under final Sec. 23.450, swap dealers
and major swap participants need only have a reasonable basis to
believe that an ERISA plan representative is an ERISA fiduciary. This
interpretation of Section 4s(h)(5) of the CEA is informed by the
comprehensive federal regulatory scheme that applies to plans subject
to regulation under ERISA, the importance of harmonizing the Dodd-Frank
Act requirements with ERISA to avoid unintended consequences, and the
Commission's view that ERISA plans will continue to benefit from the
many other protections under subpart H of part 23 of the Commission's
rules. The Commission declines to opine on commenters claims that
requirement's under ERISA for plan fiduciaries are comparable,\840\ or
not,\841\ to those criteria in subclauses (I)-(VI) of Section
4s(h)(5)(A)(i). That is more appropriately addressed by DOL, the
primary regulator of ERISA plans.
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\839\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36-37; ERIC Feb.
22 Letter, at 2 and 6; ABC/CIEBA June 3 Letter, at 6.
\840\ See, e.g., ERIC Feb. 22 Letter, at 6-9.
\841\ AFSCME Feb. 22 Letter, at 5.
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Thus, the Commission is adopting proposed Sec. 23.450(b)(7)
(renumbered as Sec. 23.450(b)(2)) as a separate provision that applies
only with respect to ERISA plans as defined in Sec. 23.401(c)(3). A
swap dealer or major swap participant that offers or enters into a swap
with an ERISA plan need only have a reasonable basis to believe that
the ERISA plan's representative is an ERISA fiduciary.
c. Duty To Assess the Qualifications of a Special Entity's
Representative
The Commission has determined to clarify the final rule text to
address commenters' concerns that a swap dealer or major swap
participant could use the statutory framework prescribed for assessing
the qualifications of a Special Entity representative to overreach in
requesting information from the Special Entity or to otherwise gain a
negotiating advantage. Thus, the Commission has added Sec. 23.450(d),
which states that a swap dealer or major swap participant shall have a
reasonable basis to believe a Special Entity's chosen representative
complies with all criteria under Sec. 23.450 where the swap dealer or
major swap participant receives certain representations from the
Special Entity and its representative.\842\ The representations under
Sec. 23.450(d) may be made, as appropriate, on a relationship basis in
counterparty relationship documentation consistent with Sec. Sec.
23.402(d) and 23.450(e). Finally, Sec. 23.450(f) requires a swap
dealer or major swap participant's chief compliance officer to review
any determination that the swap dealer or major swap participant does
not have a reasonable basis to believe that a Special Entity's
representative meets the criteria in Sec. 23.450. The chief compliance
officer's review must ensure that there is a substantial, unbiased
basis for the determination.
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\842\ Section 23.450(d) supra fn. 833. See also Section
IV.C.3.e. of this adopting release for a discussion of Sec.
23.450(d).
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d. Representative Qualifications
i. Regulated Entities and Suggested Certification Regime
The Commission declines commenters' suggestion that a swap dealer
or major swap participant be permitted to conclude that a Special
Entity's representative is per se qualified because it has a particular
status such as CTA, bank, investment adviser, insurance company,
municipal advisor, state law pension fiduciary, or is an employee of
the Special Entity.\843\ The statutory language does not reference any
``status'' other than a fiduciary as defined in ERISA. As a result the
Commission is not inclined to conclude that regulatory status alone is
a sufficient proxy for the enumerated criteria in Section 4s(h)(5)(A).
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\843\ The Commission's determination that ERISA plan
representatives that are ERISA fiduciaries will meet the
requirements of the rule is premised on the statutory language
referencing the comprehensive Federal regulatory scheme under ERISA.
See also Section IV.C.3.b. of this adopting release for a discussion
of representatives of ERISA plans.
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The Commission is continuing to consider commenters' suggestion
that the Commission or an SRO develop a voluntary certification and
proficiency examination program for independent representatives that
would permit a swap dealer or major swap participant to rely on such
certification as satisfying the enumerated criteria.\844\ In this
regard, the Commission notes, that it has begun informal consultations
with the staffs of the SEC, NFA, and MSRB to harmonize regulatory
requirements for municipal advisors and CTAs that advise municipalities
on swaps. The Commission intends to continue to explore whether such
efforts could be incorporated into a broader application for the
independent representatives of all Special Entities.
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\844\ The Commission is considering both legal and practical
issues raised by commenters' certification proposal. See, e.g.,
Section 4o(2) of the CEA makes it unlawful for any CTA or commodity
pool operator registered under the CEA to ``represent or imply in
any manner whatsoever that such person has been sponsored,
recommended, or approved by the United States or any agency or
officer thereof.'' From a practical standpoint, the proposal would
depend on resources committed by an SRO or private certification
board.
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In the meantime, however, the Commission believes that final Sec.
23.450 provides a manageable approach for qualifying Special Entity
representatives that addresses the commenters' concerns about the role
of swap dealers and major swap participants under the statutory
framework and proposed Sec. 23.450. The Commission has clarified the
means of compliance for a swap dealer or major swap participant,
including compliance through representations made on a relationship
basis, as appropriate. Furthermore, the Commission is adopting an
alternative means of compliance under Sec. 23.450(d) \845\ with clear,
objective criteria that will permit a swap dealer or major swap
participant to form a reasonable basis to believe that a Special
Entity's representative meets the relevant criteria, without undue
influence on the selection process.
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\845\ See Section IV.C.3.e. of this adopting release for a
discussion of Sec. 23.450(d) (under Sec. 23.450(d), as adopted, a
swap dealer or major swap participant shall have a reasonable basis
to believe a Special Entity's chosen representative complies with
all criteria under Sec. 23.450 where the swap dealer or major swap
participant receives certain representations from the Special Entity
and its representative).
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ii. Sufficiently Knowledgeable
The Commission requested comment on whether there are other
qualifications that should be considered regarding whether an
independent representative has sufficient knowledge to evaluate the
transaction and risks.\846\ The Commission did not receive comments
addressing any additional qualifications other than a representative
that holds a particular regulatory, state law, or employment
status.\847\ Therefore, the Commission is adopting Sec. 23.450(b)(1)
as proposed (renumbered as Sec. 23.450(b)(1)(i)).
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\846\ Proposing release, 75 FR at 80653.
\847\ The Commission separately addressed comments regarding a
Special Entity's representative that holds a particular regulatory,
state law or employment status. See Section IV.C.3.d.i. of this
adopting release.
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The Commission has determined to delete from the final rule text
the list of factors that a swap dealer or major swap participant would
be expected to consider in determining whether an independent
representative meets the enumerated criteria in the proposed rule.\848\
Commenters found the
[[Page 9795]]
proposed rule text confusing and unworkable.\849\ In light of the
comments, the Commission has determined that such considerations are
more appropriate as guidance regarding whether a representative is
sufficiently knowledgeable, and would be relevant where the Special
Entity did not provide the representations specified in Sec. 23.450(d)
for establishing the qualifications of a representative.
---------------------------------------------------------------------------
\848\ The proposed rule set out several factors to be considered
by swap dealers and major swap participants in determining whether
the Special Entity's representative satisfies certain of the
enumerated criteria, including (1) the nature of the Special Entity-
representative relationship; (2) the representative's ability to
make hedging or trading decisions; (3) the use of consultants or,
with respect to employee benefit plans subject to ERISA, use of a
QPAM or INHAM; (4) the representative's general level of experience
in the financial markets and particular experience with the type of
product under consideration; (5) the representative's ability to
understand the economic features of the swap; (6) the
representative's ability to evaluate how market developments would
affect the swap; and (7) the complexity of the swap. These criteria
will serve as guidance to swap dealers and major swap participants
required to undertake due diligence to assess the sophistication of
a Special Entity's representative.
\849\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 3.
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Where a swap dealer or major swap participant is required to
undertake due diligence to assess whether it has a reasonable basis to
believe that a representative has sufficient knowledge to evaluate the
transaction and risks, it should consider: (1) The representative's
capability to make hedging or trading decisions, and the resources
available to the representative to make informed decisions; (2) the use
by the representative of one or more consultants; (3) the general level
of experience of the representative in financial markets and specific
experience with the type of instruments, including the specific asset
class, under consideration; (4) the representative's ability to
understand the economic features of the swap involved; (5) the
representative's ability to evaluate how market developments would
affect the swap; and (6) the complexity of the swap or swaps involved.
Additional considerations may also include the representative's ability
to analyze the credit risk, market risk, and other relevant risks posed
by a particular swap and its ability to determine the appropriate
methodologies used to evaluate relevant risks and the information which
must be collected to do so. The listed considerations are illustrative
guidance.\850\
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\850\ The Commission does not intend to imply that each
consideration is necessarily a prerequisite for a swap dealer or
major swap participant to form a reasonable basis to believe the
representative is sufficiently knowledgeable. For example, an
employee of a Special Entity, in some cases, may not use one or more
third party consultants. However, this would not mean, in and of
itself, that the representative is not sufficiently knowledgeable.
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iii. Statutory Disqualification
The Commission did not receive any comments regarding this
criterion under proposed Sec. 23.450(b)(2); therefore, the Commission
adopts Sec. 23.450(b)(2) (renumbered as Sec. 23.450(b)(1)(ii)) and
the definition of ``statutory disqualification'' in Sec. 23.450(a)(3)
as proposed with respect to Special Entities other than ERISA plans.
The Commission also clarifies that a representative must satisfy the
criterion regardless of whether it is registered or is required to
register with the Commission, such as an employee of the Special
Entity.
iv. Independence
The Commission proposed a three prong test to determine whether the
Special Entity representative was ``independent'' of the swap dealer or
major swap participant. A representative would be deemed to be
independent if: (1) It was not, within one year, an associated person
of the swap dealer or major swap participant (proposed Sec.
23.450(c)(1)); (2) there was no ``principal relationship'' between the
representative and the swap dealer or major swap participant (proposed
Sec. 23.450(a)(2) and (c)(2)); and (3) the representative did not have
a ``material business relationship'' with the swap dealer or major swap
participant (proposed Sec. 23.450(a)(1) and (c)(3)).\851\
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\851\ Proposing release, 75 FR at 80651-52 and 80660.
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a. Associated Person
The Commission is adopting the ``associated person'' prong in
proposed Sec. 23.450(c)(1) and clarifies that ``within one year''
means ``within one year of representing the Special Entity in
connection with the swap.'' The Commission clarifies that where the
Special Entity's representative is an entity, the representative could
still satisfy the ``associated person prong'' in final Sec.
23.450(c)(1) if the representative had an employee that was an
associated person of the swap dealer or major swap participant within
the preceding twelve months (``restricted associated person'').\852\ To
satisfy the ``associated person'' prong in this situation, a Special
Entity's representative must comply with policies and procedures
reasonably designed to manage and mitigate the conflict. Such policies
and procedures, for example, should impose compensation restrictions to
avoid having the restricted associated person benefit from the Special
Entity's transactions with the swap dealer or major swap participant
and provide for informational barriers, as appropriate, between any
restricted associated person and those employees that directly provide
advice, make trading decisions or otherwise manage and supervise the
Special Entity's account with respect to swaps with the swap dealer or
major swap participant.
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\852\ The definition of ``associated person of a swap dealer or
major swap participant'' under Section 1a(4) of the CEA (7 U.S.C.
1a(4)) is limited by its terms to natural persons. Section 1a(4)
states in relevant part that the term ``means a person who is
associated with a swap dealer or major swap participant as a
partner, officer, employee, or agent (or any person occupying a
similar status or performing similar function) in any capacity that
involves--(i) the solicitation or acceptance of swaps; or (ii) the
supervision of any person or persons so engaged.''
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b. Principal Relationship
The Commission is also adopting the ``principal relationship''
prong of the proposed independence test with one clarification. Section
23.450(a)(2) (renumbered as Sec. 23.450(a)(1)) is amended to clarify
that the term ``principal,'' with respect to any swap dealer, major
swap participant, or Special Entity's representative, means any person
listed in Sec. 3.1(a)(1)-(3) as opposed to a person defined in Sec.
3.1(a).
c. Material Business Relationship
Proposed Sec. 23.450(a)(1) defined ``material business
relationship'' as any relationship, whether compensatory or otherwise,
that could reasonably affect the independent judgment or decision
making of the representative. The Commission has determined to delete
the ``material business relationship'' prong of the independence test
in proposed Sec. 23.450(a)(1) and (c)(3) and to substitute the
following three criteria that were encompassed within the definition.
First, under Sec. 23.450(c)(3), to be deemed ``independent,'' a
representative must (1) provide timely and effective disclosures of all
material conflicts of interest that could reasonably affect the
judgment or decision making of the representative with respect to its
obligations to the Special Entity, and (2) comply with policies and
procedures reasonably designed to manage and mitigate all such material
conflicts of interest. In the Commission's view, to be ``timely and
effective'' the disclosures would be have to be sufficient to permit
the Special Entity to assess the conflict of interest and take steps to
mitigate any materially adverse effect on the Special Entity that could
be created by the conflict. In determining whether a conflict of
interest exists, a representative would be expected to review its
relationships with the swap dealer or major swap participant and their
affiliates, including lines of
[[Page 9796]]
business in which the representative will solicit business on an
ongoing basis.\853\ Additionally, where applicable, the representative
should review relationships of its principals and employees who could
reasonably affect the judgment or decision making of the representative
with respect to its obligations to the Special Entity. The
representative must also manage and mitigate its material conflicts of
interest to avoid having a materially adverse effect on the Special
Entity. A representative should establish and comply in good faith with
written policies and procedures that identify, manage and mitigate
material conflicts of interest including, where appropriate, those
arising from (1) compensation or incentives for employees that carry
out the representative's obligations to the Special Entity, and (2)
lines of business, functions and types of activities conducted by the
representative for the swap dealer or major swap participant.\854\
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\853\ For example, a representative may have separate lines of
business in which it provides services to swap dealers, major swap
participants, or their affiliates. The representative should
consider whether such ongoing relationships where it has an interest
in maintaining existing business or soliciting future business could
reasonably affect its judgment or decision making with respect to
its obligations to the Special Entity.
\854\ Similarly, the Special Entity and representative should
consider the basis upon which the representative will be compensated
by the Special Entity to ensure that the representative's
compensation is not contingent upon executing, for example, a
particular swap, or a swap with a particular dealer or major swap
participant. The Commission understands based on industry practice
that representative fees are sometimes paid at the time of execution
of the swap by the swap dealer or major swap participant at the
direction of the Special Entity for services provided by the
representative in connection with the swap. In the proposed rule,
the Commission recognized that such transfer of payment on behalf of
the Special Entity would not necessarily be a material conflict of
interest between the representative and the swap dealer or major
swap participant. See proposed definition of material business
relationship in proposed Sec. 23.450(a)(1). Proposing release, 75
FR at 80660. However, Special Entities and representatives must
ensure that the compensation arrangement does not undermine the
independence and ``best interests'' duty of the representative as a
result of the contingent nature of the fee arrangement. As a
nonexclusive example, where a representative's compensation is
contingent on execution by the Special Entity of a specific
transaction with a specific swap dealer, the representative will
have a material conflict of interest and will not be incentivized to
act in the best interests of the Special Entity. Special Entities
should ensure that the fee arrangements with their representatives
do not compromise the independence of the representative, create
conflicts of interest or otherwise undermine the quality of the
advice provided by the representative.
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Second, the Commission has added Sec. 23.450(c)(4) to the
independence test to clarify that a representative may not, directly or
indirectly, control, be controlled by, or be under common control with
the swap dealer or major swap participant. This provision is consistent
with the ``principal relationship'' prong and clarifies that a
representative would not be deemed ``independent'' where there is
indirect control through one or more persons or common control with the
swap dealer or major swap participant.
Finally, the Commission is adopting Sec. 23.450(c)(5), which
clarifies that a representative will not be deemed independent if the
swap dealer or major swap participant refers, recommends, or introduces
the representative to the Special Entity within one year of the
representative's representation of the Special Entity in connection
with the swap. The Commission believes a Special Entity should retain a
representative without input from the swap dealer or major swap
participant. If a swap dealer or major swap participant is asked by a
Special Entity for a name or list of names of potential
representatives, the swap dealer or major swap participant would be
expected either to decline to answer or direct the Special Entity to,
for example, an independently maintained repository of business
listings such as a list of registrants with a relevant SRO, a trade
association unaffiliated with the swap dealer or major swap
participant, or a widely-available independent publication that
provides industry contact information.
The Commission has considered the comments and believes that
deleting the ``material business relationship'' prong and substituting
the enumerated criteria in Sec. 23.450(c) resolves commenters' primary
issues about clarity and workability. In addition, the reformulation of
the treatment of ERISA plans under Sec. 23.450(b)(2) eliminates any
potential conflict with the independence test under ERISA.\855\ The
final rule also resolves commenters' concern that the standard would
inappropriately preclude qualified asset managers with complex business
relationships with swap dealers or major swap participants from acting
as Special Entity representatives. Furthermore, any added costs
associated with the duty to disclose and mitigate material conflicts of
interest will only be incremental because many third party independent
representatives will already be subject to similar or identical
disclosure obligations by virtue of being a CTA, investment adviser,
municipal advisor, or other fiduciary to the Special Entity. The
Commission has also determined that a conflicts disclosure regime
paired with an obligation to manage and mitigate conflicts
appropriately balances the statutory independence criterion with any
associated costs.
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\855\ See Section IV.C.3.b. of this adopting release.
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v. Duty To Act in the Best Interests
The Commission agrees with commenters that a swap dealer or major
swap participant could rely \856\ on evidence of legal arrangements
between the Special Entity and its representative that the
representative is obligated to act in the best interests of the Special
Entity, including by contract, an employment agreement, or requirements
under state or federal law.\857\ Having considered the comments, the
Commission is adopting Sec. 23.450(b)(4) as proposed (renumbered as
Sec. 23.450(b)(1)(iv)).
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\856\ In making the representations specified in Sec. 23.450(d)
for establishing the qualifications of a representative Special
Entities are encouraged to ensure that their policies and procedures
are sufficiently robust to evaluate the effectiveness and
enforceability of the obligations of the representative to act in
the best interests of the Special Entity, to make appropriate and
timely disclosures, and to evaluate the appropriateness and pricing
of any swaps entered into by the Special Entity.
\857\ This is also consistent with proposed Sec.
23.450(d)(2)(i), which stated that relevant considerations for a
swap dealer or major swap participant include: ``The nature of the
relationship between the Special Entity and the representative and
the duties of the representative, including the obligation to act in
the best interests of the Special Entity.'' As with proposed Sec.
23.450(d)(2)(ii) (vii), the Commission has decided to delete
proposed Sec. 23.450(d)(2)(i) and adopt it as guidance.
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As more fully discussed in connection with Sec. 23.440, the
Commission has determined that a best interests duty under Sec. Sec.
23.440 and 23.450 will be the duty to act in good faith, make full and
fair disclosure of all material facts and conflicts of interest, and to
employ reasonable care to advance the Special Entity's stated
objectives.\858\
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\858\ Section IV.B.3.c. of this adopting release.
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vi. Appropriate and Timely Disclosures
The Commission also agrees with commenters and confirms that a swap
dealer or major swap participant could rely on appropriate legal
arrangements between a Special Entity and its representative to form a
reasonable basis to believe the representative makes appropriate and
timely disclosures. Therefore, the Commission is adopting Sec.
23.450(b)(5) as proposed (renumbered as Sec. 23.450(b)(1)(v)).\859\
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\859\ See supra, fn. 856.
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The Commission expects that ``appropriate disclosures'' will be
assessed in the context of the Special Entity-representative
relationship. For example, a third party advisor would be expected to
disclose all compensation it receives, directly or indirectly, with
[[Page 9797]]
respect to the swap, and it would be expected to disclose all material
conflicts of interest. Disclosures should also include all fees and
compensation structures in a manner that is clearly understandable to
the Special Entity.\860\ A representative that is a Special Entity's
employee would be expected to disclose material information not
otherwise known to a Special Entity through the employment relationship
such as any material compensation the representative receives from a
third party or where the representative trades for its own account in
the same or a related market. The Commission also expects that a
representative would timely disclose to the Special Entity (or to
appropriate supervisors in the case of an employee), where appropriate,
unexpected gains or losses, unforeseen changes in the market place,
compliance irregularities or violations, and other material
information.\861\
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\860\ For example, where a representative's fee is expressed as
basis points on the notional amount of the transaction, the
representative should also disclose a calculation of the fee in
dollars.
\861\ The Commission encourages Special Entities to consider the
factors discussed in this adopting release in developing appropriate
policies and procedures for selecting a qualified representative and
monitoring their ongoing performance.
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vii. Fair Pricing and Appropriateness
Section 4s(h)(5)(A)(i)(VI) states that the representative will
provide ``written representations to the Special Entity regarding fair
pricing and the appropriateness of the transaction.'' Proposed Sec.
23.450(b)(6) refined the statutory language to state that the
representative ``evaluates, consistent with any guidelines provided by
the Special Entity, fair pricing and the appropriateness of the
swap.''\862\ Having considered the comments, the Commission is adopting
Sec. 23.450(b)(6) as proposed (renumbered as Sec. 23.450(b)(1)(vi)).
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\862\ Proposing release, 75 FR at 80652-53 and 80660. A
commenter requested that the Commission confirm that implementation
of a hedge policy and periodic review of compliance with the policy
would be sufficient to meet the fair pricing and appropriateness
criterion. APGA Feb. 22 Letter, at 6. The Commission declines to
endorse any particular method of compliance with the statutory
criteria in light of the principles based nature of the rule but
believes such considerations would be relevant to an assessment of
compliance with the criterion.
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The Commission also clarifies that this provision does not require
that the representative provide transaction-by-transaction
documentation to the Special Entity with respect to fair pricing and
appropriateness of the swap. The Commission expects that in
circumstances where the representative is given discretionary trading
authority, for example, the representative could undertake in an
investment management agreement or other agreement to ensure that the
representative will evaluate pricing and appropriateness of each swap
consistent with any guidelines provided by the Special Entity prior to
entering into the swap. The Commission notes, however, that the
independent representative would be expected to prepare and maintain
adequate documentation of its evaluation of pricing and appropriateness
to enable both the representative and Special Entity to audit for
compliance with the duty.
viii. Restrictions on Political Contributions by the Independent
Representative of a Governmental Special Entity
The Commission is adopting Sec. 23.450(b)(8) (renumbered as Sec.
23.450(b)(1)(vii)) with modifications to the term ``municipal entity.''
\863\ Consistent with the modifications to Sec. 23.451, the phrase
``municipal entity as defined in Sec. 23.451'' has been replaced with
the phrase ``Special Entity as defined in Sec. 23.401(c)(2) or (4).''
This modification clarifies that the rule only applies to
representatives of State and municipal Special Entities and
governmental plans. The Commission also clarifies that the exclusion
for employees of such Special Entities is limited to paragraph Sec.
23.450(b)(1)(vii).
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\863\ Although the Commission did not receive any comments
regarding the requirements of proposed Sec. 23.450(b)(8), two
commenters requested the Commission clarify the differences between
the term ``municipal entity'' in proposed Sec. 23.450(b)(8) and
Sec. 23.451 and the definition of Special Entity. See, APGA Feb. 22
Letter, at 2; AMG-SIFMA Feb. 22 Letter, at 13. The Commission has
addressed the substance of those comments in the definitions section
(see Section IV.A.3.b. of this adopting release) and the section on
Sec. 23.451 (see Section IV.D.3. of this adopting release).
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The Commission also notes that while the provision requires an
assessment of whether the representative is subject to restrictions on
certain political contributions imposed by the Commission, SEC, or an
SRO, neither the Commission nor a registered futures association has,
as of the adoption of these rules, promulgated such requirements for
CTAs that advise State and municipal Special Entities or governmental
plans.\864\ Therefore, the Commission has set a separate implementation
schedule for Sec. 23.450(b)(1)(vii).\865\
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\864\ Investment advisers registered with the SEC are currently
subject to SEC Advisers Act Rule 206(4)-5, Political Contributions
by Certain Investment Advisers, effective date Sept. 13, 2010, 17
CFR 275.206(4)-5; see also SEC's proposed rules, 76 FR 41018.
Pending final adoption of the SEC's registration rule for municipal
advisors, the MSRB has withdrawn the Proposed Interpretive Notice
Concerning the Application of Rule G-17, on Conduct of Municipal
Securities and Municipal Advisory Activities, to Municipal Advisors,
SR-MSRB-2011-15 (August 24, 2011). In a press release, the MSRB
stated, ``Upon the SEC's adoption of a permanent definition of the
term `municipal advisor' under the Exchange Act, the MSRB plans to
resubmit these rule proposals,'' MSRB Notice 2011-51 (Sept. 9,
2011).
\865\ See Section V at fn. 926 of this adopting release for a
discussion of the implementation schedule for Sec.
23.450(b)(1)(vii).
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e. Reasonable Reliance on Representations
Final Sec. 23.450 allows swap dealers and major swap participants
to comply with the rule by relying on representations of counterparties
with respect to the qualifications of their independent
representatives. Commenters were particularly concerned with the
language in proposed Sec. 23.450(d) (renumbered as Sec. 23.450(e))
that the representations be reliable ``taking into consideration the
facts and circumstances of a particular Special Entity-representative
relationship, assessed in the context of a particular transaction'' and
that the representations be ``sufficiently detailed.'' \866\ New final
Sec. 23.450(d) (safe harbor) and final Sec. 23.450(e) (reasonable
reliance on representations of the Special Entities) together address
many of the commenters' concerns by clarifying the content of
representations that will be deemed to provide a swap dealer or major
swap participant a reasonable basis to believe a Special Entity's
representative meets the qualification criteria.\867\ The
[[Page 9798]]
Commission also confirms that such representations, where appropriate,
can be contained in counterparty relationship documentation to avoid
transaction-by-transaction compliance.\868\
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\866\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36; proposing
release, 75 FR at 80660.
\867\ Final Sec. 23.450(d) and (e) provide:
(d) Safe Harbor. (1) A swap dealer or major swap participant
shall be deemed to have a reasonable basis to believe that the
Special Entity, other than a Special Entity defined in Sec.
23.401(c)(3), has a representative that satisfies the applicable
requirements of paragraph (b)(1) of this section, provided that: (i)
The Special Entity represents in writing to the swap dealer or major
swap participant that it has complied in good faith with written
policies and procedures reasonably designed to ensure that it has
selected a representative that satisfies the applicable requirements
of paragraph (b) of this section, and that such policies and
procedures provide for ongoing monitoring of the performance of such
representative consistent with the requirements of paragraph (b) of
this section; and (ii) The representative represents in writing to
the Special Entity and swap dealer or major swap participant that
the representative: (A) Has policies and procedures reasonably
designed to ensure that it satisfies the applicable requirements of
paragraph (b) of this section; (B) Meets the independence test in
paragraph (c) of this section; and (C) Is legally obligated to
comply with the applicable requirements of paragraph (b) of this
section by agreement, condition of employment, law, rule,
regulation, or other enforceable duty. (2) A swap dealer or major
swap participant shall be deemed to have a reasonable basis to
believe that a Special Entity defined in Sec. 23.401(c)(3) has a
representative that satisfies the applicable requirements in
paragraph (b)(2) of this section provided that the Special Entity
provides in writing to the swap dealer or major swap participant the
representative's name and contact information, and represents in
writing that the representative is a fiduciary as defined in Section
3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C.
1002).
(e) Reasonable reliance on representations of the Special
Entity. A swap dealer or major swap participant may rely on written
representations of a Special Entity and, as applicable under this
section, the Special Entity's representative to satisfy any
requirement of this section as provided in Sec. 23.402(d).
\868\ As the Commission stated in the proposing release, such
representations can be included in counterparty relationship
documentation or other written agreement between the parties and
that the representations can be deemed applicable or renewed, as
appropriate, to subsequent swaps between the parties if the
representations continue to be accurate and relevant with respect to
the subsequent swaps. Proposing release, 75 FR at 80641.
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Some commenters suggested that the Commission permit a simple
representation that a Special Entity's representative satisfies the
criteria in the statute and rule. The Commission does not believe that
such an approach is consistent with the statutory framework or the
intent of Congress to provide meaningful protections for Special
Entities. Nevertheless, the Commission believes it is appropriate to
limit the ability of swap dealers and major swap participants to
subvert the purpose of the independent representative provisions in
Section 4s(h)(5). The Commission further believes that the final rule
addresses commenters concerns while encouraging processes to ensure
that the quality of representation is consistent with the statutory
criteria. The Commission's formulation of the representations will
encourage Special Entities and independent representatives to undertake
appropriate due diligence to ensure that they incorporate the statutory
criteria in the selection and ongoing performance of the independent
representative.\869\ For example, a representative with specific
expertise in interest rate swaps might not be qualified to advise on an
oil swap. Under the rule, the Special Entity and independent
representative would have to undertake to ensure that their policies
and procedures were sufficiently robust to take account of changing
circumstances. In addition, Special Entities and their representatives
should ensure that their policies and procedures require that the
representations provided to the swap dealer or major swap participant
are authorized at the appropriate decision making level of the Special
Entity or representative.\870\
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\869\ See, e.g., SEC and DOL guidance--Selecting and Monitoring
Pension Consultants: Tips for Plan Fiduciaries, available at http://www.dol.gov/ebsa/newsroom/fs053105.html; also available at http://www.sec.gov/investor/pubs/sponsortips.htm.
\870\ Such representations would also apply to representatives
that are employees of the Special Entity. For example, the Special
Entity could represent that it has (1) complied in good faith with
policies and procedures reasonably designed to ensure that its
representative employee meets the criteria, and (2) has reasonably
designed policies and procedures that the employee must follow to
ensure that it satisfies the criteria. The employee could represent
that it has complied in good faith with the Special Entity's
policies and procedures and that it is legally obligated under its
employment agreement or by law to comply with the applicable
criteria of Sec. 23.450(b).
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A swap dealer or major swap participant would be able to rely on
representations unless it had information that would cause a reasonable
person to question the accuracy of the representation.\871\ The
Commission declines to adopt other commenters' suggestion that swap
dealers and major swap participants be permitted to rely on
representations unless it had actual knowledge that the representations
were untrue. The Commission has determined that an actual knowledge
standard may inappropriately encourage the swap dealer or major swap
participant to ignore red flags.\872\
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\871\ The Commission's determination is consistent with several
commenters' suggestions. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36
(``[swap dealers] should be permitted to rely on a written
representation * * * that the counterparty and/or its representative
satisfies the standards * * * absent actual notice of countervailing
facts (or facts that reasonably should have put [a swap dealer] on
notice), which would trigger a consequent duty to inquire
further.''); see also supra fn. 724 and 820.
\872\ See Section III.A.3.d. of this adopting release for a
discussion of Sec. 23.402(d)--Reasonable reliance on
representations.
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Commenters requested that the Commission clarify that the exchange
of representations will not give parties any additional rescission,
early termination, or monetary compensation rights.\873\ The Commission
declines to opine as to potential liability in disputes between private
parties, which will depend on the facts and circumstances of the
particular case and applicable law.\874\
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\873\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 12-13 (asserting
that a swap dealer faced with a highly volatile market and
disadvantageous swap position could claim that a Special Entity
provided inaccurate representations to avoid its obligations); AMG--
SIFMA Feb. 22 Letter, at 10.
\874\ For the same reasons, the Commission declines to opine as
to whether a swap dealer or major swap participant would have
liability to the Special Entity or its representative as a result of
its good faith determination that the representative was not
qualified. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38-39. The
Commission notes, however, that the duty under Section 4s(h)(5)(A)
and final Sec. 23.450 only requires a swap dealer to have a
reasonable basis to believe that a representative is qualified.
Thus, any determination under proposed Sec. 23.450(e), as clarified
in the final rule (renumbered as Sec. 23.450(f)), would not be a
determination by the swap dealer or major swap participant that the
representative is unqualified.
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f. Chief Compliance Officer Review
The Commission has determined to adopt proposed Sec. 23.450(e)
(renumbered as Sec. 23.450(f)) with one modification. The phrase
``determines that the representative * * * does not meet the criteria''
has been changed to read ``determines that [the swap dealer or major
swap participant] does not have a reasonable basis to believe that the
representative * * * meets the criteria.'' This clarifies the
Commission's view that Sec. 23.450 does not give swap dealers and
major swap participants the authority to determine whether a
representative meets the criteria under Sec. 23.450(b). Rather,
consistent with the duty, a swap dealer or major swap participant is
required to have a reasonable basis to believe the representative
satisfies the criteria. The Commission has determined that the
clarifications and modifications to Sec. 23.450 provide meaningful
protections against commenters' concerns that a swap dealer or major
swap participant may overreach or otherwise gain a negotiating
advantage when requesting information from the Special Entity. The
Commission declines to adopt a commenter's suggestion that the written
determination be made by the trading supervisor instead of the chief
compliance officer. As stated in the rule, the Commission expects the
chief compliance officer to review such determination to ensure that
the swap dealer or major swap participant has a substantial, unbiased
basis for the determination.\875\ The Commission believes that a chief
compliance officer is in a better position to review such a
determination for compliance with the rules. A trading supervisor is
more likely to be directly involved with the Special Entity and to have
direct material incentives or bonus structures that could be affected
by such a determination.
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\875\ The Commission believes that reviewing the determination
is part of the CCO's duty to ``take reasonable steps to ensure
compliance.'' See proposed Sec. 3.3(d)(3), CCO proposed rules, 75
FR at 70887.
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One commenter also requested that the rule require the written
record also be submitted to the Commission for review. The Commission
notes that such records of compliance must be kept and made available
to the Commission for
[[Page 9799]]
inspection.\876\ In addition, chief compliance officers are required
under Section 4s(k) of the CEA and proposed Sec. 3.3 to report to the
Commission annually about the firm's compliance record.\877\ Thus, the
Commission will be apprised of material compliance failures on an
annual basis.
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\876\ Section 23.402(g) requires swap dealers and major swap
participants to create a record of their compliance and retain and
make available for inspection such records in accordance with Sec.
1.31 (17 CFR 1.31).
\877\ See Section 4s(k) of the CEA and proposed Sec. 3.3, CCO
proposed rules, 75 FR at 70887.
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g. Disclosure of Capacity
The Commission is adopting Sec. 23.450(f) (renumbered as Sec.
23.450(g)) as proposed. A swap dealer or major swap participant that
acts in a capacity other than as a swap counterparty to a Special
Entity must disclose the material differences between such capacities.
For example, a swap dealer that is also a registered FCM would have to
disclose that when it acts as an FCM it is the Special Entity's agent
with respect to executing orders; however, when it acts as a swap
dealer it is the Special Entity's counterparty and its interests are
adverse to the Special Entity's. Such disclosure would be required, at
a minimum, at a reasonably sufficient time prior to entering into a
swap.\878\ The Commission declines commenters' suggestion that the
required disclosure should be limited to different capacities in
connection with the swap. Such a limitation would not address
counterparty confusion that could arise when a swap dealer changes
status from transaction to transaction. The Commission clarifies that
such disclosures could be made on a relationship basis in counterparty
relationship documentation, where appropriate. Permitting such
disclosure on a relationship basis implements the statutory duty while
appropriately mitigating associated costs.
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\878\ See, e.g., Section III.D. of this adopting release for a
discussion of Sec. 23.431 (Sec. 23.431(a) requires disclosures
``at a reasonably sufficient time prior to entering into a swap'').
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D. Section 23.451--Political Contributions by Certain Swap Dealers
1. Proposed Sec. 23.451
Pursuant to the Commission's discretionary rulemaking authority
under Section 4s(h) of the CEA, proposed Sec. 23.451 prohibited swap
dealers and major swap participants from entering into swaps with
``municipal entities'' if they make certain political contributions to
officials of such entities.\879\ The Commission stated that the
proposed rule was meant to deter undue influence and other fraudulent
practices that harm the public and to promote consistency in the
business conduct standards that apply to financial market professionals
dealing with municipal entities. Proposed Sec. 23.451 complemented
existing pay-to-play prohibitions imposed by the SEC and the MSRB.
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\879\ Proposing release, 75 FR at 80654.
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In a manner similar to the prohibitions contained in SEC Advisers
Act Rule 206(4)-5 \880\ and MSRB Rules G-37 and G-38,\881\ proposed
Sec. 23.451, generally, made it unlawful for a swap dealer or major
swap participant to offer to enter or to enter into a swap with a
municipal entity for a two-year period after the swap dealer or major
swap participant or any of its covered associates makes a contribution
to an official of the municipal entity. The proposed rule also
prohibited a swap dealer or major swap participant from paying a third-
party to solicit municipal entities to enter into a swap, unless the
third-party is a ``regulated person'' that is itself subject to a so-
called pay-to-play restriction under applicable law.
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\880\ 17 CFR 275.206(4)-5 (``SEC Advisers Act Rule 206(4)-5'').
\881\ See MSRB Rule G-37, Political Contributions and
Prohibitions on Municipal Securities Business; MSRB Rule G-38,
Solicitation of Municipal Securities Business.
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The Commission proposed to define ``regulated person,'' for
purposes of Sec. 23.451, to mean, generally, a person that is subject
to rules of the SEC, the MSRB, an SRO or the Commission prohibiting it
from engaging in specified activities if certain political
contributions have been made, or its officers or employees.\882\
Similar to SEC Advisers Act Rule 206(4)-5, the proposing release
defined ``covered associate'' of a swap dealer or major swap
participant as: ``(i) any general partner, managing member or executive
officer, or other individual with a similar status or function; (ii)
any employee who solicits a municipal entity for the swap dealer or
major swap participant and any person who supervises, directly or
indirectly, such employee; and (iii) any political action committee
controlled by the swap dealer or major swap participant or any of its
covered associates.'' \883\
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\882\ Proposing release, 75 FR at 80654 fn. 133.
\883\ Id., at 80654.
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The proposed rule barred a swap dealer or major swap participant
from soliciting or coordinating contributions to an official of a
municipal entity with which the swap dealer or major swap participant
is seeking to enter into or has entered into a swap, or payments to a
political party of a state or locality with which the swap dealer or
major swap participant is seeking to enter into or has entered into a
swap.\884\ The proposed rule also included a provision that would make
it unlawful for a swap dealer or major swap participant to do
indirectly or through another person or means anything that would, if
done directly, result in a violation of the prohibitions contained in
the proposed rule.\885\
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\884\ Id.
\885\ Id.
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The Commission's proposal included three exceptions. First, the
proposed rule permitted an individual that is a covered associate to
make aggregate contributions up to $350 per election, without being
subject to the two-year time out period, to any one official for whom
the individual is entitled to vote, and up to $150 per election to an
official for whom the individual is not entitled to vote. Second, the
proposed rule did not apply to contributions by an individual made more
than six months prior to becoming a covered associate of the swap
dealer or major swap participant, unless such individual solicits the
municipal entity after becoming a covered associate. Third, the
prohibitions did not apply to a swap that is initiated on a DCM or SEF,
for which the swap dealer or major swap participant does not know the
identity of the counterparty.
In addition to the above-mentioned exceptions, proposed Sec.
23.451 included an automatic exemption for those cases where (1) a
contribution made by a covered associate did not exceed $150 or $350,
as applicable, (2) was discovered by the swap dealer or major swap
participant within four months of the date of contribution, and (3) was
returned to the contributor within 60 calendar days of the date of
discovery.\886\ In addition, the Commission proposed that a swap dealer
or major swap participant could apply to the Commission for an
exemption from the two-year ban and, when considering the exemption
application, the Commission would consider certain factors enumerated
in the proposing release, including, for example, whether the exemption
is necessary or appropriate in the public
[[Page 9800]]
interest and consistent with the protection of investors and the
purposes of the CEA.\887\
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\886\ The scope of this proposed exception was limited to the
types of contributions that are less likely to raise pay-to-play
concerns, and the exception is intended to provide swap dealers with
the ability to undo certain mistakes. Because it would operate
automatically, the proposed exception was subject to conditions that
are objective and limited to capture only those contributions that
are unlikely to raise pay-to-play concerns. See also SEC Final
Rules, Political Contributions by Investment Advisors, 75 FR 41035-
36, Jul. 14, 2010.
\887\ Id., at 80655.
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The Commission sought general and specific comment on a number of
questions regarding proposed Sec. 23.451, including whether the term
``municipal entity'' was appropriately defined or whether certain
alternatives should be considered. The Commission also sought comment
on whether the proposed rule should apply only to swap dealers.\888\
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\888\ Id.
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2. Comments
The Commission received several comments representing a diversity
of views on proposed Sec. 23.451. Where one commenter believed
proposed Sec. 23.451 represented an indispensable element of the
business conduct standards and should be strengthened to prohibit a
swap dealer from making a political contribution after the completion
of a transaction, another believed the proposed rule should be deleted
as unduly burdensome for those swap dealers that are part of financial
institutions that are not, or will not be, subject to the rules of the
MSRB.\889\ Alternatively, it was suggested by the latter commenter that
any final rule parallel in certain respects the MSRB regulations on
political contributions made in connection with municipal securities
business and, in so doing, limit the final rule's scope to swap dealers
and major swap participants already covered by the relevant MSRB
regulations.\890\ In another alternative, this commenter requested that
the Commission consider replacing as the triggering occasion for the
application of the rule an ``offer to enter into or enter into a swap
or a trading strategy involving a swap'' with the phrase ``engage in
municipal swaps business.'' \891\ The commenter suggested that
``municipal swap business'' be defined to mean ``the execution of a
swap with a municipal entity.'' \892\
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\889\ Cf. CFA/AFR Feb. 22 Letter, at 18, with SIFMA/ISDA Feb. 17
Letter, at 39-40.
\890\ SIFMA/ISDA Feb. 17 Letter, at 40.
\891\ Id.
\892\ Id.
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Regarding proposed Sec. 23.451(a)(3)'s definition of municipal
entity,\893\ one commenter requested the Commission clarify differences
with the definition of a State and municipal Special Entity under
Section 4s(h)(1)(C)(2)(ii) \894\ and proposed Sec. 23.401, which
limits the definition of Special Entity to ``a State, State agency,
city, county, municipality, or other political subdivision of a
State.'' \895\ Another commenter recommended excluding certain state-
established plans that are run by third-party investment advisers, such
as 529 college savings plans, from the definition of ``municipal
entity'' or, at a minimum, creating a safe harbor from the pay-to-play
provision where a Special Entity is represented by a qualified
financial advisor and that advisor affirmatively selects the swap
dealer.\896\
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\893\ See supra fn. 60 for a definition of the term ``municipal
entity.''
\894\ See Section IV.A. of this adopting release for a
discussion of municipal entities and Special Entities.
\895\ APGA Feb. 22 Letter, at 2.
\896\ AMG-SIFMA Feb. 22 Letter, at 13.
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Regarding the proposed rule's definition of ``solicit,'' one
commenter stated that the term could implicate communication by
employees of a financial institution that do not have a role in the
swaps business and who are already regulated by the MSRB.\897\ This
commenter advocated that the Commission narrow the definition of
``solicit'' to include only ``direct communication by any person with a
municipal entity for the purpose of obtaining or retaining municipal
swaps business.'' In so doing, the commenter stated that the proposed
rule does not include an analogous provision of MSRB Rule G-37 (and
MSRB Proposed Rule G-42, Political Contributions and Prohibitions on
Municipal Advisory Activities) limiting the scope of the rule to
municipal financial professionals ``primarily engaged in municipal
financial representative activities * * *.'' \898\ The same commenter
urged the Commission to include a provision, parallel to the relevant
MSRB rules, which specifies an operative date for the rule, such that
it only applies to contributions made on or after its effective
date.\899\
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\897\ SIFMA/ISDA Feb. 17 Letter, at 40.
\898\ Id.
\899\ Id.
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Another commenter stated that it is unclear how regulated entities
will monitor for compliance with the proposed rule and suggested a re-
writing of the rule in a more targeted fashion prohibiting ``political
contributions with the intent to solicit swaps business.'' \900\ This
commenter also stated that the term ``offer'' should be defined in a
manner that is consistent with its traditional legal definition.\901\
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\900\ CEF Feb. 22 Letter, at 24.
\901\ Id.
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3. Final Sec. 23.451
The Commission has determined to adopt proposed Sec. 23.451 with
changes to reflect certain of the comments and to harmonize its rule
with the SEC's proposed pay-to-play prohibition.\902\ The SEC's
proposed prohibition on certain political contributions by security-
based swap dealers, proposed Rule 15Fh-6, would bar an SBS Dealer from
entering into a security-based swap agreement with a ``municipal
entity'' after they make contributions, with the aim of eliminating
pay-to-play.\903\ Moreover, the Commission's approach to final Sec.
23.451 is also consistent with MSRB Rules G-37 and G-38. Through such
harmonization, the Commission achieves its goal of preventing quid pro
quo arrangements while avoiding unnecessary burdens associated with
disparities between the SEC's proposed rule and the Commission's final
rule and guidance. In this way, the incremental cost of complying with
the Commission's prohibition is expected to be minimal as many of the
entities that will be subject to its restrictions should already have
in place policies and procedures on political contributions by way of
their compliance with existing requirements under SEC Advisers Act Rule
206(4)-5 and MSRB Rules G-37 and G-38.
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\902\ In making this determination, the Commission concluded
that final Sec. 23.451 is fully authorized by the discretionary
rulemaking authority vested in the Commission by Section 731 of the
Dodd-Frank Act, which amended the CEA by adding Section 4s(h). See
Section 4s(h)(3)(D) (``Business conduct requirements adopted by the
Commission shall establish such other standards and requirements as
the Commission may determine are appropriate in the public interest,
for the protection of investors, or otherwise in furtherance of the
purposes of [the CEA].''); see also Sections 4s(h)(1)(D),
4s(h)(5)(B) and 4s(h)(6).
\903\ SEC's proposed rules, 76 FR at 42432-33.
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There were two main changes made to proposed Sec. 23.451 in final
Sec. 23.451. First, the Commission decided to exclude major swap
participants from the pay-to-play prohibition because major swap
participants, as defined, do not ``solicit'' swap transaction business
within the meaning of the final rule and, as such, the Commission does
not expect that major swap participants will assume a dealer-type role
in the swap market.
Second, in place of the term ``municipal entity'' in Sec.
23.451(a), the Commission used the term ``governmental Special Entity''
as defined in final Sec. 23.451(a)(3).\904\ This change clarifies that
the pay-to-play
[[Page 9801]]
prohibition applies not just to municipalities, but to any
contributions made for the purpose of obtaining state and/or local
government business. It also addresses comments recommending that the
Commission clarify that the prohibition only applies to certain Special
Entities as defined in Section 4s(h) and final Sec. 23.401.
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\904\ Section 23.451(a)(3) defines ``governmental Special
Entity'' as any Special Entity defined in Sec. 23.401(c)(2) (a
State, State agency, city, county, municipality, other political
subdivision of a State, or any instrumentality, department, or a
corporation of or established by a State or political subdivision of
a State) or Sec. 23.401(c)(4) (any governmental plan, as defined in
Section 3 of the Employee Retirement Income Security Act of 1974 (29
U.S.C. 1002)).
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The Commission declined to make changes to proposed Sec. 23.451
based on comments recommending the prohibition on pay-to-play be
deleted as unduly burdensome for those swap dealers that are part of
financial institutions that are not, or will not be, subject to the
rules of the MSRB. Rather, the Commission believes that a pay-to-play
prohibition is integral to the business conduct standards framework for
the protection of governmental Special Entities. The final rule is
intended to protect the public by ensuring that swap dealers solicit
and compete for governmental Special Entity business on the merits of
their proposals rather than on the basis of their ability and
willingness to make political contributions. Similarly, the Commission
declines, as one commenter suggested, to limit the prohibition to the
``execution'' of swap business because the final rule is designed to
protect the public in all phases of the transaction, including the
solicitation or offering stage. At the same time, the Commission is
taking steps to mitigate costs by harmonizing the final rule with both
the SEC's and MSRB's prohibitions on certain political contributions.
The Commission does not believe that a safe harbor from the final
rule is appropriate merely because a governmental Special Entity is
being represented by a qualified financial advisor who selects the swap
dealer. By its nature, pay-to-play is covert because participants do
not broadcast that contributions or payments are being made or accepted
for the purpose of influencing the selection of a particular financial
services provider. Given the covert and nefarious purpose behind such
contributions or payments, the Commission believes any potential
loophole, or Commission parsing of the word ``offer,'' would only breed
mischief by would-be wrongdoers and unnecessarily expose the public to
fraudulent dealings.
As the rule text makes clear, the final rule is designed to prevent
``fraud.'' Given this fact, the Commission believes that it is
unnecessary, as some commenters requested, to fashion the prohibition
to reach only those ``political contributions made with the intent to
solicit swaps business.'' Such an intent-based test in this context
would again ignore the covert nature of such contributions or payments.
Rather, the Commission believes that Sec. 23.451(b)(1)'s limiting
principle (i.e., that it prohibits fraud), and the various exceptions
to the prohibitions contained in Sec. 23.451(b)(2), should ameliorate
any concerns that the prohibition may be unduly burdensome to monitor
for compliance. Presumably, swap dealers already have in place policies
and procedures designed to prevent their employees and agents from
perpetrating fraud of this sort.
As with the other business conduct standards being promulgated in
this adopting release, Sec. 23.451 cannot be read in insolation. Of
particular relevance here is the Commission's anti-evasion rule Sec.
23.402(a) which, together with Sec. 23.451(c)'s provision that no swap
dealer shall circumvent the prohibitions of the rule, will provide an
effective safeguard against those who may be inclined to devise an end-
run around final Sec. 23.451. Given these protections, the Commission
does not find it necessary, as one commenter recommended, to change the
rule text to make sure that improper contributions do not occur both
before and after the solicitation and consummation of the transaction.
Further, Sec. 23.451(d) provides a mechanism by which a swap dealer
can apply for an exemption from the prohibitions of the final rule.
Together, these rules ensure that Sec. 23.451 is balanced, flexible
and capable of prohibiting multifarious forms of fraud while
accommodating legitimate requests for relief based on various facts and
circumstances. Similarly, Sec. 23.451(e) specifies where prohibitions
are inapplicable, including where the contribution does not exceed the
dollar thresholds or timing considerations provided in the rule.
V. Implementation
A. Effective Dates and Compliance Dates
In the proposing release, the Commission requested comment on
whether it should delay the effective date of any of the proposed
requirements to allow additional time to comply and, if so, commenters
were asked to identify the particular requirement and compliance burden
that should merit a delay. Under Section 754 of the Dodd-Frank Act, the
rules in subpart H of part 23 would be effective not less than 60 days
after publication of the final rules implementing Section 731, which
adds Section 4s(h) to the CEA.
B. Comments
The Commission received comments concerning implementation of the
final external business conduct standards rules. The majority of the
comments urged the Commission to implement the external business
conduct standards after the implementation of the entity definitions
and registration rules applicable to swap dealers and major swap
participants and to allow sufficient time to implement appropriate
policies and procedures and execute counterparty relationship
documentation.\905\
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\905\ See MFA Mar. 24 Letter, at Annex A p. 3; EEI June 3
Letter, at 7; NFA Aug. 31 Letter, at passim, NextEra Mar. 11 Letter,
at 6; Comm. Cap. Mkts. June 24 Letter, at 2; Financial Assns. May 26
Letter, at 3; Financial Assns. June 10 Letter, at 8-9 (The business
conduct standards rulemaking should occur after the definitions
rulemakings because, in most places, the Dodd-Frank Act refers to
``swap dealers'' instead of ``registered swap dealers,'' and the
statutory definition of swap dealer is vague. Many persons could
unwittingly violate the business conduct standards rules because
they would not have known that they were subject to the rules.
Certain terms such as ``Special Entity,'' ``best interests'' and
``acts as an advisor'' must be clarified by rule prior to the
effectiveness of the business conduct standards rules.); see also
ISDA June 3 Letter, at 2-4; WMBAA June 3 Letter, at 5; AGA June 3
Letter, at 3.
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Other commenters suggested that the Commission's rules, including
the business conduct standards rules, be implemented in a certain
number of phases. The suggestions varied from as few as three to as
many as sixteen phases. From among the commenters who believed that the
rules should be implemented in phases, one commenter stated that the
Commission should divide the rulemakings into three phases, with
business conduct standards in the middle phase.\906\ Another commenter
believed that the business conduct rules should be effective in the
third of three phases.\907\
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\906\ CME June 3 Letter, at 3-4 and 7 (Rulemaking should occur
in three phases--``early,'' ``middle'' and ``late.'' The early phase
rules should deal solely with systemic risk. Business conduct
standards, by contrast, should be in the middle phase.).
\907\ BlackRock June 3 Medero, Prager and VedBrat Letter, at 2-3
(The Commission should publish a proposed sequencing plan that
details both the sequence and implementation for all rules.
Implementation should be divided into three phases and business
conduct rules would be effective in the final phase.); see also
BlackRock June 3 Medero and Prager Letter, at 6.
---------------------------------------------------------------------------
Among the commenters who believed that the rules should be
implemented in four phases, one commenter stated that the external
business conduct rules should be implemented during the second of four
phases, following the implementation of the definitions rules.\908\
Another commenter believed
[[Page 9802]]
the Commission should issue the business conduct standard rules in the
second of four phases, but they recommended that the Commission should
grant a ``one year blanket exemption'' for entities that engage in
bilateral exempt commodity transactions.\909\ Another commenter
suggested that the Commission should implement the business conduct
standards during the last of four phases.\910\ One commenter suggested
that the Commission's swap rules should be implemented in the fourth of
eight phases,\911\ while another commenter opined that the rules should
be divided into 16 phases with business conduct standards being
implemented in phase number seven.\912\
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\908\ MFA Mar. 24 Letter, at Annex A p. 3 (Business conduct
standards rules should be implemented during the second of four
phases, following the implementation of definitions rules. The
second phase should include implementation of clearing rules, swap-
data reporting rules and internal/external business conduct
standards for swap dealers and major swap participants. The third
phase should prioritize SEF trading and segregation of uncleared
swaps. The final phase should include real-time/public reporting and
all other rulemaking, including antifraud and market manipulation
rules.).
\909\ NextEra Mar. 11 Letter, at 6 and 8 (The Commission should
issue definitional rules first, then proceed to the core substantive
rules, and then turn to non-core and ancillary rules. The second
phase of rule implementation, which would follow the first phase of
definitional rules, would implement business conduct standards,
registration, governance, and capital and margin rules. The third
phase would implement clearing requirements, the fourth phase would
cover reporting and record-keeping standards, and the fifth phase
would implement ancillary rules and necessary discretionary rules.).
\910\ EEI June 3 Letter, at 7 (The Commission: (i) Should build
its final rules in a common-sense manner (to start with basic
definitions of ``swap,'' ``swap dealer,'' and ``major swap
participant''); (ii) next build strong institutions such as SEFs,
DCOs, and SDRs; (iii) then implement the mandatory clearing,
exchange-trading, reporting, recordkeeping and other rules
controlling those new markets; and (iv) then, finally, implement the
obligations [e.g., business conduct standards] of swap dealers and
major swap participants in a phased manner that is synchronized to
the development of the new markets and the institutions that support
them.).
\911\ Comm. Cap. Mkts. June 24 Letter, at 2 (The first phase
would include definitions and standards, and the second phase would
include rules to reduce systemic risk, such as central clearing.
Business conduct standards would occur in the fourth phase.).
\912\ Financial Serv. Roundtable April 6 Letter, at 4-5.
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One commenter specifically mentioned the phases that were suggested
by Commissioner O'Malia.\913\ The commenter stated that the Commission
should adopt a schedule for implementation with each such phase. The
commenter stated that if all the rules cited in Commissioner O'Malia's
Phase 2 were adopted simultaneously, then it would be a burden on the
commenter and, therefore, the rules should be implemented in a
staggered schedule.\914\
---------------------------------------------------------------------------
\913\ MGEX June 3 Letter, at 1-2; see also Extension of Comment
Periods, 76 FR at 25276 Appendix 2.
\914\ MGEX June 3 Letter, at 1-2.
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Some commenters did not suggest a specific number of phases, but
had suggestions regarding the implementation of the rules. One
commenter stressed the importance of the Commission providing a clear
date for implementation and believed that market participants would
work towards that date.\915\ The commenter also suggested that if
documentation of customer relationships is a concern because of the
large numbers of customers, some phasing in should be considered by the
Commission.\916\
---------------------------------------------------------------------------
\915\ Better Markets June 3 Letter, at 20.
\916\ Id.
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Another commenter believed that the public should be given an
opportunity to review the rule changes that resulted from public
comments and have an opportunity to comment on the changes prior to the
final rules being promulgated.\917\
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\917\ Noble July 7 Letter, at 2. The Commission declines to
reopen the comment period on this rulemaking. If the Commission were
to delay the final rulemaking to allow additional comments to
address changes that were a result of comments that are already part
of the public record, then it would only be fair to allow further
comments to changes made as a result of those subsequent comments.
The result would be the indefinite delay of the final rules for so
long as someone is willing to comment on changes that were made.
---------------------------------------------------------------------------
One commenter suggested that the Commission should sequence and
implement the final rules by asset class.\918\ Another commenter opined
that the Commission should require clearing, reporting and electronic
execution for the ``better-prepared'' asset classes first (e.g.,
certain commodity and interest rate products that are already quite
liquid and standardized) and should provide ample time for the
maturation of those asset classes and products that are not yet at that
stage.\919\
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\918\ ETA May 4 Letter, at 2-5 (The rules should be implemented
first for market infrastructure entities, then registration of
market professionals, and finally registration of financial entities
with new roles in each asset class.).
\919\ Financial Assns. May 4 Letter, at 2-3 (Phased
implementation by type of market participant will also allow the
Commission and market participants to use lessons learned from
larger market participants when developing rules applicable to end
users. In addition, the Commission should, within each asset class
and type of market participant, prioritize implementation of
requirements that reduce systemic risk ahead of other requirements.
Implementation of requirements designed to achieve other goals, such
as trade execution, should be phased in only once clearing has been
successfully implemented. This commenter also submitted charts that
would sequence rules over nine separate stages. The Associations
propose that the CFTC ``initiate'' business conduct standards in the
sixth stage and ``finalize'' business conduct standards in the ninth
and final stage.).
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The Commission received numerous comments on other portions of the
business conduct standards rules that deal with Special Entities. \920\
With regard to the implementation and phasing of the Commission's
rules, one commenter stated that it is ``critical'' that, on or before
finalization of the proposed rules, the Commission and DOL make a joint
formal announcement that no action required by the business conduct
standards will make a swap dealer or major swap participant an ERISA
fiduciary.\921\
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\920\ Commenters submitted alternatives to the proposed rule
regarding independent representatives for Special Entities (proposed
Sec. 23.450). See, e.g., CalPERS Feb. 18 Letter, at 5-6; CEF Feb.
22 Letter, at 23; Cityview Feb. 22 Submission; Riverside Feb. 22
Letter, at 1-2; SFG Feb. 22 Letter, at 1; CFA/AFR Aug. 29 Letter, at
23. CalPERS suggested a testing regime for independent
representatives but noted that it would take time to create the
testing framework. CalPERS recommended that, should their proposal
advance, it may be necessary to delay the effective date of the
independent representative provision of the regulations to permit
implementation of their alternative approach. The Commission has
modified proposed Sec. 23.450 to respond to commenters concerns,
but has determined not to adopt a testing regime at this time.
CalPERS Feb. 18 Letter, at 4-6. See Section IV.C.3. of this adopting
release for a discussion of final Sec. 23.450.
\921\ ABC/CIEBA Feb. 22 Letter, at 2-3 (The proposed rules
should not be finalized when there is any uncertainty regarding
whether the DOL regulations will be compatible with the CFTC's
rules. If the DOL is not prepared to make the announcement when the
CFTC is ready to finalize its proposed rules, the only workable
solution is to delay the finalization of the business conduct
standards with respect to ERISA plans until the DOL is prepared to
act. Any other course of action would elevate timing issues over the
retirement security of millions of Americans.). The Commission has
harmonized the rulemaking with DOL requirements. See Section II of
this adopting release for a discussion of ``Regulatory
Intersections.''
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Two commenters believed that the rules should be phased in with the
mandatory rulemaking being implemented first, followed by the
implementation of rules issued using the Commission's discretionary
authority.\922\
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\922\ BlackRock Feb. 22 Letter, at 2 (The Commission should
adopt only mandatory rules, and after the Commission has gained more
familiarity with the swaps marketplace, it may consider changing
those standards.); Encana Feb. 22 Letter, at 2 (Some of the business
conduct standards rules were not mandated by Congress and, in light
of the compressed timeline for the implementation of the Dodd-Frank
Act and current budgetary constraints, the Commission should
reconsider its decision to impose non-mandatory requirements on swap
dealers and major swap participants at this time. Encana suggests
that, for swap dealers and major swap participants whose
counterparties are normally end-users, the Commission should limit
the rules to the requirements mandated by the Dodd-Frank Act. If,
after a few years of experience, the Commission believes that
additional business conduct standards are necessary, then the
Commission could explore imposing additional requirements on swap
dealers and major swap participants at that time.). The Commission
has determined to adopt both mandatory and discretionary rules. See
Section III.A.1. of this adopting release for a discussion of Sec.
23.400-Scope.
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[[Page 9803]]
One commenter stated that the Commission should continue to apply
the exclusion for swaps available under pre-Dodd-Frank Act Section 2(h)
of the CEA to allow firms such as its members to facilitate an orderly
transition to the new rules. The commenter suggested that the
Commission's rules be applicable first to bank holding companies, then
later to other swaps participants.\923\
---------------------------------------------------------------------------
\923\ CEF June 3 Letter, at 2.
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One commenter stated that, although Section 721 of the Dodd-Frank
Act limits the Commission's exemptive authority with regard to certain
provisions of the CEA, the Commission still retains authority to exempt
persons from its own implementing rules.\924\ This commenter asked that
the Commission use its authority to exempt persons from its
implementing regulations to address instances where such an exemption
would be in the public interest.
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\924\ NY City Bar June 13 Letter, at 3.
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Another commenter suggested that the Commission should adopt
implementing regulations deferring the effective date of the provisions
of Title VII to be in line with the ongoing international effort to
implement reforms of the OTC derivatives market by December 31, 2012,
following the September 2009 meeting of the G20 in Pittsburgh.\925\
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\925\ Bank of Tokyo May 6 Letter, at 4.
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C. Commission Determination
After considering the comments, the Commission has determined that
the effective date of the rules in subpart H of part 23 will be 60 days
after publication of the final rules in the Federal Register. Swap
dealers and major swap participants must comply with the rules in
subpart H of part 23 on the later of 180 days after the effective date
of these rules or the date on which swap dealers or major swap
participants are required to apply for registration pursuant to
Commission rule 3.10.\926\
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\926\ Under Sec. 23.450(b)(1)(vii), any swap dealer or major
swap participant that offers to enter or enters into a swap with a
Special Entity, other than a Special Entity defined in Sec.
23.401(c)(3), shall have a reasonable basis to believe that the
Special Entity has a representative that, in the case of a Special
Entity as defined in Sec. 23.401(c)(2) or (4), is subject to
restrictions on certain political contributions imposed by the
Commission, the SEC, or an SRO subject to the jurisdiction of the
Commission or the SEC; provided however, that Sec.
23.450(b)(1)(vii) shall not apply if the representative is an
employee of the Special Entity. Because neither the Commission nor
an SRO registered with the Commission has established restrictions
on certain political contributions as provided in Sec.
23.450(b)(1)(vii), swap dealers and major swap participants will not
have to have a reasonable basis to believe that a qualified
independent representative of a Special Entity is subject to such
restrictions on political contributions until the later of 180 days
after the effective date of the final subpart H rules or the
effective date of any rules promulgated by the Commission or an SRO
registered with the Commission imposing such restrictions on
political contributions that would apply to such qualified
independent representative.
---------------------------------------------------------------------------
The compliance schedule established by the Commission for the
subpart H rules will allow swap dealers and major swap participants to,
among other things, implement appropriate policies and procedures,
train relevant personnel, execute any necessary amendments to
counterparty relationship documentation, receive any representations
from counterparties and enable Special Entities to ensure that they
have qualified independent representatives as provided in Sec.
23.450.\927\ While the schedule does not distinguish among swap
dealers, asset classes or counterparties as suggested by various
commenters, the schedule does provide a time certain for compliance and
a substantial lead time of a minimum of eight months to accommodate the
tasks that must be completed by affected market participants. The
Commission was not persuaded that the distinctions among swap dealers,
asset classes, counterparties or mandatory versus discretionary rules
provide a compelling basis for the Commission to phase-in the
implementation of the bulk of the external business conduct standards
rules. Rather, the Commission believes that swap dealers and major swap
participants will be able to develop and implement the required
compliance mechanisms efficiently by considering their affected
business processes across the board. Within the time frame provided,
swap dealers and major swap participants will be able to phase-in their
compliance according to their own priorities, provided that the
requirements are implemented by the applicable compliance date.
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\927\ The compliance dates in this adopting release are subject
to any superseding order of the Commission providing exemptive
relief from certain requirements under the CEA pending completion of
certain other rulemakings, including the entity and product
definitions rulemakings. See, e.g. Effective Date for Swap
Regulation, 76 FR 42508, Jul. 19, 2011; Amendment to July 14, 2011
Order for Swap Regulation, 76 FR 80233, Dec. 23, 2011.
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VI. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') requires Federal agencies
to consider the impact of its rules on ``small entities.'' \928\ A
regulatory flexibility analysis or certification typically is required
for ``any rule for which the agency publishes a general notice of
proposed rulemaking pursuant to'' the notice-and-comment provisions of
the Administrative Procedure Act, 5 U.S.C. 553(b).\929\ As the
Commission stated in the proposing release, it previously has
established that certain entities subject to its jurisdiction are not
small entities for purposes of complying with the RFA.\930\ However, as
the Commission also noted in the proposing release, swap dealers and
major swap participants are new categories of registrant for which the
Commission had not previously addressed the question of whether such
persons are small entities.\931\
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\928\ 5 U.S.C. 601 et seq.
\929\ 5 U.S.C. 601(2), 603, 604 and 605.
\930\ Proposing release, 75 FR at 80655-56.
\931\ See id.
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In this regard, the Commission explained in the proposing release
that it previously had determined that FCMs should not be considered
small entities for purposes of the RFA, based, in part, upon FCMs'
obligation to meet the minimum financial requirements established by
the Commission to enhance the protection of customers' segregated funds
and protect the financial condition of FCMs generally.\932\ Like FCMs,
swap dealers will be subject to minimum capital and margin requirements
and are expected to comprise the largest global financial firms, and
the Commission is required to exempt from designation as a swap dealer
entities that engage in a de minimis quantity of swap dealing in
connection with transactions with or on behalf of customers.\933\
Accordingly, for purposes of the RFA for the proposing release and
future rulemakings, the Commission proposed that swap dealers should
not be considered small entities for essentially the same reasons that
it had previously determined FCMs not to be small entities.\934\
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\932\ Policy Statement and Establishment of Definitions of
``Small Entities'' for Purposes of the Regulatory Flexibility Act,
47 FR 18618, Apr. 30, 1982.
\933\ See Section 1a(49)(D) of the CEA.
\934\ Proposed Rules for Registration of Swap Dealers and Major
Swap Participants, 75 FR at 71385.
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The Commission further explained that it also had previously
determined that large traders are not small entities for RFA purposes,
with the Commission considering the size of a trader's position to be
the only appropriate test for the purpose of large trader reporting.
The Commission then noted that a
[[Page 9804]]
person will be obligated to register as a major swap participant based
upon its maintenance of substantial positions in swaps, creating
substantial counterparty exposure that could have serious adverse
effects on the financial stability of the United States banking system
or financial markets. Accordingly, for purposes of the RFA for the
proposing release and future rulemakings, the Commission also proposed
that major swap participants should not be considered to be small
entities for essentially the same reasons that it previously had
determined large traders not to be small entities.\935\
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\935\ Id., at 71385-86.
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In response to the proposing release, one commenter, representing a
number of market participants, submitted a comment related to the RFA,
stating that ``[e]ach of the complex and interrelated regulations
currently being proposed by the Commission has both an individual, and
a cumulative, effect on [certain] small entities,'' and that the Small
Business Administration had determined some of its members to be small
entities.\936\ These members, as the Commission understands, have been
determined to be small entities by the SBA because they are ``primarily
engaged in the generation, transmission, and/or distribution of
electric energy for sale and [their] total electric output for the
preceding fiscal year did not exceed 4 million megawatt hours.'' \937\
Thus, the commenter concluded that the Commission should conduct a
regulatory flexibility analysis for each of its rulemakings under the
Dodd-Frank Act, including this rulemaking applicable to Business
Conduct Standards for Swap Dealers and Major Swap Participants with
Counterparties.\938\
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\936\ ETA June 3 Letter, at 20-21.
\937\ Small Business Administration, Table of Small Business
Size Standards, (Nov. 5, 2010).
\938\ ETA June 3 Letter, at 20-21.
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This commenter did not provide any information on how the proposing
release may have a significant economic effect on a substantial number
of small entities. Nonetheless, the Commission has reevaluated this
rulemaking in light of the statements made to it by this commenter.
After further consideration of those statements, the Commission has
again determined that this final rulemaking, which is applicable to
swap dealers and major swap participants, will not have a significant
economic effect on a substantial number of small entities.
In terms of affecting a substantial number of small entities, the
Commission is statutorily required to exempt from registration as a
swap dealer those entities that engage in a de minimis quantity of swap
dealing. Thus, it is expected that most small entities will not be
required to register with the Commission as a swap dealer.\939\
Additionally, the Commission does not expect that the small entities
identified by the commenter will be subject to registration with the
Commission as a major swap participant, as most entities with total
electric output not exceeding 4 million megawatt hours are not expected
to maintain ``a substantial position in swaps'' or swap positions that
will ``create substantial counterparty exposure that could have serious
adverse effects on the financial stability of the United States banking
system or financial markets.'' \940\
Accordingly, for the reasons stated in the proposing release, the
Commission continues to believe that the Business Conduct Standards for
Swap Dealers and Major Swap Participants with Counterparties rulemaking
will not have a significant economic impact on a substantial number of
small entities. Therefore, the Chairman, on behalf of the Commission,
hereby certifies, pursuant to 5 U.S.C. 605(b), that these regulations
being published today by this Federal Register release will not have a
significant economic impact on a substantial number of small entities.
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\939\ Section 1a(49)(D) of the CEA (7 U.S.C. 1a(49)(D)).
\940\ Section 1a(33)(A)(ii) of the CEA (7 U.S.C. 1a(33)(A)(ii)).
See also Section 1a(33)(B) (7 U.S.C. 1a(33)(B)) (requiring the
application of a threshold for ``substantial position,'' below which
an entity will not be required to register as an MSP).
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B. Paperwork Reduction Act
The Paperwork Reduction Act (``PRA'') \941\ imposes certain
requirements on Federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA. Certain
provisions of these regulations will result in new collection of
information requirements within the meaning of the PRA. An agency may
not conduct or sponsor, and a person is not required to respond to, a
collection of information unless it displays a currently valid control
number.
---------------------------------------------------------------------------
\941\ 44 U.S.C. 3501 et seq.
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In the proposing release, the Commission informed the public that,
while the proposed rules did contain collections of information, these
collections would overlap with collections proposed by the Commission
in the Business Conduct Standards--Internal rulemakings \942\ and with
collections under the proposed rules adapting the recordkeeping,
reporting and daily trading records requirements under Sec. 1.31 to
account for swap transactions.\943\ Thus, the Commission did not submit
the proposing release to OMB for approval or for assignment of an OMB
control number.
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\942\ See proposing release, 75 FR at 80656. The Business
Conduct Standards--Internal rulemakings referenced in the proposing
release and their proposing release citations are: Governing the
Duties of Swap Dealers, 75 FR 71397; CCO proposed rules, 75 FR
70881; and Conflict-of-Interest Standards by Swap Dealers, 75 FR
71391. The Commission submitted these proposing releases to the
Office of Management and Budget (OMB) for review in accordance with
44 U.S.C. 3507(d) and 5 CFR 1320.11. The Commission requested that
OMB approve, and assign a new control number for, the collections of
information covered by the proposing releases.
\943\ See Adaptation of Regulations to Incorporate Swaps, 76 FR
33066, Jun. 7, 2011. The Commission requested that OMB approve
amendments to existing collections of information in connection with
this proposal.
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The Commission invited comment on the accuracy of its estimate that
no additional recordkeeping or information collection requirements or
changes to existing collection requirements, other than those in the
overlapping rulemakings, would result from the proposed rules. The
Commission received no comments directly addressing this request, but
it did receive one comment indirectly responsive to its
invitation.\944\ In it, the commenter asserted that, for electric
utilities that are governmental entities, the proposed rules require
swap dealers and major swap participants to provide valuation and
scenario analysis, as well as advice and disclaimers that are not
currently requested or required by these electrical utilities.\945\
According to this commenter, these requirements will create new
``paperwork'' for the swap dealer or major swap participant, thereby
creating new costs for the end-user.
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\944\ ETA May 4 Letter.
\945\ Id., at 8.
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The Commission has accounted for the information collection costs
attributable to the swap dealer and major swap participant as required
by the PRA in the information collections prepared for the rulemakings
noted above, and understands that the only costs that may be created
for end-users is any costs for which the Commission has accounted that
may be passed on to the end-user in the form of transaction fees, if at
all, which would not require an increase in the Commission's burden
estimates in the information collections. Moreover, as the Commission
noted in the proposing release, not only were the proposed disclosure
rules aligned with current industry best practices, but several large
swap dealers had told the
[[Page 9805]]
Commission staff during consultations that they were already providing
counterparties with scenario analysis, at no extra charge.\946\
Therefore, considering what swap dealers have represented the current
landscape to be, any ``paperwork'' associated with scenario analysis
should already be passed along to today's end-user. Moreover, to
address counterparty concerns about costs and delay, the final rules
will require scenario analysis only when requested by the counterparty
for any swap not available for trading on a DCM or SEF and only from
swap dealers, not major swap participants. In other circumstances, a
swap dealer will have to notify its counterparty of the right to
receive a scenario analysis. Thus, any pass-through costs for scenario
analysis will be borne by those end-users that elect to receive it.
---------------------------------------------------------------------------
\946\ See proposing release, 75 FR at 80645.
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Regardless, for purposes of this PRA analysis, these collections
are part of the overall (1) supervision, compliance and recordkeeping
requirements imposed by the Commission in the Business Conduct
Standards--Internal rulemakings \947\ and (2) recordkeeping, reporting
and daily trading records requirements under Sec. Sec. 1.31 and 1.35
of the Commission Regulations (17 CFR 1.31 and 1.35).\948\ By their
terms, these rules are part of the supervision, compliance and
recordkeeping requirements that are provided for under the Business
Conduct Standards-Internal rulemaking and the rulemaking adapting
Sec. Sec. 1.31 and 1.35 to swap transactions, and those rulemakings
are compliant with PRA.
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\947\ The Business Conduct Standards--Internal rulemakings
referenced in the proposing release and their proposing release
citations are: Governing the Duties of Swap Dealers, 75 FR 71397;
CCO proposed rules, 75 FR 70881; and Conflict-of-Interest Standards
by Swap Dealers, 75 FR 71391. The Commission submitted these
proposing releases to the Office of Management and Budget (OMB) for
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The
Commission requested that OMB approve, and assign a new control
number for, the collections of information covered by the proposing
releases.
\948\ See Adaptation of Regulations to Incorporate Swaps, 76 FR
33066, Jun. 7, 2011. The Commission requested that OMB approve
amendments to existing collections of information in connection with
this proposal.
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C. Cost-Benefit Considerations
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its action before promulgating a regulation under
the CEA.\949\ In particular, the costs and benefits of the proposed
Commission action shall be evaluated in light of the following five
considerations: (1) Protection of market participants and the public;
(2) efficiency, competitiveness and financial integrity of futures
markets; (3) price discovery; (4) sound risk management practices; and
(5) other public interest considerations. The Commission has considered
the costs and benefits of its business conduct standards rulemaking as
part of the deliberative rulemaking process and discussed them below
and throughout the preamble.
---------------------------------------------------------------------------
\949\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------
The final rules in this adopting release implement Section 4s(h) of
the CEA, which provides the Commission, subject to certain statutory
requirements, with both mandatory and discretionary rulemaking
authority to impose business conduct standards requirements on swap
dealers and major swap participants in their dealings with
counterparties, including Special Entities. Many of the final rules in
this adopting release are mandated by Section 731 of the Dodd-Frank
Act, leaving the Commission with little or no discretion to consider
any alternatives where the statute prescribes particular requirements.
Therefore, in many cases, the Commission's final regulations adhere
closely to the enabling language of the statute. For example, the
statute directs the Commission to adopt rules requiring swap dealers
and major swap participants to verify that counterparties meet
eligibility criteria, disclose material information about contemplated
swaps to counterparties, including the material risks and
characteristics of the swap, and incentives and conflicts of interest
that the swap dealer or major swap participant may have in connection
with the swap. The Commission also must adopt rules that require swap
dealers and major swap participants to provide counterparties with a
daily mark for swaps and establish a duty for swap dealers and major
swap participants to communicate in a fair and balanced manner based on
principles of fair dealing and good faith. In formulating the final
mandatory rules, the Commission adopted approaches that mitigate the
potential costs while maintaining fidelity to the congressional intent
behind Section 731 the Dodd-Frank Act.
In adopting rules using its discretionary authority, the Commission
has acted consistently with the intent of Congress as expressed in
Section 4s(h)(3)(D) to establish business conduct standards that the
Commission determines are appropriate in the public interest, for the
protection of investors or otherwise in furtherance of the purposes of
the CEA.\950\ The discretionary rules include confidential treatment of
counterparty information, institutional suitability, ``know your
counterparty,'' scenario analysis and pay-to-play restrictions. The
discretionary rules reflect the Commission's expertise in establishing
and overseeing an effective regulatory scheme for derivatives market
professionals and appropriate harmonization with existing business
conduct standards across market sectors. The final rules strike an
appropriate balance between protecting the public interest and
providing a workable compliance framework for market participants.
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\950\ In exercising its broad discretionary authority under
Section 4s(h), the Commission was guided by the purposes of the CEA
contained in Section 3. Section 3 explicitly includes among the
purposes of the CEA ``to protect all market participants from
fraudulent or other abusive sales practices * * *'' and ``to promote
* * * fair competition * * * among * * * market participants.'' The
final business conduct standards accomplish that by holding swap
dealers and major swap participants to fair dealing standards and by
providing counterparties with tools necessary to negotiate
effectively with swap dealers and major swap participants and make
informed trading decisions. See also Sections 4s(h)(1)(D),
4s(h)(5)(B) and 4s(h)(6) of the CEA.
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Section 731 of the Dodd-Frank Act, which added new Section 4s(h) to
the CEA, gave the Commission broad new authority to set business
conduct standards rules for swap dealers and major swap participants in
response to abuses in the unregulated derivatives markets. Among the
abuses were those that targeted Special Entities, such as
municipalities and school districts, which led to the heightened
protections for Special Entities in Sections 4s(h)(4) and (5). These
abuses have been the subject of congressional hearings, regulatory
enforcement actions and private litigation. Section 4s(h) is aimed at
reversing a caveat emptor trading environment and providing
transparency in dealings between swap dealers or major swap
participants and their counterparties. Transparency is enhanced
through: Mandatory pre-trade disclosures of material information and a
daily mark; communications based on principles of fair dealing and good
faith; and Special Entity provisions to ensure that swap transactions
are in the ``best interests'' of the Special Entity. Congress also
included a robust anti-fraud provision that applies to swap dealers and
major swap participants in their dealings with counterparties.
As contemplated by Congress through its grant of broad
discretionary authority, the Commission supplemented the mandatory
provisions in Section 4s(h) to limit the ability of
[[Page 9806]]
dealers to employ abusive practices that could disadvantage market
participants that are less sophisticated or have less market power. The
final rules endeavor to protect market participants and the public
without unduly restricting access to the important risk management
tools and investment opportunities provided by swap markets. The final
rules are informed by extensive consultations with relevant federal and
foreign regulators and stakeholders. Where possible, the rules are
harmonized with requirements in related market sectors, industry best
practice recommendations and SRO rules.
The Commission received comments regarding the potential costs and
benefits of the proposed rules, which are discussed in detail above in
each section of the preamble relating to the rules. The Commission
considered these comments in adopting the final rules. The benefits of
the final rules identified by commenters and the Commission include:
(1) Enhanced transparency and reduced information asymmetries among
market participants resulting from required disclosures and
communications standards; (2) principles based duties that are
sufficiently flexible to address emerging compliance issues; (3)
Special Entity provisions to protect taxpayers, pensioners and
charitable institutions from abusive practices; (4) a compliance
framework and mechanisms, including safe harbors, that facilitate
information flow and market access, mitigate costs and enhance legal
certainty, while raising business conduct standards consistent with
legislative intent; and (5) regulatory harmonization of existing
business conduct standards and best practices in related market sectors
and among dealers, including consideration of SRO guidance for
comparable principles based rules.
The costs identified by commenters include assertions that: (1)
Required disclosures are costly both in resources and possible delays,
and could create potential liability unless disclosure can be
standardized with appropriate safe harbors; (2) requiring swap dealers
and major swap participants to make suitability evaluations of
counterparties for specific trades will increase transaction costs and
may create execution delays (both when a counterparty with an
established relationship with a given swap dealer elects to begin
trading a product outside of that relationship and a counterparty with
no such relationship looks to begin trading with a given dealer); (3)
principles based rules may expose swap dealers and major swap
participants to potential compliance risk in both enforcement and
private rights of actions; as a result, swap dealers and major swap
participants will pass the costs of added risk to their counterparties
or there will be fewer possible swap dealer trading relationships,
which could reduce liquidity; (4) execution delay and the chilling of
trading activity may result as the rules will interfere with the flow
of information between swap dealers or major swap participants and
counterparties and impose barriers to efficient execution of
transactions and possibly create moral hazard; and (5) the cost and
risks to Special Entities may increase if dealers avoid such
counterparties, and sophisticated Special Entities may not need the
protections provided by the rules.
The Commission considered the comments it received and, as
discussed in detail in the various sections of the preamble above, and
as highlighted below, has taken steps to mitigate the costs and lower
the burdens to the extent possible while also achieving the regulatory
objectives of the Dodd-Frank Act. For example, the final rules in this
adopting release allow compliance on a relationship basis rather than a
transaction basis, when appropriate, to meet disclosure and due
diligence duties. In addition, whenever possible, the Commission
provides guidance in complying with the principles based statutory
disclosure duties, which should reduce the burdens of complying with
such obligations. The Commission also confirmed that certain business
conduct standards rules will not apply to swaps executed on a SEF or
DCM where the swap dealer or major swap participant does not know the
identity of the counterparty prior to execution, including verification
of eligibility, disclosures and Special Entity requirements. Finally,
the Commission created safe harbors where appropriate, including an
affirmative defense for swap dealers and major swap participants to a
non-scienter fraud claim, and, for non-scienter violations of the other
rules, the Commission will consider good faith compliance with policies
and procedures in exercising its prosecutorial discretion if such
policies and procedures are reasonably designed to comply with the
requirements of any particular rule.
The Commission has considered the costs and benefits of the final
rules in this adopting release pursuant to Section 15(a) of the CEA,
including the comments it received relating to potential costs and
benefits of each rule, where applicable. A discussion of the final
rules in light of the Section 15(a) considerations is included below.
In some cases, the Section 15(a) discussions apply to clusters of rules
where the rules have a common purpose and shared costs and benefits.
For example, the rules requiring disclosure of material information
(risks, characteristics, incentives and conflicts of interest) have the
common purpose of providing information to counterparties in a manner
sufficient to enable counterparties to assess transactions before
assuming the associated risks. The costs and benefits of providing such
disclosures are similarly shared and, therefore, are addressed together
to fully appreciate their cumulative effects. The Commission has
indicated with respect to each rule how it has analyzed the five
considerations in Section 15(a) of the CEA.
With respect to quantification of the costs and benefits of the
final business conduct standards rules, the Commission notes that,
because the Dodd-Frank Act establishes a new regulatory regime for the
swaps market, there is little or no reliable quantitative data upon
which the Commission can evaluate, in verifiable numeric terms, the
economic effects of the final business conduct standards rules. No
commenters presented the Commission with verifiable data pertinent to
any of the proposed rules, stated whether such verifiable data exists,
or explained how such cost data or any empirical analysis of that data
would inform the choice of implementation pursuant to a specific
provision of the Dodd-Frank Act or whether such data and resultant
empirical analysis is ascertainable with a degree of certainty that
could inform Commission deliberations.\951\
[[Page 9807]]
Commenters did not provide any verifiable cost estimates.\952\
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\951\ For example, with respect to potential costs associated
with restrictions on information flows from dealers to their
counterparties and increased reliance by counterparties on dealers,
there is no clear means of quantification because of the difficulty
in designing metrics for these potential costs. In addition, because
there is no historical period in which similar rules were in effect,
there remains the formidable (and costly) challenge of comparing the
current environment to the post-rule environment. This challenge is
compounded by the likelihood that the effect of the rule will differ
across dealers and across counterparties. Quantification of the
potential delays in swap execution and higher associated fees faces
similar challenges, including lack of available data over which to
measure the effect (if any) of such delays. The combination of these
factors makes it impractical to determine reliable estimates of
these types of costs. Moreover, no commenters provided verifiable
estimates. As a consequence, the discussion of these potential costs
is undertaken in qualitative terms.
The Commission recognizes that the business conduct standards
rules impose certain compliance costs, most of which are the result
of statutory mandates. Generally, the costs are anticipated to be
incremental, because they are associated with existing, highly
complementary compliance burdens imposed by the SEC or prudential
regulators. These existing regulations, however, are not uniformly
applied across the entire dealer community. As a consequence,
certain dealers are expected to face higher compliance costs than
others. The lack of dealer-specific information (e.g., on current
staffing levels and those levels envisioned as being necessary for
compliance with the rule) prevents reliable estimation of these
costs, and no such information was provided to the Commission during
the comment period.
\952\ One late-filing commenter recently provided the Commission
with a report to support its position that cost-benefit
considerations compel excluding entities ``engaged in production,
physical distribution or marketing of natural gas, power, or oil
that also engage in active trading of energy derivatives''--termed
``nonfinancial energy companies'' in the report--from regulation as
swap dealers, including this final rulemaking. See NERA Dec. 20
letter, at 1. Based on responses to an anonymous survey of an
unspecified number of firms identified only in the aggregate as
nonfinancial energy companies that ``could be captured'' under the
swap dealer definition, the report estimates that nonfinancial
energy companies would incur certain initial and recurring
regulatory compliance costs relevant to this rulemaking. As
indicated in fn. 951, the Commission recognizes the potential for
compliance costs associated with this rule to fall
disproportionately across all swap dealers. The final rule attempts
to minimize these burdens overall while remaining consistent with
statutory intent.
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1. Section 23.402(a)--Policies and Procedures To Ensure Compliance and
Prevent Evasion and Section 23.402(g)--Record Retention
a. Benefits
Section 23.402(a) requires that swap dealers and major swap
participants (1) have written policies and procedures to ensure
compliance with subpart H of part 23 and to prevent evasion of any
provision of the CEA or Commission Regulations, and (2) implement and
monitor compliance with such policies and procedures as part of their
supervision and risk management requirements as specified in subpart J
of part 23. Section 23.402(g) requires that swap dealers and major swap
participants create a record of their compliance with subpart H and
retain records in accordance with subpart F and Sec. 1.31. As a
result, the requirements of Sec. 23.402(a) and (g) are part of the
overall supervision, compliance and recordkeeping regime established in
Section 4s of the CEA and as implemented in the relevant internal
business conduct standards rulemakings. As such, the costs and benefits
of Sec. 23.402(a) and (g) discussed herein are part of the overall
costs and benefits of the related internal business conduct standards
requirements as discussed in connection with those rulemakings \953\
and are a function of the requirements in the other rules that comprise
subpart H. In this way, Sec. 23.402(a) and (g) facilitates compliance
with all of the subpart H business conduct standards rules.
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\953\ Because the firm-wide supervision, compliance, and
recordkeeping functions are all accounted for in the Business
Conduct Standards--Internal Rulemakings (see Governing the Duties of
Swap Dealers, 75 FR 71397; CCO proposed rules, 75 FR 70881; and
Conflict-of-Interest Standards by Swap Dealers, 75 FR 71391) and
Sec. 1.31 (see Adaptation of Regulations to Incorporate Swaps, 76
FR 33066, Jun. 7, 2011), and these policies and procedures and
record retention provisions are subsets of the overall supervision,
compliance and recordkeeping functions of the swap dealer or major
swap participant, the Commission also has considered the costs and
benefits of these rules in connection with those other rulemakings.
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Although difficult to quantify, robust policies and procedures and
documentation requirements will benefit all market participants.\954\
Swap dealers and major swap participants will benefit because, in the
absence of fraud, the Commission will consider good faith compliance
with policies and procedures reasonably designed to comply with the
business conduct standards rules as a mitigating factor when exercising
its prosecutorial discretion for violation of the rules.\955\ In
addition, swap dealers and major swap participants will be able to rely
on their policies and procedures to demonstrate compliance with subpart
H in connection with their registration applications.\956\ The
requirement to document compliance with the business conduct standards
rules will reduce misunderstandings and complaints between swap dealers
or major swap participants and counterparties. Robust compliance
procedures will also benefit counterparties by encouraging a culture of
compliance that will help to ensure that swap dealers and major swap
participants deliver the protections intended by Section 4s(h). Section
23.402(a) also requires swap dealers and major swap participants to
have policies and procedures to prevent evasion of the CEA and
Commission Regulations. Such policies and procedures will assist
regulators in ensuring that the intent of Congress, particularly
through the Dodd-Frank Act amendments, is abided and that the
Commission's jurisdictional markets are not used to circumvent
regulatory requirements, including by engaging in fraud or other
abuses.\957\ Implementing anti-evasion policies and procedures as part
of the supervision, risk management and compliance regimes of swap
dealers and major swap participants should benefit swap markets by
enhancing transparency and encouraging participation.
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\954\ This benefit is enhanced by the Commission requirement
that recordkeeping policies and procedures ensure that records are
sufficiently detailed to allow compliance officers and regulators to
determine compliance.
\955\ In particular, in connection with allegations of fraud
under Sec. 23.410(a)(2) and (3) (for violations of the fraud
provisions under subpart H), final Sec. 23.410(b) provides that a
swap dealer or major swap participant may establish an affirmative
defense against allegations of violations of final Sec.
23.410(a)(2) and (3) by demonstrating that it did not act
intentionally or recklessly and complied in good faith with written
policies and procedures reasonably designed to meet the particular
requirement that is the basis for the alleged violation.
\956\ As part of the materials submitted in an application for
registration as a swap dealer or major swap participant, an
applicant may submit its written policies and procedures to
``demonstrate, concurrently with or subsequent to the filing of
their Form 7-R with the National Futures Association, compliance
with regulations adopted by the Commission pursuant to section[] * *
* 4s(h) * * * of the [CEA] * * *.'' The Commission adopted final
registration rules on the same day as these business conduct
standards rules. See also proposed Sec. 3.10(a)(1)(v)(A), Proposed
Rules for Registration of Swap Dealers and Major Swap Participants,
75 FR 71379.
\957\ See Section 747 of the Dodd-Frank Act.
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b. Costs
While there will be costs associated with establishing,
implementing, testing, reviewing and auditing compliance with policies
and procedures, the Commission expects these costs to be incremental.
Many swap dealers and major swap participants are already subject to
comprehensive supervision, compliance and recordkeeping requirements
imposed in related regulated market sectors, including futures, banking
and securities. Therefore, the additional costs will be limited to
adapting existing policies and procedures to accommodate these new
requirements. Regardless, the costs will be an incremental part of a
swap dealer's or major swap participant's overall risk management
program as required under subpart J and may be tailored to the swap
related business conducted by a particular swap dealer or major swap
participant.
Similarly, there will be costs associated with record retention,
including the costs of creating a record of compliance and storing it.
To mitigate these costs, the Commission has confirmed that counterparty
relationship documentation containing standard form disclosures, other
material information and counterparty representations may be part of
the written record of compliance with the external business conduct
rules that require certain disclosures and due diligence. Further, swap
dealers and major swap participants may choose to
[[Page 9808]]
use internet based applications to provide disclosures and daily
marks.\958\
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\958\ Swap dealers and major swap participants will have to
retain a record of all required information irrespective of the
method used to convey such information.
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c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of final Sec. 23.402(a) and (g) pursuant to the five
considerations identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
The Commission believes that the Sec. 23.402(a) policies and
procedures and record retention requirements, which are part of the
overall supervision, risk management and compliance systems of swap
dealers and major swap participants included in subparts F and J of
part 23, reinforce subpart H's protections for swap market participants
and the public by promoting compliance with subpart H and discouraging
evasion of regulatory requirements. The costs of compliance are
incremental and do not diminish the intended benefits of the business
conduct standards rules for market participants.
ii. Efficiency, Competitiveness and Financial Integrity
The Commission believes that effective internal risk management and
oversight protects the financial integrity of the critical market
participants--individual swap dealers and major swap participants.
Their financial integrity, in turn, promotes the financial integrity of
derivatives markets as a whole by fostering confidence in financial
system stability. Additionally, the Commission believes that Sec.
23.402(a) will enhance the efficiency and competitiveness of markets to
the extent that swap dealers and major swap participants have sound
risk management programs.
Accurate recordkeeping is foundational to sound risk management and
the financial integrity of swap dealers and major swap participants.
The recordkeeping rules, including Sec. 23.402(g), will enhance
confidence in the financial integrity of the market and encourage
participation by avoiding misunderstandings and reducing the potential
for disputes between counterparties and evasion of regulatory
requirements. Documentation will facilitate compliance reviews and
Commission enforcement actions for failure to comply with disclosure,
due diligence and fair dealing requirements.
iii. Price Discovery
The Commission does not believe that Sec. 23.402(a) and (g) will
have a material impact on price discovery.
iv. Sound Risk Management Practices
The policies and procedures and record retention provisions in
Sec. 23.402(a) and (g) which apply principally to counterparty
relationships of swap dealers and major swap participants are subsets
of the overall supervision, compliance, recordkeeping and risk
management functions of the swap dealer or major swap participant (as
accounted for in the Business Conduct Standards--Internal
rulemakings).\959\ The Commission believes that proper recordkeeping is
essential to risk management because it facilitates an entity's
awareness of its swap business. Such awareness supports sound internal
risk management policies and procedures by ensuring that decision-
makers within swap dealers and major swap participants are fully
informed about the entity's activities, including its dealings with
counterparties, and can take steps to mitigate and address significant
risks faced by the entity. When individual market participants engage
in sound risk management practices, the entire market benefits. On the
other hand, compliance with these policies and procedures and
recordkeeping requirements is likely to require investment in
recordkeeping, as well as front office and back office systems. The
costs associated with this investment might otherwise be used to
enhance other aspects of a firm's risk management program.
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\959\ See Governing the Duties of Swap Dealers, 75 FR 71397; CCO
proposed rules, 75 FR 70881; Conflict-of-Interest Standards by Swap
Dealers, 75 FR 71391; and Sec. 1.31 (see Adaptation of Regulations
to Incorporate Swaps, 76 FR 33066).
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v. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations in connection with Sec. 23.402(a) or (g).
2. Section 23.402(b)--Know Your Counterparty; Section 23.402(c)--True
Name and Owner; and Section 23.434--Recommendations to Counterparties--
Institutional Suitability
a. Benefits
The Commission is promulgating certain due diligence rules for swap
dealers pursuant to its discretionary authority under Section 4s(h)
that further the purposes of the Dodd-Frank Act business conduct
standards provisions. These final rules are Sec. Sec. 23.402(b)--Know
your counterparty, 23.402(c)--True name and owner, and 23.434--
Institutional suitability (collectively, the ``due diligence rules'').
Sections 23.402(b) and 23.402(c) require a swap dealer to use
reasonable due diligence to obtain and retain a record of the essential
facts concerning each counterparty whose identity is known to the swap
dealer prior to the execution of the transaction and the authority of
any person acting for such counterparty. Final Sec. 23.434 requires
swap dealers making recommendations to undertake reasonable diligence
to understand the potential risks and rewards of the swap or trading
strategy and to have a reasonable basis to believe that the swap is
suitable for the counterparty.
All of the due diligence rules confer similar benefits in that they
protect the public and market participants by requiring swap dealers to
have essential information about their counterparties prior to entering
into transactions and, to the extent they are making a recommendation,
understand the trading objectives and characteristics of the
counterparty. While not readily amenable to quantification, the
benefits of the rules are significant. The rules are designed to
prevent the potentially considerable costs for the counterparty (and
incidentally the swap dealer when a counterparty is unable or unwilling
to cover losses) of entering into unsuitable transactions. Such costs
include losses associated with the position, generally, and the costs
(at times considerable) of both exiting the position and establishing a
new position, recognizing that the discovery of an ``unsuitable'' trade
is more likely to occur during a period of market stress, which may
magnify these costs. In this way, the due diligence rules are an
integral component of the business conduct standards that are, in large
part, designed to ensure that the counterparties and dealers understand
the swap or trading strategy and place the dealer and counterparty on
equal footing with respect to the risks and rewards of a particular
swap or trading strategy.
The Commission believes that the due diligence rules will
secondarily benefit dealers and regulators by requiring that a dealer
be able to document essential information about its counterparties and
any swaps or trading strategies that it recommends. While not a
quantifiable benefit, documentation will facilitate effective review of
a recommendation's suitability and render such recommendations less
susceptible to ``second-guessing,'' as well as review of the authority
of its counterparty to enter into transactions. The due diligence
[[Page 9809]]
rules relate to the risk management systems of the swap dealer making
explicit the requirement that the swap dealer obtain facts required to
implement the swap dealer's credit and operational risk management
policies in connection with transactions entered into with the
counterparty. The due diligence rules also harmonize the requirements
for market professionals in related market sectors, including futures,
securities and banking. An ancillary public interest benefit of such
rules in those related markets has been their deterrence of
counterparty misconduct, including, for example, unauthorized trading
and money laundering.
b. Costs
The primary costs of final Sec. Sec. 23.402(b), (c) and 23.434 are
associated with obtaining information necessary to identify the
counterparty, conducting any required due diligence before making a
recommendation and maintaining records of essential customer
information and suitability determinations. The Commission believes
these costs are mitigated by at least five factors. First, as stated
above, many of the dealers subject to these rules have long been
subject to similar obligations under either NFA rules or the mandates
of regulatory authorities in other markets, including banking and
securities.\960\ As such, the incremental costs of complying with the
Commission's final rules are likely to be insignificant. Indeed, the
Commission confirmed that it would consider SRO interpretations of
analogous provisions, as appropriate, when assessing compliance with
the due diligence rules by swap dealers.\961\ Second, in response to
the comments it received, the Commission elected to promulgate several
cost-mitigating alternatives to the proposed due diligence rules. For
example, the Commission made clear that a dealer could fulfill its
counterparty-specific suitability obligations through certain
representations from the counterparty. Third, the Commission provided
additional guidance, including a detailed explanation of what is likely
and, as importantly, unlikely to constitute a ``recommendation'' within
the meaning of final Sec. 23.434. The guidance is included in the
preamble to the final rules as well as in Appendix A to subpart H of
part 23 of the Commission's Regulations. Fourth, the Commission made
clear that a determination of whether a dealer acted in compliance with
the rules is an objective inquiry based on a consideration of all the
relevant facts and circumstances surrounding a particular
recommendation. Fifth, the Commission set forth various safe harbors
from which a dealer could demonstrate compliance. In these and other
ways, the Commission believes that it has taken meaningful steps to
minimize the risks and costs of compliance and any ancillary costs
associated with, for example, vexatious litigation by a counterparty
experiencing buyer's remorse.
---------------------------------------------------------------------------
\960\ See, e.g., Section III.A.3.b. at fn. 179 discussing SRO
know your customer rules; see also Section III.G.3. at fn. 536
discussing suitability requirements under the banking and federal
securities laws.
\961\ See Section III.A.3.b. of this release at fn. 188
discussing final Sec. 23.402(b) (know your counterparty), Section
III.F.3. of this release at fn. 500 discussing final Sec. 23.433
(communications-fair dealing), and Section III.G.3. of this release
at fn. 542 discussing final Sec. 23.434 (recommendations to
counterparties-institutional suitability).
---------------------------------------------------------------------------
Commenters expressed concerns about potential costs of the due
diligence rules. They claimed that the proposed due diligence
requirements would interfere with efficient execution of transactions
if required on a transaction-by-transaction basis. The proposed rules
also may have disadvantaged counterparties by requiring them to provide
confidential information to swap dealers that could be used against
them in negotiations or misappropriated by swap dealers. The Commission
has made a number of changes in the final rules to mitigate those
costs. For example, the Commission clarified that the due diligence
requirements can be satisfied on a relationship basis, where
appropriate, in accordance with final Sec. 23.402(d), through
representations from the counterparty that can be contained in
counterparty relationship documentation. The Commission also amended
the requirements in the ``know your counterparty'' rule to align with
the arm's length nature of the relationship between swap dealers and
counterparties. In addition, the Commission adopted a confidential
treatment rule, Sec. 23.410(c), that protects confidential
counterparty information from disclosure and use that would be
materially adverse to the interests of the counterparty.
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of the final due diligence rules pursuant to the five
considerations identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
The final due diligence rules, although discretionary, are
important components of the business conduct standards regime that
Congress mandated to add to the integrity of the swaps market. By
codifying and, in some cases, enhancing current market practices, the
final rules provide protections for counterparties. More specifically,
the rules protect market participants and the public from the risks
attendant to swap dealers subrogating customers' interests to increase
the dealer's own profit maximizing interests by selling unsuitable
swaps or trading strategies. The requirement that dealers make suitable
recommendations, together with the requirement that swap dealers know
their counterparty, should help to ameliorate the risks associated with
unfair dealing. Taken together, these practices should also help
regulators perform their functions in an effective manner. The
informational and diligence costs associated with this rulemaking are
incremental and do not diminish these benefits.
ii. Efficiency, Competitiveness and Financial Integrity
A frequent criticism of the swaps market leading up to the 2008
financial crisis was that dealers engaged in self-dealing to the
detriment of customers and counterparties, such as by offering swaps
and trading strategies that the dealers knew were unsuitable for the
specific counterparty.\962\ Recommending products that have no
beneficial purpose other than to enrich the dealer erodes confidence in
markets, which, in turn, casts doubt on the efficiency, competitiveness
and financial integrity of the markets subject to the jurisdiction of
the Commission.
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\962\ See, e.g., CFA/AFR Feb. 22 Letter, at 1-4; Better Markets
Feb. 22 Letter, 1-2; Sen. Levin Aug. 29 Letter, at 2-5 and 8-10;
Senate Report, at 382, 397-98 and 619-24.
---------------------------------------------------------------------------
The Commission designed these rules to achieve the intended
statutory benefits set forth in the Dodd-Frank Act and concludes that
any incremental costs above the statutory-baseline will not be of such
magnitude so as to impede swap market efficiency, competitiveness or
financial integrity of the markets.
iii. Price Discovery
To the extent the final due diligence rules, which are part of a
larger business conduct standards regulatory framework, prevent the
aforementioned erosion of confidence in the markets,
[[Page 9810]]
they also facilitate price discovery albeit indirectly.
iv. Sound Risk Management Practices
Verification and recording of counterparty identities, and
carefully considered and well-documented recommendations, improve the
risk management practices of a swap dealer and have concomitant
benefits in that actual compliance with the final rules will help to
insulate the dealer from later accusations by a disgruntled
counterparty seeking to exit an unprofitable swap position by alleging,
for example, that the dealer engaged in malfeasance or recklessness in
recommending a swap or trading strategy. The above-acknowledged
informational and diligence costs do not directly diminish these
benefits.
v. Other Public Interest Considerations
The due diligence rules have the ancillary benefit of dissuading
market participants from using Commission regulated derivatives markets
to engage in illegal conduct in violation of other criminal laws,
including money laundering and tax evasion. Swap dealers will be
required to obtain certain essential information from counterparties to
know their identity, their authority to trade and who controls their
trading. This type of information has been helpful in related market
sectors, like futures, securities and banking, in detecting and
deterring such misconduct.
3. Section 23.402(d)--Reasonable Reliance on Representations
a. Benefits
Section 23.402(d) does not impose any affirmative duties on swap
dealers or major swap dealers, but rather provides them with an
alternative means of compliance with certain other rules under subpart
H of part 23 that require due diligence.\963\ In this way, the rule
benefits market participants by facilitating compliance with certain of
the business conduct standards rules without undermining the
protections intended by the rules.
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\963\ See Sections III.A.3.b., III.C., III.G., IV.B. and IV.C.
in this adopting release for a discussion of the following final due
diligence rules, respectively: Sec. 23.402(b)--Know your
counterparty; Sec. 23.430--Verification of counterparty
eligibility; Sec. 23.434--Institutional suitability; Sec. 23.440--
Requirements for swap dealers acting as advisors to Special
Entities; and Sec. 23.450--Requirements for swap dealers and major
swap participants acting as counterparties to Special Entities.
---------------------------------------------------------------------------
The rule allows swap dealers and major swap participants to rely on
written representations from counterparties and their representatives
to satisfy certain due diligence obligations unless the swap dealer or
major swap participant has information that would cause a reasonable
person to question the accuracy of the representation. Furthermore,
representations can be made on a relationship basis in counterparty
relationship documentation and need not be made on a transaction-by-
transaction basis, provided that the counterparty undertakes to timely
update such representations in connection with new swaps.
Swap dealers and major swap participants requested clarity about
the type of information that would satisfy their due diligence
obligations, and counterparties were concerned that they would be
required to provide confidential financial and position information
that would give swap dealers and major swap participants an unfair
advantage in their swap related negotiations. Section 23.402(d),
coupled with the safe harbors and guidance provided to address
compliance with the due diligence rules in subpart H, will benefit all
parties by streamlining the means of compliance to enable efficient
execution of transactions without materially diminishing the
protections intended by the Dodd-Frank Act business conduct standards.
b. Costs
Section 23.402(d) does not, by itself, impose any direct costs on
market participants. The costs of this rule, if any, are indirect since
the rule is only applicable where swap dealers, major swap participants
and counterparties choose to rely on counterparty representations to
satisfy due diligence requirements imposed by other business conduct
standards rules. As such, any costs of the rule are accounted for in
the analysis of the related rules. One other cost that could arise is
if the swap dealer or major swap participant had information that would
cause a reasonable person to question the accuracy of a representation.
In that situation, the swap dealer or major swap participant could not
rely on the representation without undertaking appropriate due
diligence and incurring any costs associated with further inquiry.
However, swap dealers and major swap participants benefit from such
inquiry if it keeps them from entering into a swap under false
pretenses. Moreover, if the Commission determined not to adopt the
rule, the cost to swap dealers and major swap participants would be
significant. Under that alternative, as one commenter asserted in
connection with Sec. 23.450--Acting as a counterparty to a Special
Entity, swap dealers and major swap participants might stop entering
into swaps altogether or, at the very least, pass increased costs onto
their counterparties.\964\
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\964\ See SWIB Feb. 22 Letter, at 5. The costs and benefits
associated with the ability of swap dealers and major swap
participants to reasonably rely on a counterparty's representations
are discussed in greater detail under the cost-benefit
considerations for the particular requirements to which it applies:
Sec. 23.402(c) (True Name and Owner), Sec. 23.430 (Verification of
Counterparty Eligibility), Sec. 23.434 (Recommendations to
Counterparties--Institutional Suitability), Sec. 23.440
(Requirements for Swap Dealers Acting as Advisors to Special
Entities), and Sec. 23.450 (Requirements for Swap Dealers and Major
Swap Participants Acting as Counterparties to Special Entities).
---------------------------------------------------------------------------
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of final Sec. 23.402(d) pursuant to the five
considerations identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
The purpose of the business conduct standards rules is to protect
market participants and the general public. Final Sec. 23.402(d)
furthers that intent by providing clear instruction on how market
participants can comply with certain of those rules. The proviso that a
swap dealer and major swap participant can only rely on a
counterparty's representation in the absence of information that would
cause them to question the accuracy of the representation protects swap
dealers and major swap participants from the potentially negative
consequences of entering into a swap in reliance on false information.
This rule also protects counterparties by providing counterparties with
control over the amount and type of information provided to a swap
dealer or major swap participant.
ii. Efficiency, Competitiveness and Financial Integrity
This rule gives swap dealers and major swap participants a timely
and cost-effective way to comply with their duties to counterparties.
This increases the efficiency, competitiveness and financial integrity
of the swaps market relative to an alternative that retains a due
diligence requirement without an explicit means of compliance.
Moreover, the Commission believes that the protection of proprietary
information, which also is achieved through this rule, is essential for
the competitiveness and integrity of derivatives markets.
[[Page 9811]]
iii. Price Discovery
The Commission does not believe that Sec. 23.402(d) will have a
material impact on price discovery.
iv. Sound Risk Management Practices
The Commission does not believe that Sec. 23.402(d) will adversely
impact sound risk management practices. While the principles based
nature of the rules may introduce some uncertainty into the process of
complying with the due diligence business conduct standards rules, the
compliance roadmap in this particular rule decreases that risk by
providing an efficient means for swap dealers and major swap
participants to comply with several of their pre-transactional duties.
v. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations in connection with Sec. 23.402(d).
4. Section 23.402(e)--Manner of Disclosure; Section 23.402(f)--
Disclosures in a Standard Format; Section 23.431--Disclosure of
Material Risks, Characteristics, Material Incentives and Conflicts of
Interest Regarding a Swap; Section 23.432--Clearing Disclosures; and
Section 23.433--Communications--Fair Dealing
a. Benefits
Final Sec. 23.431, which requires disclosures of material
information, and the associated disclosure rules in subpart H of part
23 (the ``disclosure rules'') \965\ contain the disclosure regime for
swap dealers and major swap participants. These rules are fundamental
to the transparency objectives of Section 4s(h) of the Dodd-Frank Act.
The disclosure rules primarily benefit counterparties by requiring that
swap dealers and major swap participants disclose material information
regarding potential swap transactions, including material risks,
characteristics, incentives, conflicts of interest, daily marks and
rights relating to clearing of the swap. They also benefit
counterparties by providing flexible and reliable means of compliance
to take account of the nature of the swaps being offered and to avoid
undue interference with the execution process.
---------------------------------------------------------------------------
\965\ Consistent with Section 4s(h)(3)(B) of the CEA, Sec.
23.431--Disclosures of material information, requires disclosure of
material risks, characteristics, material incentives, conflicts of
interest and daily mark relating to a swap. Associated rules
include: Sec. 23.402(e)--Manner of disclosure; Sec. 23.402(f)--
Disclosures in a standard format; and Sec. 23.432--Clearing.
---------------------------------------------------------------------------
In addition, the communications-fair dealing rule in final Sec.
23.433 adopts the statutory language in Section 4s(h)(3)(C) and
requires swap dealers and major swap participant ``to communicate in a
fair and balanced manner based on principles of fair dealing and good
faith.'' The fair dealing rule works in concert with the disclosure
rules and the anti-fraud rules in Sec. 23.410 (the ``abusive practices
rules'') to provide transparency to market participants in dealing with
swap dealers and major swap participants.\966\
---------------------------------------------------------------------------
\966\ See Section III.F. of this adopting release for a
discussion of Sec. 23.433--Communications--Fair Dealing.
---------------------------------------------------------------------------
While not readily amenable to quantification, the benefits of the
disclosure and fair dealing rules are significant for counterparties.
The disclosure rules will allow counterparties to better assess the
risks and rewards of a swap and avoid swaps that are inconsistent with
their trading objectives. The fair dealing rule ensures that swap
dealers' and major swap participants' communications to counterparties
are not exaggerated and discussions or presentations of profits or
other benefits are balanced with the associated risks. The disclosure
and fair dealing regime imposed by Section 4s(h) reverses the caveat
emptor environment that permeated the unregulated derivatives
marketplace prior to enactment of the Dodd-Frank Act and afforded
little transparency or protection for either sophisticated
counterparties or Special Entities. Legislative history indicates that
the business conduct standards in Section 4s(h) were the result of
widespread concerns about sharp practices and significant information
asymmetries between swap dealers and their counterparties that created
significant imbalances in their respective bargaining power and the
assumption of unanticipated risks by counterparties. The disclosure and
fair dealing rules implement the statutory objective of transparency
for all swap transactions.
With respect to disclosures of the daily mark for uncleared swaps,
the rules will provide counterparties, on a daily basis, the mid-market
mark for the swap.\967\ This information will provide an objective
reference mark for counterparties to assist them in valuing open
positions on their books for a variety of purposes, including risk
management. The standard in the rule is intended to achieve a degree of
consistency in the calculation of the daily mark across swap dealers
and major swap participants. Such consistency will provide added
transparency in pricing transactions and enhance the ability of
counterparties to consider daily marks for their own valuation
purposes. Counterparties will also receive from the swap dealer or
major swap participant a mid-market mark along with the price of any
swap prior to entering into the swap. Again, receiving the mid-market
mark prior to execution of a swap will assist counterparties in
assessing the price of a swap and negotiating swap terms, generally,
with swap dealers and major swap participants.
---------------------------------------------------------------------------
\967\ The mid-market mark will not include amounts for profit,
credit reserve, hedging, funding, liquidity or any other costs of
adjustments.
---------------------------------------------------------------------------
The Commission believes that the disclosure rules will secondarily
benefit swap dealers, major swap participants and regulators by
requiring documentation of swap-related disclosures. While not a
quantifiable benefit, documentation will facilitate effective
supervision and compliance with required disclosures, which should
reduce potential complaints, investigations and litigation. The fair
dealing rule also benefits swap dealers and major swap participants by
harmonizing the statutory requirements with similar protections that
currently apply to registrants in the futures and securities
markets.\968\
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\968\ See NFA Interpretive Notice 9041-Obligations to Customers
and other Market Participants (``Communications with the Public--
Under NFA Compliance Rules 2-4 and 2-29(a)(1), all communications
with the public regarding security futures products must be based on
principles of fair dealing and good faith * * *.''); see also NASD
Rule 2210(d). Final Sec. 23.433 is also harmonized with the SEC's
proposed Fair and Balanced Communications rule for SBS Entities. See
proposed 17 CFR 240.15Fh-3(g), SEC's proposed rules, 76 FR at 42455;
and SEC's proposed rules Correction, 76 FR 46668, Aug. 3, 2011.
---------------------------------------------------------------------------
b. Costs
The primary costs of the disclosure rules are associated with
implementing policies and procedures to achieve compliance with the
principles based disclosure requirements, preparing and disseminating
the disclosures, and maintaining records of the disclosures. The
Commission expects that expenses will vary depending on the regulatory
status of the swap dealer or major swap participant with financial
firms regulated by prudential or securities authorities having
relatively less additional costs because of existing regulatory
requirements. Costs will also vary depending on the nature of the
business conducted by the swap dealer considering that the process of
making disclosures may be more streamlined for standardized swaps than,
for example, complex bespoke swaps.
Regardless, the Commission believes that any costs associated with
the disclosure rules will be incremental for
[[Page 9812]]
the following reasons. First, as stated above in Section III.D. of this
adopting release, many swap dealers and major swap participants subject
to this scheme have long been subject to similar disclosure obligations
based on informal OTC derivatives industry practice and under the
mandates of regulatory authorities in related market sectors, including
banking, securities and insurance. As such, the incremental cost of
complying with the Commission's final rules is likely to be small
relative to the overall costs of operating as a swap dealer or major
swap participant.
Second, in response to comments, the Commission elected to
promulgate several cost-mitigating alternatives in the final disclosure
rules. For example, the Commission made clear that a swap dealer or
major swap participant could fulfill its disclosure obligations by any
reliable means agreed to in writing by the counterparty. In addition,
disclosures applicable to multiple swaps may be made in counterparty
relationship documentation or other written agreements rather than on a
transaction-by-transaction basis. The scenario analysis rule was
revised from mandatory to elective and limited to swaps that are not
made available for trading on a DCM or SEF. Further, anonymous
transactions initiated on a SEF or DCM are exempt from the pre-
transaction disclosure requirements.
Third, the Commission provided additional guidance in response to
comments regarding many aspects of the disclosure scheme, including
manner of disclosure, disclosures in a standard format, material risks,
scenario analysis, material characteristics, material incentives,
conflicts of interest, daily mark and clearing issues. Fourth, the
Commission made clear that in exercising its prosecutorial discretion
for disclosure violations, it would consider whether the swap dealer or
major swap participant had complied in good faith with policies and
procedures reasonably designed to comply with the particular disclosure
requirement. In these and other ways, the Commission believes that it
has taken meaningful steps to minimize the risks and costs of
compliance and any ancillary costs associated with, for example,
private rights of action by counterparties unhappy with a particular
swap transaction.
The Commission is allowing swap dealers and major swap participants
to satisfy their disclosure obligations, where appropriate, on a
relationship basis, as opposed to a transaction-by-transaction basis as
a way of avoiding trading delays and the associated costs. However, in
certain instances, consistent with the statutory requirement that swap
dealers and major swap participants disclose information about the
material risks and characteristics of the swap, the disclosure
obligation will require supplements to standardized disclosures that
are, to a degree, tailored to the individual transaction under
consideration. The costs and benefits of these types of transaction-
specific disclosures are considered relative to a case where material
risk disclosure, as required under the statute, is accomplished at a
level less granular than that which tailors such disclosure to a
particular swap type. In addition, since the requirement for scenario
analysis, through its value for illustrating material risk, is made at
the discretion of the Commission, its associated costs and benefits are
discussed relative to the absence of such a requirement.
Commenters also identified costs associated with the fair dealing
rule. One commenter asserted that the principles based nature of the
proposed fair dealing rule had the potential to impose costs on swap
dealers and major swap participants including costs resulting from
compliance risk.\969\ As discussed in the introduction to this Section
VI.C. of this adopting release, such costs are not readily subject to
quantification. Another commenter requested that the Commission clarify
the standards for communication by reference to existing SRO standards
applicable in related market sectors.\970\
---------------------------------------------------------------------------
\969\ NY City Bar Feb. 22 Letter, at 3.
\970\ FHLBanks Feb. 22 Letter, at 6.
---------------------------------------------------------------------------
In response to commenters, the Commission clarifies in this
adopting release that it will consider NFA guidance when interpreting
Sec. 23.433.\971\ The Commission believes harmonizing with existing
SRO rules and precedents in the futures and securities markets
diminishes the potential costs associated with legal uncertainty.
Furthermore, the Commission clarifies in this adopting release that, in
the absence of fraud, the Commission will consider good faith
compliance with policies and procedures reasonably designed to comply
with the fair dealing rule as a mitigating factor when exercising its
prosecutorial discretion in connection with a violation of Sec.
23.433.
---------------------------------------------------------------------------
\971\ See Section III.F.3. of this adopting release for a
discussion of final Sec. 23.433 and NFA guidance.
---------------------------------------------------------------------------
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of the final disclosure rules and the fair dealing rule
pursuant to the five considerations identified in Section 15(a) of the
CEA as follows:
i. Protection of Market Participants and the Public
The principal purpose of the disclosure rules is to protect market
participants and the public by making swaps more transparent to enable
counterparties to better assess the risks and rewards of entering into
a particular transaction. The disclosure rules are a core component of
the overall business conduct standards regime imposed in Section 4s(h)
of the Dodd-Frank Act.
In determining how to implement the statutory disclosure
requirements, the Commission considered certain negative externalities
that may be created by requiring swap dealers and major swap
participants to provide transaction specific disclosures. One risk is
that requiring such disclosures by swap dealers and major swap
participants could create disincentives to counterparties for
performing their own independent assessments of a transaction under
consideration. As a result, there is an increased likelihood that any
insufficiencies in the information provided by swap dealers and major
swap participants that are not easily discernible at the time the
disclosure is made could impact an expanded class of market
participants in a similar way. For instance, the model risk borne by
swap dealers and major swap participants may be transferred onto a
broader set of market participants.
In addition, transaction-specific disclosures, generally, and
specifically those based on model outputs (e.g., certain scenario
analyses) require ongoing validation to ensure their sufficiency,
accuracy and relevance. To the extent that the level of these
validation efforts varies across swap dealers and major swap
participants, the risk of relative insufficiencies or omissions in
disclosure borne by the counterparties reliant on this information will
vary correspondingly.
Because the disclosure rules are principles based, the quality of
policies and procedures adopted by swap dealers and major swap
participants will play a significant role in determining the
sufficiency, accuracy and relevance of the disclosures made to
counterparties. Moreover, some of the disclosures are models-based,
whether through disclosures of a given product's sensitivity to certain
market risk factors or the performance of the product during different
scenario events or episodes. Policies and procedures, generally, and
especially those governing models require ongoing
[[Page 9813]]
validation to ensure their sufficiency, accuracy and relevance. The
consequences of varying levels of supervision, to the extent that these
levels vary in their ability to preserve the sufficiency, accuracy and
relevance of the disclosures, will be borne by counterparties. Any such
differences in supervisory efforts, to the extent they are allowed to
persist, lessen the degree to which counterparties can rely on the
information being provided to them. To mitigate these concerns, the
Dodd-Frank Act imposes robust supervision and compliance requirements
on swap dealers and major swap participants, which are implemented in
subpart J of part 23. In subpart H, and in guidance in this adopting
release, the Commission has endeavored to clarify the relationship
between swap dealers and major swap participants, on the one hand, and
counterparties on the other to discourage undue reliance and to
incentivize counterparties to engage in appropriate due diligence
before entering into swaps.
Transaction-specific information is certainly valuable to the
counterparty to assess the relative merits of a prospective
transaction. Through economies of scale, swap dealers and major swap
participants may be better positioned to provide these disclosures (as
opposed to the counterparty discovering the information itself). In
other words, swap dealers and major swap participants may be the
lowest-cost provider of this information. As a result, efficiency gains
may be realized by requiring swap dealers and major swap participants
to disseminate this information. The fact that commenters point to
significant information advantages enjoyed by swap dealers and major
swap participants over their counterparties supports this lowest-cost
solution.
Additionally, the fair dealing rule protects market participants
and the public by requiring that communications between swap dealers or
major swap participants and their counterparties are conducted based on
principles of fair dealing and good faith. The rule raises the standard
for communications in the previously unregulated swaps market and
encourages confidence in the swap market by market participants and the
public. The fair dealing rule, particularly in conjunction with the
disclosure rules, ensures that market participants have information
necessary to assess the risks and rewards of a swap when dealing with
swap dealers and major swap participants, which have had informational
advantages over their counterparties by virtue of their roles in the
marketplace.
ii. Efficiency, Competitiveness and Financial Integrity
Commenters raised concerns that requiring material information
disclosure prior to execution may delay execution, increase market risk
and adversely affect efficiency. Further, the required disclosures may
result in proceedings or litigation, which could test the financial
integrity of certain swap market participants.
The Commission has designed the disclosure rules to minimize
potential inefficiencies and anti-competitive results, and to bolster
financial integrity. For example, the rules allow disclosures to be
made by any reliable means agreed to by the counterparty. In addition,
risk disclosures in a standard format may be included in counterparty
relationship documentation or other written agreements between the
parties. Scenario analysis is elective rather than mandatory. Moreover,
because the disclosure rules are principles based, the Commission will
take into account whether reasonably designed policies and procedures
are in place prior to exercising its prosecutorial discretion when
considering violations of the disclosure rules.
The fair dealing rule principally protects counterparties; however,
there are additional benefits for markets. The fair dealing rule,
particularly when considered with the abusive practices rules and the
disclosure rules, improves transparency and discourages abusive
practices, and thereby encourages participation in the market, which
contributes to liquidity, efficiency and competitiveness in the
marketplace. Furthermore, the fair dealing rule assists market
participants to assess potential risk in connection with a swap and
make more informed decisions consistent with their trading objectives.
iii. Price Discovery
Transaction specific disclosures may, to a degree, cause delays in
execution. These delays may occur either when a counterparty with an
established relationship with a given swap dealer or major swap
participant elects to begin trading a product outside of that
relationship or a counterparty with no such relationship looks to begin
trading with a given swap dealer or major swap participant. These
delays may have negative consequences on liquidity, potentially
subjecting counterparties to heightened transaction costs. Moreover,
these delays may be pro-cyclical, meaning that they increase during
times of heightened market volatility. In recognition of the potential
for these delays, the Commission adopted several procedural provisions
to mitigate adverse consequences, including (1) allowing, where
appropriate, disclosures to be made at the relationship level as
opposed to the transaction level, (2) allowing certain oral disclosures
if agreed to by the counterparty and confirmed in writing, (3) making
Web site-based disclosures (password-protected if for the daily mark)
available, and (4) allowing swap dealers and major swap participants to
partner with DCMs, SEFs, and/or third-party vendors to make certain
disclosures.
To the extent that delays in execution foster a more complete
assessment of the merits of a particular transaction, the likelihood of
after-the-fact realizations of ill-conceived positions may be reduced
as well as any trading activity these realizations encourage. To the
extent that this trading activity impacts market volatility, its
reduction has positive implications for price discovery. Moreover,
since these realizations are more likely to occur during periods of
market stress, the corresponding benefit of their reduction may be
elevated during such periods.
As stated in the price discovery consideration of final Sec.
23.410, the fair dealing rule benefits counterparties but also provides
added benefits for markets.\972\ The fair dealing rule requires swap
dealer and major swap participant communications to be fair and
balanced and restricts misleading or other potentially abusive
communications that could undermine the price discovery function of the
swap market.
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\972\ See Section VI.C.5.c.iii. of this adopting release for a
discussion of price discovery considerations of final Sec. 23.410--
Prohibition on fraud, manipulation and other abusive practices.
---------------------------------------------------------------------------
iv. Sound Risk Management Practices
Presumably, exercising the opt-in feature for scenario analysis
will impart some cost to the counterparty. This cost will depend on the
specificity of the analysis being requested and will be paid through
some combination of delayed execution and/or higher fees. The rule
attempts to mitigate these costs by making scenario analysis optional
on the part of the counterparty as it is under current industry
practice. Moreover, exercising this feature signals that the
counterparty values the information provided by the analysis and,
therefore, is willing to bear the associated costs. In contrast, a
policy of mandatory scenario analysis forces this cost to be borne, to
varying degrees, by
[[Page 9814]]
all market participants, even though the corresponding benefit to a
subset of those participants may be at or near zero. As a result, the
final scenario analysis provision furthers a primary objective of the
Dodd-Frank Act by encouraging sound risk management practices among
market participants without unduly imposing costs.
Consistent with the statutory framework in Section 4s(h), whether
standard form or particularized disclosures are sufficient in any given
case will depend on the facts and circumstances of the subject
transaction. Principles based disclosure rules take into account the
various types of swap transactions that are subject to the rules (from
highly standardized agreements to complex bespoke swaps), as well as
the varied scope of swap related business undertaken by swap dealers
and major swap participants. Compliance with principles based rules,
like the disclosure rules, is by nature a matter of interpretation by
swap dealers or major swap participants in the design of their policies
and procedures, as well as by regulators and counterparties in their
after-the-fact review of such disclosures, prompted, for example, by
performance results that are claimed to be inconsistent with such
disclosures. Subjective criteria introduce uncertainty into the
compliance process and, in so doing, contribute to heightened risk
costs that, at least in part, may be passed on to counterparties.
Depending on how this uncertainty distributes across all swaps
products, certain market participants may bear a disproportionate share
of the resulting costs. The Commission attempts to dampen these costs,
generally, by considering good faith compliance with policies and
procedures reasonably designed to comply with the requirements of any
particular rule. The rules also supply guidance for complying with
these duties as a means for mitigating any uncertainty in regulatory
compliance.
To the extent that the disclosure rules contribute to execution
delays, for the duration of these delays, market participants will
either need to bear certain market risks or be prevented from taking on
those risks.\973\
---------------------------------------------------------------------------
\973\ See the discussions of price discovery above for a
description of the provisions designed to mitigate these delays.
---------------------------------------------------------------------------
The fair dealing rule does not undermine sound risk management
practices for swap dealers or major swap participants and has the
potential to enhance risk management practices for counterparties.
Counterparties will be able to manage their swap related risks based on
more complete and reliable information from swap dealers and major swap
participants. Swap dealers and major swap participants will be
incentivized to implement policies and procedures reasonably designed
to ensure that they make fair and balanced communications that provide
their counterparties with a sound basis for evaluating the facts with
respect to any swap. Similar to the discussion of the cost-benefit
considerations of the anti-fraud rules, such practices will reduce
counterparties' risk that they may otherwise enter into a swap that is
inconsistent with their trading objectives based on unbalanced or
misleading communications.
v. Other Public Interest Considerations
The disclosure rules are designed to address historical information
asymmetry between counterparties and swap dealers or major swap
participants and should enable counterparties to better protect their
own interests before assuming the risk of any particular swap
transaction. In addition, requiring both the disclosure of material
information and fair dealing will enhance transparency and promote
counterparty confidence in the previously unregulated swap market,
which better enables counterparties to use swaps to assume and manage
risk.
5. Section 23.410--Prohibition on Fraud, Manipulation and Other Abusive
Practices
a. Benefits
Final Sec. 23.410 prohibits fraud, manipulation and other abusive
practices and is applicable to swap dealers and major swap
participants. Section 23.410(a) mirrors the language of Section
4s(h)(4)(a) of the CEA. Section 23.410(b) provides an affirmative
defense for swap dealers and major swap participants to alleged non-
scienter violations of Sec. 23.410(a)(2) and (3). Final Sec.
23.410(c) prohibits swap dealers and major swap participants from
disclosing confidential counterparty information or using such
confidential information in a manner that would tend to be adverse to
the counterparty.
The rule primarily benefits counterparties, including Special
Entities, in that it prohibits fraudulent, deceptive and manipulative
practices by swap dealers and major swap participants and misuse of
confidential information to the detriment of the counterparty. While
not readily amenable to quantification, the benefits of the rule are
significant. The rule is designed to mitigate the potentially
considerable costs associated with a counterparty entering into a swap
having been induced by fraudulent, deceptive or manipulative conduct.
The rule also reduces the possibility that counterparties will be
disadvantaged by manipulative conduct or misuse of confidential
information by, among other things, improper disclosure of the
counterparty's trading positions, intentions to trade or financial
status.\974\ In these ways, the rule is an integral component of the
business conduct standards, which are, in large part, designed to
ensure that counterparties and swap dealers are on equal footing with
respect to understanding the risks and rewards of a particular swap or
trading strategy.
---------------------------------------------------------------------------
\974\ The protections in final Sec. 23.410 also address
historical imbalances in negotiating power between swap dealers and
counterparties related to sophistication and financial wherewithal.
The treatment of confidential counterparty information by swap
dealers depended on the relative ability of the parties to negotiate
terms in their interest.
---------------------------------------------------------------------------
The rule also enhances the authority of the Commission to ensure
fair and equitable markets. Market participants and the public will
benefit substantially from such enhanced prevention and deterrence of
fraud and manipulation. Rules protecting the confidential treatment of
counterparty information and prohibiting fraud and manipulation
encourage market participation, with the ensuing positive implications
such participation has on market efficiency and price discovery.
b. Costs
The Commission does not believe that there will be significant
costs in connection with final Sec. 23.410. First, Sec. 23.410(a)
merely codifies Section 4s(h)(4)(A) of the CEA.\975\ To the extent
there were any costs to be considered, Congress made that determination
in promulgating Section 4s(h)(4)(A). Further, final Sec. 23.410(b) has
added an affirmative defense, which mitigates any costs that may have
been imposed by the application of non-scienter fraud provisions in
final Sec. Sec. 23.410(a)(2) and (3) to swap dealers and major swap
participants. The Commission believes that swap dealers and major swap
participants already have in place policies and procedures, and provide
training to ensure that their traders and staff do not engage in fraud
and manipulation. To the extent there are any costs with respect to
final Sec. 23.410(a), such costs will be related to training staff and
ensuring that existing compliance procedures are up-to-date. In
addition, such policies and procedures are already accounted for by
virtue of the Commission's
[[Page 9815]]
promulgation of final Sec. Sec. 180.1 and 180.2, which similarly
prohibit manipulative or deceptive conduct, as well as the other
applicable anti-fraud and manipulation prohibitions in the CEA.
---------------------------------------------------------------------------
\975\ See Section 731 of Dodd-Frank Act.
---------------------------------------------------------------------------
To the extent there are costs with respect to the protection of
confidential counterparty information, the primary costs of this rule
are associated with implementing policies and procedures designed to
protect such information. The design of the final rule, and the
Commission guidance in this adopting release, address concerns by
commenters that the proposed confidential treatment and trading ahead
provisions would have unduly affected the ability of swap dealers and
major swap participants to enter into transactions with other
counterparties or manage their own risks. The Commission believes that
the actual costs to swap dealers and major swap participants will be
insubstantial and have been mitigated by the final rules.
First, as stated above, swap dealers and major swap participants
subject to final Sec. 23.410(a) are already subject to Section
4s(h)(4)(A) of the CEA, which was added by the Dodd-Frank Act. In
addition, as stated above, the Commission believes that swap dealers
and major swap participants already have policies and procedures and a
compliance regime in place to prevent fraud and manipulation by traders
and staff. Further, swap dealers and major swap participants have long
been subject to either self-imposed internal business conduct rules or
to contractual requirements of confidentiality contained in negotiated
swap agreements for individual swaps or in counterparty relationship
documentation with counterparties.\976\
---------------------------------------------------------------------------
\976\ See SIFMA/ISDA Feb. 17 Letter, at 11.
---------------------------------------------------------------------------
The Commission understands that there will be incremental costs
associated with adapting existing policies and procedures to the new
rules, but believes that these costs would be materially the same
regardless of the rules' substance. Final Sec. 23.410(a) imposes no
affirmative duties, and it is unlikely that it will impose any
additional costs beyond the existing costs associated with ensuring
that behavior and statements are not fraudulent, deceptive or
manipulative.\977\ In this regard, the Commission believes it will not
be necessary for firms that currently have adequate compliance programs
to hire additional staff or significantly upgrade their systems to
comply with the new rules, although firms may incur some compliance
costs such as the cost associated with training traders and staff about
the new rules.
---------------------------------------------------------------------------
\977\ See Prohibition on Manipulative and Deceptive Devices, 76
FR at 41408-41409, for a discussion of the costs and benefits of
final Sec. Sec. 180.1 and 180.2.
---------------------------------------------------------------------------
Finally, in response to comments regarding proposed Sec.
23.410(a), the Commission elected to revise the proposed rule by adding
a cost-mitigating section. Final Sec. 23.410(b) provides that a swap
dealer or major swap participant may establish an affirmative defense
against allegations of violations of final Sec. 23.410(a)(2) and (3)
by demonstrating that it did not act intentionally or recklessly and
complied in good faith with written policies and procedures reasonably
designed to meet the particular requirement that is the basis for the
alleged violation. With respect to the confidential treatment of
counterparty information, the Commission provided that such
confidential information may be disclosed or used for effective
execution of the swap with the counterparty, to hedge or mitigate
exposure created by the swap, or to comply with requests from
regulators or as required by law, or as agreed by the counterparty. In
these and other ways, the Commission believes that it has taken
appropriate steps to minimize the risks and costs of compliance and any
ancillary costs associated with final Sec. 23.410 (e.g., vexatious
litigation by a counterparty experiencing buyer's remorse).
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of final Sec. 23.410 pursuant to the five considerations
identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
The purpose of final Sec. 23.410 is to protect market participants
and the public by prohibiting fraud, manipulation and other abusive
practices. Final Sec. 23.410(a) codifies Section 4s(h)(4)(A) of the
CEA and appropriately extends the protections intended under the Dodd-
Frank Act. Final Sec. 23.410(c) provides protection for counterparties
by prohibiting disclosure and misuse of their confidential information.
As such, Sec. 23.410(c), although discretionary, is a central element
in the business conduct standards regime that Congress mandated the
Commission implement by imposing standards on swap dealers and major
swap participants in their dealings with counterparties. The rule is
also guided by Section 3(b) of the CEA, which explicitly includes among
the purposes of the CEA ``* * * to protect all market participants from
fraudulent or other abusive sales practices * * *.'' In addition, the
rule implements the discretionary authority provided by Congress in
Section 4s(h)(1)(A) of the CEA, which authorizes the Commission to
prescribe rules that relate to ``fraud, manipulation, and other abusive
practices involving swaps (including swaps that are offered but not
entered into * * *).'' As provided by Sections 3 and 4s(h)(1)(A) of the
CEA, the rule protects market participants, generally, and Special
Entities, particularly (which, when victims of fraud, manipulation or
abuse, can have significant negative implications for taxpayers,
pensioners and charitable institutions).
In addition, the requirements that dealers disclose counterparty
information only on a ``need to know'' basis and establish policies and
procedures to protect confidential counterparty information, together
with the other important requirements set forth in this rulemaking,
ameliorate the risks associated with disclosure of confidential
information to a swap dealer or major swap participant. The above-
acknowledged diligence costs do not diminish these benefits.
ii. Efficiency, Competitiveness and Financial Integrity
While final Sec. 23.410 is aimed at protecting counterparties,
there are ancillary benefits for markets. Markets that are free of
fraud, manipulation and other abusive practices encourage
participation, which adds to liquidity, efficiency and competitiveness.
The final rule enhances these benefits by appropriately restricting
abusive conduct by swap dealers and major swap participants. In
addition, protections against fraud, manipulation and misuse of
counterparty information promote the financial integrity of
counterparties by reducing the likelihood of (1) their being victims of
fraud (and needing to bear the costs associated with such fraud) or
manipulation in the value of their positions, and (2) their
confidential information being used in ways that are adverse to their
investment objectives. These protections look to reduce the level of
risk to which counterparties are exposed when conducting business in
the swaps markets.
iii. Price Discovery
As stated in the previous section, while final Sec. 23.410 is
aimed at protecting counterparties from abusive conduct by swap dealers
and major swap participants, there are ancillary
[[Page 9816]]
benefits for markets. These benefits are key to providing ``a means for
managing and assuming price risks, discovering prices, or disseminating
pricing information through trading in liquid, fair and financially
secure trading facilities.'' \978\ Indeed, it is an explicit purpose of
the CEA ``to deter and prevent price manipulation or any other
disruptions to market integrity.'' \979\ The final rule appropriately
restricts abusive conduct by swap dealers and major swap participants
without unduly chilling legitimate trading that could undermine the
price discovery function of the market.
---------------------------------------------------------------------------
\978\ Section 3(a) of the CEA (7 U.S.C. 5(a)).
\979\ Section 3(b) of the CEA (7 U.S.C. 5(b)).
---------------------------------------------------------------------------
iv. Sound Risk Management Practices
Final Sec. 23.410 supports sound risk management practices for
swap dealers and major swap participants by incentivizing them to
expand their policies and procedures to avoid misuse of confidential
counterparty information. This will reduce the risks faced by
counterparties that their proprietary information will be
misappropriated, while concomitantly mitigating litigation risks for
swap dealers and major swap participants. The above-acknowledged
diligence costs do not diminish these benefits.
v. Other Public Interest Considerations
Final Sec. 23.410 is consistent with prohibitions against
fraudulent and manipulative practices in other market sectors,
including futures, securities and banking. It is also consistent with
market abuse prohibitions that are generally in effect in foreign
markets. Harmonization reduces compliance costs and enhances
protections for market participants whose trading strategies cross
market sectors and international borders.
6. Section 23.430--Verification of Counterparty Eligibility
a. Benefits
Final Sec. 23.430--Verification of counterparty eligibility, is a
due diligence business conduct requirement for swap dealers and major
swap participants that is mandated by Section 4s(h) of the CEA. The
final rule implements congressional intent that only ECPs have access
to swaps that are traded bilaterally or on a SEF (where the swap dealer
or major swap participant knows the identity of the counterparty). The
final rule also ensures that swap dealers and major swap participants
determine prior to offering to enter into or entering into a swap
whether its counterparty is a Special Entity, which would trigger
additional protections under Sections 4s(h) and subpart H of part
23.\980\ To avoid interfering with the efficient execution of
transactions, the rule provides a safe harbor that allows swap dealers
and major swap participants to rely on counterparty representations,
which can be contained in counterparty relationship documentation. The
rule specifies the content of the written representations on which the
swap dealer or major swap participant can reasonably rely.
---------------------------------------------------------------------------
\980\ See Section 4s(h)(4) and (5) of the CEA and Sec. Sec.
23.440 and 23.450.
---------------------------------------------------------------------------
While not readily amenable to quantification, the benefits of the
verification rule are material. The principal benefit is the
implementation of congressional intent that certain swaps be available
only to ECPs and that retail customers be limited to swaps trading only
on a DCM. The rule also fosters compliance with the Special Entity
rules by verifying Special Entity status early in the relationship
between the swap dealer or major swap participant and the Special
Entity counterparty. Swap dealers and major swap participants benefit
from the rule to the extent that verification of eligibility will
assist them in avoiding non-ECP counterparties that would seek to avoid
liability for unprofitable swaps based on ineligibility. The
requirement to verify the Special Entity status of a counterparty is
implicit in the provisions that afford heightened protections for
Special Entities.\981\
---------------------------------------------------------------------------
\981\ Id.
---------------------------------------------------------------------------
b. Costs
As discussed above, Congress required the Commission to implement a
counterparty eligibility verification rule. The Commission is not
required to consider the costs and benefits of Congress' mandate;
rather Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its regulatory actions. In this case, the primary
costs of final Sec. 23.430 are associated with obtaining information
necessary to verify that a counterparty is an ECP, and where relevant a
Special Entity or counterparty able to elect Special Entity protections
as provided in Sec. 23.401(c)(6), and maintaining records regarding
the verification. The Commission believes that its implementing
regulation mitigates these costs by closely adhering to the existing
industry best practices, which provide that professional
intermediaries, prior to entering into any transaction, evaluate
counterparty legal capacity, transactional authority and credit. In
addition, the Commission's regulation is similar to swap counterparty
restrictions under the Commodity Futures Modernization Act amendments
to the CEA.\982\ Given existing OTC derivatives market practice and
historical restrictions on market access, the Commission expects the
cost of complying with final Sec. 23.430 will be insignificant. In
addition, the final rule specifically allows swap dealers and major
swap participants to rely on written representations by the
counterparty to satisfy the verification rule for both ECP and Special
Entity status and such representations can be made in counterparty
relationship documentation. The rule also specifies the content of
representations that would provide a reasonable basis for reliance, and
the Commission confirmed that a change in a counterparty's ECP status
during the term of a swap will not affect the enforceability of the
swap. Based on the foregoing, the Commission believes that it has taken
meaningful and appropriate steps to minimize the risks and costs of
compliance with Congress' directive to implement a counterparty
eligibility verification rule as mandated in Section 4s(h) of the CEA.
---------------------------------------------------------------------------
\982\ See Sections 2(g) and 2(h) of the CEA prior to the Dodd-
Frank Act amendments.
---------------------------------------------------------------------------
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of final Sec. 23.430 pursuant to the five considerations
identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
Congress has determined that swap market participation, except on a
DCM, should be limited to ECPs, and final Sec. 23.430 furthers that
determination by establishing a procedure for restricting access by
unqualified persons. In this way, the rule provides protection for
market participants and the public by limiting access to qualified
persons. The due diligence costs associated with this rulemaking are
incremental and do not diminish the benefits.
ii. Efficiency, Competitiveness and Financial Integrity
The final verification rule mitigates negative effects on
efficiency, competitiveness and financial integrity by addressing costs
associated with execution delays. In addition, the financial integrity
of the market may be enhanced by requiring due diligence by swap
dealers and major swap participants to restrict participation by non-
ECPs that generally have limited
[[Page 9817]]
ability to evaluate and assume the risk of complex bilateral swaps.
iii. Price Discovery
By virtue of the compliance mechanisms built into the rule, the
Commission believes that it will not unduly interfere with the price
discovery function of the market that could result from execution
delays. Section 4s(h) limits market participation to ECPs, which could
negatively affect liquidity and price discovery, but the final rule
does not exacerbate such potential consequences by limiting market
access. Indeed, by ensuring that only ECPs (the CEA proxy for
sophistication and financial wherewithal) can participate, other ECPs
may be encouraged to participate, thereby enhancing liquidity and price
discovery.
iv. Sound Risk Management Practices
The final rule addresses counterparty risk, which is one of the
primary risks in the swaps market. As indicated above, the final rule
codifies OTC derivatives industry best practice by requiring swap
dealers and major swap participants to verify that the potential
counterparty is an ECP and, where relevant, a Special Entity. This
verification supplements the industry best practice requirement
advising that, prior to trading, market professionals should check a
counterparty's legal capacity, transactional authority and credit.
Therefore, the rule complements existing market practice and sound risk
management practices.
v. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations.
7. Section 23.440--Requirements for Swap Dealers Acting as Advisors to
Special Entities; Section 23.450--Requirements for Swap Dealers and
Major Swap Participants Acting as Counterparties to Special Entities;
and Section 23.451--Political Contributions by Certain Swap Dealers
a. Benefits
Final Sec. Sec. 23.401(c), 23.440, 23.450 and 23.451 (the
``Special Entity rules'') provide heightened protections to a
particular class of swap market participant when dealing with swap
dealers and major swap participants. Special Entities play an important
public interest role by virtue of their responsibility for managing
taxpayer funds, the assets of public and private employee pension plans
and endowments of charitable institutions. The Special Entity rules
implement the congressional mandate to establish a higher standard of
care for swap dealers that act as advisors to Special Entities and to
ensure that Special Entities are represented by knowledgeable,
independent advisors when dealing with swap dealers and major swap
participants.
The Special Entity rules also prohibit swap dealers from entering
into swaps with a governmental Special Entity \983\ if the swap dealer
makes certain political contributions to officials of that governmental
Special Entity to prevent what is known as ``pay-to-play.'' The
Commission believes that the pay-to-play rule in Sec. 23.451 is a
necessary and appropriate prohibition to prevent swap dealers and
others from engaging in fraudulent practices. Given the competitive
nature of the swaps market, the incentives to engage in pay-to-play may
be significant. The rule also harmonizes with existing pay-to-play
restrictions applicable to certain swap dealers who are also subject to
pay-to-play rules in the securities sector to promote regulatory
consistency across related market sectors.
---------------------------------------------------------------------------
\983\ Final Sec. 23.451(a)(3) defines ``governmental Special
Entity'' as State and municipal Special Entities defined in Sec.
23.402(c)(2) and governmental plans as defined in Sec.
23.402(c)(4); see also Section IV.D. of this adopting release at fn.
904.
---------------------------------------------------------------------------
The Special Entity rules provide substantial benefits to Special
Entities and the general public. Swaps may have complex terms or employ
leverage that can expose counterparties to significant financial risks,
and unanticipated losses from a swap transaction can be financially
devastating. Because financial losses in connection with a swap depend
on the facts and circumstances regarding the particular swap and the
particular Special Entity, the costs of such losses are not reliably
quantifiable and, therefore, the benefits of preventing such losses are
also not reliably quantifiable.
Although the costs of the Special Entity rules are not readily
quantifiable, the benefits to Special Entities are significant.
Ensuring that Special Entities are represented by independent advisors
that have sufficient knowledge to evaluate the transaction and risks of
a swap is a vitally important protection for Special Entities.
Independent and knowledgeable advice will benefit Special Entities, and
those whose interests they represent, by creating a more level playing
field when negotiating with swap dealers and major swap participants.
Final Sec. 23.450 mitigates the likelihood that a Special Entity will
assume risks and any consequent losses based on (1) inadequate advice
due to a lack of understanding of the risks, or (2) biased advice that
is not in the best interests of the Special Entity.
Final Sec. 23.440 benefits Special Entities by restricting swap
dealers from providing advice that is not in the Special Entity's best
interests. A swap dealer that markets a swap to counterparties has an
inherent conflict of interest, but is often in the best position to
know the risks and characteristics of a complex swap, and the
incentives for a swap dealer to provide conflicted advice that is not
in the best interests of the Special Entity are substantial. The
Commission believes that Sec. 23.440 will provide important
protections to make sure that a swap dealer's communications that are
the most susceptible to being misleading or abusive are subject to the
statutory ``best interests'' standard.
Commenters were in general agreement that pay-to-play is a serious
issue that should be addressed by the Commission. As discussed in this
adopting release, the Commission expects that final Sec. 23.451 will
yield several important, if unquantifiable, benefits. Overall, the rule
is intended to address pay-to-play relationships that interfere with
the legitimate process by which a governmental Special Entity decides
to enter into swaps with a particular swap dealer. Such a process
should be determined on the merits rather than on contributions to
political officials. The potential for fraud to invade the various,
intertwined relationships created by pay-to-play arrangements has been
documented in notorious cases of abuse. The Commission believes that
the prohibition will reduce the occurrence of fraudulent conduct
resulting from pay-to-play and, as a result, will achieve its goals of
protecting market participants and the public from the resulting harms.
By addressing pay-to-play practices, Sec. 23.451 helps to ensure
that governmental Special Entities consider the merits of any
particular transaction with a swap dealer and not the size of a swap
dealer's political contributions. These benefits, although difficult to
quantify, could result in substantial savings to government
institutions, public pension plans and their beneficiaries, resulting
in better performance for taxpayers. Efficiencies are enhanced when
government counterparties competitively award business based on price,
performance and service and not the influence of pay-to-play, which in
turn enables firms to compete on merit, rather than their
[[Page 9818]]
ability or willingness to make contributions.\984\
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\984\ In addition to Sec. 23.451, which prohibits swap dealers
from engaging in pay-to-play practices with governmental Special
Entities, Sec. 23.450(b)(1)(vii) similarly requires a swap dealer
or major swap participant to have a reasonable basis to believe that
a governmental Special Entity's representative (other than an
employee) is subject to pay-to-play prohibitions imposed by the
Commission, SEC or an SRO subject to the jurisdiction of the
Commission or the SEC. The Commission believes that Sec.
23.450(b)(1)(vii) will create substantially similar benefits to
those described regarding Sec. 23.451. Therefore, the Commission
believes governmental Special Entities and their beneficiaries will
benefit from advisers that are selected based on the quality of
their advisory services and not the size of their political
contributions. See Section IV.C.3.d.viii. of this adopting release
for a discussion of final Sec. 23.450(b)(1)(vii).
---------------------------------------------------------------------------
Finally, the Special Entity rules protect U.S. taxpayers, the
retirement savings of U.S. private and public employees and pensioners,
and beneficiaries of charitable endowments (``Special Entity
beneficiaries''). Losses to a company that assumes significant risk
through swaps are typically limited to its investors and creditors.
However, Special Entities that assume risk through the use of swaps
also expose Special Entity beneficiaries to such risks. When a Special
Entity suffers losses in connection with a swap, the Special Entity
beneficiaries ultimately bear such losses. Certain swaps can create
significant risk exposure that may result in substantial losses. And in
the wake of the 2008 financial crisis, significant or even catastrophic
losses have been proven not to be merely theoretical. In the case of
Special Entities, such losses could result in taxpayer bailouts of
public institutions or devastating losses to vulnerable members of the
public including pensioners and beneficiaries of charitable endowments.
Additionally, taxpayers and public employees and pensioners may benefit
from Sec. 23.451 because they might otherwise bear the financial
burden of bailing out a public institution or governmental pension plan
that has ended up with a shortfall due to poor performance or excessive
fees that might result from pay-to-play. Therefore, the Special Entity
rules provide significant protections for Special Entity beneficiaries
and the public at large by ensuring that Special Entities have
independent and knowledgeable representatives, are afforded a higher
standard of care from swap dealers that act as advisors and, in the
case of governmental Special Entities, are not unduly influenced by
political contributors. The Commission has considered a number of
regulatory alternatives proposed by commenters and has revised some of
the proposed rules in response to commenters' suggestions.\985\
---------------------------------------------------------------------------
\985\ See, e.g., Section IV.B.3.b. and d. of this adopting
release for a discussion of commenters' alternative approaches to
Sec. 23.440 and Section IV.C.3 of this adopting release for a
discussion of alternative approaches to Sec. 23.450.
---------------------------------------------------------------------------
b. Costs
As identified by commenters,\986\ the proposed Special Entity rules
had the potential to impose costs including: (1) Reduced access to swap
markets for Special Entities if swap dealers and major swap
participants decline to act as their counterparties, (2) limited flow
of information from swap dealers to Special Entities, (3) litigation
risk for swap dealers and major swap participants, (4) compliance
obligations on swap dealers and major swap participants, (5) and delays
in swap execution.\987\ As discussed in the introduction to this
Section IV.C. of this adopting release, such costs are difficult and
costly to quantify and, in some cases, are not subject to reliable
quantification. Additionally, some commenters asserted that conflicting
federal regulatory regimes could impose costs, such as penalties for
violating ERISA's prohibited transaction provisions.\988\ Any penalty
for violation of another federal law in connection with a swap will
depend on the facts and circumstances regarding the particular swap and
the particular Special Entity; therefore, the costs of such penalties
are not reliably quantifiable.
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\986\ The Commission requested comment on the costs and benefits
of the proposed Special Entity rules and invited commenters to
provide data or other information to support their views on the
proposal's costs and benefits. The Commission received general
comments on costs and benefits but no verifiable data. See proposing
release, 75 FR at 80657.
\987\ See, e.g., Section IV.C.2.g. of this adopting release for
a summary of comments regarding transaction costs and risks related
to the Special Entity rules.
\988\ See Section II of this adopting release for a discussion
of regulatory intersections with the Commission's business conduct
standards rules.
---------------------------------------------------------------------------
One commenter provided an example to quantify potential costs to
the sponsor of a fully-funded ERISA plan that could not hedge its
interest rate risk in the swap markets.\989\ The commenter stated that
an ERISA plan with $15 billion in assets and liabilities ``whose
interest rate sensitivity is somewhat higher than average,'' would be
exposed to a 13% increase in liabilities with a 1% decrease in interest
rates.\990\ According to the commenter, the 1% decrease in interest
rates would result in a $1.46 billion shortfall in plan assets to
liabilities, amortized over seven years, and the ERISA plan sponsor
would owe approximately $248 million in annual contributions to cover
the shortfall.\991\ The commenter's example, however, illustrates that
the costs to a Special Entity that cannot access the swap markets will
depend on the particular facts and circumstances of the particular
Special Entity. Therefore, quantification of such costs to Special
Entities as a class is not feasible.
---------------------------------------------------------------------------
\989\ ABC/CIEBA Feb. 22 Letter, at 4.
\990\ Id.
\991\ Id.
---------------------------------------------------------------------------
The heightened standard of care for swap dealers that act as
advisors to Special Entities, which Sec. 23.440 implements, may, to a
degree, reduce the level of information swap dealers are willing to
share with Special Entities regarding swaps products and strategies out
of a concern over triggering advisory status and the best interests
duty attached to that status. Final Sec. 23.440 attempts to mitigate
these costs by providing safe harbors that effectively exclude from the
swap dealer's best interests duty (1) communications between swap
dealers and ERISA plans and (2) communications to a Special Entity
where the swap dealer does not express an opinion as to whether the
Special Entity should enter into a recommended swap or swap trading
strategy that is tailored to the particular needs or characteristics of
the Special Entity.
The safe harbor for a swap dealer dealing with any Special Entity
in Sec. 23.440(b)(2) preserves the ability of the swap dealer to
communicate a wide range of information about swaps, including
communications where a swap dealer provides trading ideas for swaps or
swap trading strategies that are tailored to the needs or
characteristics of a Special Entity, without being subject to the best
interests duty. Moreover, to provide additional clarity on the types of
communications that would not cause a swap dealer to ``act as an
advisor,'' the Commission offers in Appendix A to subpart H a non-
exclusive list of communications not subject to the best interests duty
as guidance for swap dealers that elect to operate within the safe
harbor. Additionally, the types of communications and information not
subject to the best interests duty under the safe harbor in Sec.
23.440(b)(2) are the types information that many commenters found to be
most valuable.\992\ The types of communications and information
included in the scope of the safe harbor also facilitates swap dealers'
ability to engage in normal course of business
[[Page 9819]]
communications, including sales, marketing and trading ideas, with
Special Entities without being subject to the best interests duty and
potential litigation risks attendant to such a duty.
---------------------------------------------------------------------------
\992\ See Section IV.B.2.a. of this adopting release at fn. 624
and accompanying text.
---------------------------------------------------------------------------
Final Sec. 23.450 also establishes a safe harbor for a swap dealer
or major swap participant to satisfy its duty to have a reasonable
basis to believe that a Special Entity has a qualified independent
representative. The safe harbor under Sec. 23.450(d)(2) harmonizes the
independent representative requirements for ERISA plans. A swap dealer
or major swap participant will have a reasonable basis to believe that
an ERISA plan has a qualified independent representative whenever the
ERISA plan represents in writing that it has an ERISA fiduciary. This
safe harbor alleviates concerns raised by some commenters that
compliance with the proposed rule could cause a swap dealer or major
swap participant to become an ERISA fiduciary that would impose costs,
including private litigation liabilities, costs associated with
violations of ERISA's prohibited transaction rules or costs to ERISA
plans that may be unable to find swap dealers or major swap
participants willing to enter into swaps with them.
With respect to all Special Entities other than ERISA plans, the
safe harbor under Sec. 23.450(d)(1) permits a swap dealer or major
swap participant to rely on written representations from the Special
Entity and its representative that each, respectively, has complied in
good faith with written policies and procedures reasonably designed to
ensure that the representative satisfies the applicable requirements in
Section 4s(h)(5) and Sec. 23.450. Additionally, the Commission revised
Sec. 23.450 to address commenters' concerns regarding the proposed
``material business relationship'' prong of the independence test.\993\
---------------------------------------------------------------------------
\993\ See Section IV.C.3.d.iv. of this adopting release for a
discussion of the final independence standard in Sec. 23.450.
---------------------------------------------------------------------------
Many commenters expressed concern that the proposed independence
test would create costly and burdensome compliance requirements and
that the proposed material relationship prong was duplicative of or not
harmonized with other independence standards.\994\ The revised
independence test mitigates commenters' concerns that the ``material
business relationship'' was unadministrable by deleting the requirement
to identify and disclose all compensation that a swap dealer or major
swap participant paid to the Special Entity's representative within the
previous 12 months.\995\ The revised standard under which a
representative will be deemed independent replaced the ``material
business relationship'' prong with three requirements: (1) The
representative discloses material conflicts of interest to the Special
Entity and complies with policies and procedures designed to manage and
mitigate such conflicts; (2) the representative is not controlled by,
in control of or under common control with the swap dealer or major
swap participant; and (3) the swap dealer or major swap participant did
not refer, recommend or introduce the representative to the Special
Entity. Any costs that arise due to a representative disclosing,
managing and mitigating conflicts of interest will be incremental
because third-party advisors, generally, will be regulated entities
such as CTAs, investment advisers or municipal advisors, and will be
subject to similar requirements. In addition, representatives that are
in-house employees will likely be subject to conflict of interest
restrictions by virtue of their employment agreement.
---------------------------------------------------------------------------
\994\ See Section IV.C.2.c.ii. of this adopting release for a
summary of comments regarding the independence tests under proposed
Sec. 23.450 at fn. 779.
\995\ See proposing release, 75 FR at 80660.
---------------------------------------------------------------------------
The safe harbor under Sec. 23.450(d) reduces litigation risk
concerns raised by some commenters asserting that a swap dealer or
major swap participant may be held liable to a Special Entity for
``approving'' an unqualified representative or may be liable to a
representative that was found to be unqualified.\996\ Under the safe
harbor, a swap dealer or major swap participant may rely on written
representations that the representative is qualified thereby relieving
the swap dealer or major swap participant of engaging in extensive due
diligence to make its own determination.
---------------------------------------------------------------------------
\996\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; HOOPP Feb.
22 Letter, at 2; ABC Aug. 29 Letter, at 7.
---------------------------------------------------------------------------
Special Entities may incur additional costs to retain the services
of a representative and to develop policies and procedures to ensure
that the representative is qualified and independent. The Commission
believes that any additional costs will be incremental and relatively
minimal because, according to commenters, many Special Entities already
employ in-house or third-party expert advisors.\997\ Furthermore, the
independent representative rules implement the statutory requirement
that Special Entities have qualified independent representatives.
Therefore, Congress made the determination that the additional costs
are justified by the benefits that such a protection provides to
Special Entities and Special Entity beneficiaries. However, the final
rules implement the statutory requirements in such a way as to minimize
any additional costs associated with the concerns expressed by
commenters.
---------------------------------------------------------------------------
\997\ See, e.g., ERIC Feb. 22 Letter, at 12; VRS Feb. 22 Letter,
at 2 and fn. 3; U. Tex. System Feb. 22 Letter, at 4.
---------------------------------------------------------------------------
To mitigate and reduce any due diligence costs imposed under
Sections 4s(h)(4) and (5), both Sec. Sec. 23.440 and 23.450 permit
reliance on representations to satisfy such due diligence obligations.
Furthermore, such representations may be made on a relationship basis
to reduce or eliminate execution delays that could otherwise result
from transaction-by-transaction compliance. Commission staff has also
extensively consulted with the SEC and DOL staffs to ensure that the
final rules are appropriately harmonized and so that compliance with
the Special Entity rules will not result in violation of other federal
laws.\998\
---------------------------------------------------------------------------
\998\ See Section II of this adopting release for a discussion
of regulatory intersections and harmonization with the SEC and DOL.
---------------------------------------------------------------------------
The Commission has clarified, in response to commenters, that the
definition of Special Entity under Sec. 23.402(c) does not include
collective investment vehicles in which a Special Entity invests.\999\
Some commenters asserted that adopting a look-through test for the
Special Entity definition would create unnecessary and duplicative
compliance costs and execution delays for collective investment
vehicles and their investors.\1000\ This adopting release clarifies
that the Commission will not look-through a collective investment
vehicle to its investors to determine whether an entity is a Special
Entity and thereby eliminates these cost concerns.
---------------------------------------------------------------------------
\999\ See Section IV.A.3.e. of this adopting release for a
discussion of the Commission's determination regarding collective
investment vehicles and the definition of Special Entity.
\1000\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13.
---------------------------------------------------------------------------
The pay-to-play prohibition in Sec. 23.451 is designed to prevent
fraud. A prohibition on fraud should not, in the Commission's judgment,
impose significant costs. Nevertheless, the Commission is cognizant
that its pay-to-pay prohibition will involve some compliance costs. At
the same time, such costs are expected to be incremental and minimal
because the Commission anticipates that many of the persons subject to
Sec. 23.451 will already be subject to similar prohibitions imposed by
the MSRB or
[[Page 9820]]
SEC.\1001\ In an effort to mitigate these costs, the Commission has
adopted a practical, cost-effective means to comply with the rule
without requiring a swap dealer to impose a blanket ban on all
political contributions by its covered associates. Further, based on
comments received, the Commission modified its proposed rule to achieve
the goal of discouraging swap dealer participation in pay-to-play
practices while seeking to limit the burdens imposed by the rule. In
this regard, the Commission highlights its efforts to harmonize its
rule with the prohibition proposed by the SEC,\1002\ the exceptions for
certain de minimis contributions, automatic exemptions and safe
harbors.\1003\
---------------------------------------------------------------------------
\1001\ The Commission also believes that Sec. 23.450(b)(1)(vii)
may impose similar costs, including compliance costs. See supra fn.
984for a discussion of Sec. 23.450(b)(1)(vii)'s benefits. However,
the Commission also believes that the cost mitigating features of
Sec. 23.450 and the incremental nature of the requirements also
limit any burdens or costs imposed by the rule. The costs are
incremental because some independent representatives to governmental
Special Entities may be SEC-registered investment advisers subject
to SEC Advisers Act Rule 206(4)-5 on pay-to-play or registered
municipal advisors subject to the MSRB's pay-to-play prohibitions.
See Section II.C. of this adopting release for a discussion of
Special Entity representatives that are also municipal advisors; see
also supra fn. 880 and accompanying text.
\1002\ See proposed 17 CFR 240.15Fh-6, SEC's proposed rules, 76
FR at 42457-58.
\1003\ See Section IV.D.3. of this adopting release for a
discussion of the pay-to-play prohibitions under final Sec. 23.451.
---------------------------------------------------------------------------
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of the final Special Entity rules pursuant to the five
considerations identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
At the core of the Special Entity rules is the protection of a
specific class of market participants that are central to the public
interest. Final Sec. 23.440 ensures that swap dealers that act as
advisors to Special Entities are subject to a best interests duty.
Conversely, where the swap dealer elects to operate within the safe
harbor, the rule facilitates open communications with Special Entities
to afford them the benefits of the swap dealer's access to valuable
swap related information.
Final Sec. 23.450 seeks to ensure that any Special Entity that
enters into swaps with swap dealers or major swap participants has a
sufficiently knowledgeable representative to evaluate the risks
inherent in the transaction and to provide unbiased, independent advice
that is in the best interests of the Special Entity. The pay-to-play
prohibition protects market participants and the public from fraud.
Government business allocated on the basis of political contributions
exposes the public to several hazards, including noncompetitive pricing
and unnecessary assumption of risk.
The Commission believes that the Special Entity rules protect the
public from, among other things, taxpayer bailouts and unnecessary
losses to U.S. retirement savings and charitable endowments. To the
extent the rules impose increased costs on swap dealers or major swap
participants that may be passed on to Special Entities or may serve as
an incentive for swap dealers or major swap participants to decline to
transact with Special Entities, the Commission believes it has provided
for reasonable and practicable means of compliance that mitigate any
such costs.
ii. Efficiency, Competitiveness and Financial Integrity of Futures
Markets
The Special Entity rules do impose costs that impact efficiency.
However, the rules have been designed to mitigate the impact. For
example, the rules allow for reliance on representations on a
relationship basis to mitigate due diligence costs or transaction-by-
transaction compliance that may delay execution. In addition, Congress
made the determination that Special Entities need additional
protections by enacting Section 4s(h), and the Commission has furthered
congressional intent by mitigating the attendant costs of such
protections without materially diminishing their benefits. Furthermore,
the public interest is served and markets function more efficiently
when swap dealers compete for governmental Special Entity business
based on price and the overall utility of the swap to the Special
Entity and not on the swap dealers' willingness to make political
contributions.
iii. Price Discovery
In the event that advisory status is triggered, compliance with the
best interests duty by the affected swap dealer may lead to execution
delays. The cumulative effect of these delays may, to a degree,
adversely impact liquidity resulting in higher transaction costs for
counterparties that trade swaps. In recognition of this potential
impact, the best interests duty is limited to certain recommendations
of swaps that are tailored to the particular needs or characteristics
of the Special Entity, and the swap dealer may rely on representations
from the Special Entity to satisfy the ``reasonable efforts'' duty for
determining whether a recommended swap or swap trading strategy is in
the best interests of that Special Entity.
Final rule Sec. 23.450 provides several means to mitigate the
costs of satisfying the ``reasonable basis'' requirement. First, if the
representative to an ERISA plan is an ERISA fiduciary, then the
reasonable basis is established. Second, certain representations made
by the Special Entity will be deemed to provide such a reasonable
basis, and these representations, where appropriate, are allowable at
the relationship level as opposed to the transaction level. Third, in
the absence of such representations, the Commission has provided a list
of factors as guidance for establishing this reasonable basis.\1004\
---------------------------------------------------------------------------
\1004\ See Section IV.C.3.d. of this adopting release for a
discussion of the factors used as guidance for the requirements of
Sec. 23.450(b).
---------------------------------------------------------------------------
iv. Sound Risk Management Practices
The Special Entity rules foster sound risk management practices by
ensuring that Special Entities have representatives and advisors that
are capable of evaluating the risks and rewards of swap transactions
and that they evaluate each transaction considering the best interests
of the Special Entity. The independent representative provisions,
coupled with the disclosure rules, provide important tools for Special
Entities to enhance their risk management practices to avoid
unnecessary and inappropriate risk.
Nevertheless, execution delays, to the extent that they may result
from the Special Entity rules, force market participants to either bear
certain market risks or be prevented from earning the premiums
associated with bearing those risks over the duration of the delay. The
design of the Special Entity rules permit reliance on representations
on a relationship basis to mitigate these delays.
Any uncertainty over the triggers for advisory status, through an
increase in the risk exposure of the swap dealer, may translate into
higher fees charged to counterparties as compensation for that
increased exposure. Guidance provided by the Commission clarifying the
instances and communications that are exempt from this status mitigates
this uncertainty.
v. Other Public Interest Considerations
The Special Entity rules promote public trust in swap markets by
striving to ensure that Special Entities are adequately represented and
treated
[[Page 9821]]
fairly. When a Special Entity incurs substantial losses due to
inadequate advice, biased advice or unfair access such as through pay-
to-play schemes, the public loses confidence in the markets.
Additionally, the pay-to-play prohibition fosters public confidence in
the integrity of the means and manner in which its elected officials
handle government finances.
8. Section 4.6--Exclusion for Certain Otherwise Regulated Persons From
the Definition of the Term ``Commodity Trading Advisor''
a. Benefits
Final Sec. 4.6(a)(3) is an exclusion from the definition of CTA
for swap dealers and, correspondingly, from the application of the CTA
registration requirement, any relevant duties under part 4 of the
Commission's Regulations and Section 4o of the CEA, the anti-fraud
provision for CTAs. The Commission believes the exclusion furthers the
regulatory approach that underlies the Dodd-Frank Act by facilitating
the flow of market-related information between swap dealers and
counterparties without undermining the robust protections provided by
the business conduct standards provisions. The exclusion benefits both
swap dealers and counterparties that claimed that their communications
could be chilled, and trading stifled, if swap dealers were deemed to
be CTAs and subject to a higher standard of care when providing
services that are ``solely incidental'' to their business as a swap
dealer. The exclusion clarifies the role of swap dealers and reduces
ambiguity in the trading relationship between swap dealers and
counterparties.
While not readily amenable to quantification, the benefits of the
rule are significant. The rule is designed to avoid the potential costs
associated with a swap dealer being deemed a CTA. In addition to CTA
registration fees for a swap dealer and its associated persons, CTAs
are generally held to a fiduciary standard under case law,\1005\ a
standard that was rejected by Congress for swap dealers when it adopted
Section 4s(h).\1006\ Therefore, excluding swap dealers from the
definition of CTA when engaging in certain swap dealing activities that
overlap with CTA activities is consistent with congressional intent.
---------------------------------------------------------------------------
\1005\ See, e.g., Savage v. CFTC, 548 F.2d 192 at 197.
\1006\ See Section IV.B.3.c. at fn. 706 and accompanying text
for a discussion of the legislative history of fiduciary duties for
swap dealers; see also Sections II.D. and IV.B. of this adopting
release for a discussion of Regulatory Intersections--Commodity
Trading Advisor Status for Swap Dealers and Sec. 23.440--Final
Rules for Swap Dealers and Major Swap Participants Dealing with
Special Entities--Requirements for Swap Dealers Acting as Advisors
to Special Entities, respectively.
---------------------------------------------------------------------------
Commenters raised concerns that if a swap dealer were deemed to be
a CTA then it would increase the potential that they also would be
deemed an ERISA fiduciary when dealing with ERISA plans. That would
subject the swap dealer to a principal transaction prohibition and to
substantial penalties under ERISA. Such risks could dissuade swap
dealers from engaging in swaps with pension plans that are subject to
ERISA.\1007\ Similar risks could potentially adversely affect other
counterparties that are regulated under similar state regulatory
regimes. These counterparties could face increased costs because swap
dealers could charge more to assume the higher duties, fewer swap
dealers would be willing to do business with them or swap dealers would
offer a narrower range of services.
---------------------------------------------------------------------------
\1007\ See Section II.B. of this adopting release for a
discussion of Regulatory Intersections--Department of Labor ERISA
Fiduciary Regulations.
---------------------------------------------------------------------------
The rule benefits counterparties by reducing burdens on
communications and broadening the range of services available from swap
dealers, as well as increasing the number of swap dealers with which a
Special Entity may enter into swaps. While not a quantifiable benefit,
a greater number of swap dealers should encourage competition and
reduce prices for counterparties. Having access to a wider range of
services will allow counterparties to more effectively hedge their
exposure to market risks and to take advantage of investment
opportunities using swaps.
b. Costs
As a result of final Sec. 4.6(a)(3) relieving a burden rather than
imposing one, the Commission does not believe that there are any costs
associated with the exclusion from the definition of CTA for swap
dealers whose advice is solely incidental to its swap dealing
activities. This is particularly true because the business conduct
standards viewed as a whole provide important protections for
counterparties that are not diminished by clarifying the status of swap
dealers that make recommendations to counterparties.
c. Section 15(a) of the CEA
In light of the foregoing, the Commission has evaluated the costs
and benefits of final Sec. 4.6(a)(3) pursuant to the five
considerations identified in Section 15(a) of the CEA as follows:
i. Protection of Market Participants and the Public
The objective of Sec. 4.6(a)(3) is to allow a freer flow of
information and ideas between a swap dealer and its counterparties,
albeit subject to the disclosure and due diligence requirements of
subpart H, among other provisions. Allowing swap dealers to provide
limited advice necessary to design bespoke instruments will benefit
market participants by offering them a broader range of products to
meet their particular hedging requirements and trading objectives. The
exclusion will reduce the potential for vexatious litigation by
providing certainty regarding the applicable standard of care to be
applied to these transactions.
The exclusion is consistent with the goal of protecting market
participants and the public when considered together with the business
conduct standards in Section 4s(h) and subpart H of part 23. The
exclusion does not diminish protections for market participants and the
public in those rules, but rather furthers the intent of Congress that
swap dealers not be held to a fiduciary standard.\1008\ Moreover, the
exclusion for swap dealers from the CTA definition does not apply to
all advisory activities, but only the swap dealer's advisory activities
that are solely incidental to its business as a swap dealer. As such,
the Commission has designed these rules to be as targeted as possible
to achieve the intended statutory benefits, namely to enable the flow
of accurate and timely information between swap dealers and their
counterparties, and to continue to allow the marketplace to develop and
provide opportunities for swap dealers and counterparties to transact.
However, swap dealers will be CTAs if they provide advisory services
beyond those that are solely incidental to their swap dealing
activities, thereby preserving counterparty protections afforded by the
rules that apply to CTAs.
---------------------------------------------------------------------------
\1008\ See Section II.D. of this adopting release for a
discussion of Regulatory Intersections--Commodity Trading Advisor
Status for Swap Dealers.
---------------------------------------------------------------------------
Accordingly, in the Commission's judgment, this rule alleviates a
burden, which reduces rather than imposes costs, in such a way that the
final rule will achieve the intended benefits of protecting market
participants and the public.
ii. Efficiency, Competitiveness and Financial Integrity of Futures
Markets
Because swap dealers may not be willing to perform certain
functions, like custom tailoring a swap to meet a
[[Page 9822]]
counterparty's needs if such activities would cause the swap dealer to
be deemed to be a CTA, excluding them from the CTA definition for
certain activities could broaden the range of services that a swap
dealer may offer a counterparty. It could also increase the number of
swap dealers that are willing to perform such functions. While not a
quantifiable benefit, a greater number of swap dealers and available
products should enhance efficiency and competition and reduce prices
for counterparties. Because the rule alleviates a burden, rather than
imposing costs, the Commission concludes that Sec. 4.6(a)(3) will not
impede swap market efficiency, competitiveness or financial integrity.
iii. Price Discovery
Relative to not applying this exclusion to swap dealers, the final
rule encourages more swap dealers to offer a wider range of products to
counterparties, which promotes competition and facilitates price
discovery. Accordingly, the exclusion does not adversely affect price
discovery and potentially enhances it.
iv. Sound Risk Management Practices
While not creating material incentives for swap dealers to alter
how they manage risk, the exclusion from the CTA definition will assist
swap dealers in reducing the level of risk associated with their
counterparty interactions. The exclusion clarifies the duties owed to
counterparties and reduces the potential for litigation. Because the
standard of care for swap dealers acting as CTAs is higher than the
standard of care when they act as counterparties in principal to
principal transactions, disagreements could arise based on
misunderstandings concerning the respective roles of the parties. By
acting within the scope of the exclusion in compliance with the final
rule, swap dealers will reduce the risk of undue reliance by
counterparties and any resulting litigation.
v. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations.
List of Subjects 17 CFR Part 4
Advertising, Brokers, Commodity futures, Commodity pool operators,
Commodity trading advisors, Customer protection, Reporting and
recordkeeping requirements, Swaps.
List of Subjects 17 CFR Part 23
Antitrust, Commodity futures, Business conduct standards, Conflict
of interests, Counterparties, Information, Major swap participants,
Registration, Reporting and recordkeeping, Special Entities, Swap
dealers, Swaps.
For the reasons presented above, the Commission hereby amends part
4 and part 23 (as added on January 19, 2012 (77 FR 2613), of Title 17
of the Code of Federal Regulations as follows:
PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS
0
1. The authority citation for part 4 shall be revised to read as
follows:
Authority: 7 U.S.C 1a, 2, 4, 6(c), 6b, 6c, 6l, 6m, 6n, 6o, 12a
and 23, as amended by the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).
0
2. In Sec. 4.6, add new paragraph (a)(3) to read as follows:
Sec. 4.6 Exclusion for certain otherwise regulated persons from the
definition of the term ``commodity trading advisor.''
(a) * * *
(3) A swap dealer registered with the Commission as such pursuant
to the Act or excluded or exempt from registration under the Act or the
Commission's regulations; Provided, however, That the commodity
interest and swap advisory activities of the swap dealer are solely
incidental to the conduct of its business as a swap dealer.
* * * * *
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
Authority and Issuance
0
3. The authority citation for part 23 shall be revised to read as
follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6c, 6p, 6s, 9, 9a, 12a,
13b, 13c, 16a, 18, 19, 21 as amended by Title VII of the Dodd-Frank
Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,
124 Stat. 1376 (Jul. 21, 2010).
0
4. Add subpart H to read as follows:
Subpart H--Business Conduct Standards for Swap Dealers and Major Swap
Participants Dealing With Counterparties, Including Special Entities
Sec.
23.400 Scope.
23.401 Definitions.
23.402 General provisions.
23.403-23.409 [Reserved]
23.410 Prohibition on fraud, manipulation and other abusive
practices.
23.411-23.429 [Reserved]
23.430 Verification of counterparty eligibility.
23.431 Disclosures of material information.
23.432 Clearing disclosures.
23.433 Communications--fair dealing.
23.434 Recommendations to counterparties--institutional suitability.
23.435-23.439 [Reserved]
23.440 Requirements for swap dealers acting as advisors to Special
Entities.
23.441-23.449 [Reserved]
23.450 Requirements for swap dealers and major swap participants
acting as counterparties to Special Entities.
23.451 Political contributions by certain swap dealers.
Appendix A--Guidance on the application of Sec. Sec. 23.434 and
23.440 for swap dealers that make recommendations to counterparties
or Special Entities
Subpart H--Business Conduct Standards for Swap Dealers and Major
Swap Participants Dealing With Counterparties, Including Special
Entities
Sec. 23.400 Scope.
The sections of this subpart shall apply to swap dealers and,
unless otherwise indicated, major swap participants. These rules are
not intended to limit or restrict the applicability of other provisions
of the Act and rules and regulations thereunder, or other applicable
laws, rules and regulations. The provisions of this subpart shall apply
in connection with transactions in swaps as well as in connection with
swaps that are offered but not entered into.
Sec. 23.401 Definitions.
(a) Counterparty. The term ``counterparty,'' as appropriate in this
subpart, includes any person who is a prospective counterparty to a
swap.
(b) Major swap participant. The term ``major swap participant''
means any person defined in Section 1a(33) of the Act and Sec. 1.3 of
this chapter and, as appropriate in this subpart, any person acting for
or on behalf of a major swap participant, including an associated
person defined in Section 1a(4) of the Act.
(c) Special Entity. The term ``Special Entity'' means:
(1) A Federal agency;
(2) A State, State agency, city, county, municipality, other
political subdivision of a State, or any instrumentality, department,
or a corporation of or established by a State or political subdivision
of a State;
(3) Any employee benefit plan subject to Title I of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002);
(4) Any governmental plan, as defined in Section 3 of the Employee
Retirement
[[Page 9823]]
Income Security Act of 1974 (29 U.S.C. 1002);
(5) Any endowment, including an endowment that is an organization
described in Section 501(c)(3) of the Internal Revenue Code of 1986 (26
U.S.C. 501(c)(3)); or
(6) Any employee benefit plan defined in Section 3 of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002), not otherwise
defined as a Special Entity, that elects to be a Special Entity by
notifying a swap dealer or major swap participant of its election prior
to entering into a swap with the particular swap dealer or major swap
participant.
(d) Swap dealer. The term ``swap dealer'' means any person defined
in Section 1a(49) of the Act and Sec. 1.3 of this chapter and, as
appropriate in this subpart, any person acting for or on behalf of a
swap dealer, including an associated person defined in Section 1a(4) of
the Act.
Sec. 23.402 General provisions.
(a) Policies and procedures to ensure compliance and prevent
evasion.
(1) Swap dealers and major swap participants shall have written
policies and procedures reasonably designed to:
(i) Ensure compliance with the requirements of this subpart; and
(ii) Prevent a swap dealer or major swap participant from evading
or participating in or facilitating an evasion of any provision of the
Act or any regulation promulgated thereunder.
(2) Swap dealers and major swap participants shall implement and
monitor compliance with such policies and procedures as part of their
supervision and risk management requirements specified in subpart J of
this part.
(b) Know your counterparty. Each swap dealer shall implement
policies and procedures reasonably designed to obtain and retain a
record of the essential facts concerning each counterparty whose
identity is known to the swap dealer prior to the execution of the
transaction that are necessary for conducting business with such
counterparty. For purposes of this section, the essential facts
concerning a counterparty are:
(1) Facts required to comply with applicable laws, regulations and
rules;
(2) Facts required to implement the swap dealer's credit and
operational risk management policies in connection with transactions
entered into with such counterparty; and
(3) Information regarding the authority of any person acting for
such counterparty.
(c) True name and owner. Each swap dealer or major swap participant
shall obtain and retain a record which shall show the true name and
address of each counterparty whose identity is known to the swap dealer
or major swap participant prior to the execution of the transaction,
the principal occupation or business of such counterparty as well as
the name and address of any other person guaranteeing the performance
of such counterparty and any person exercising any control with respect
to the positions of such counterparty.
(d) Reasonable reliance on representations. A swap dealer or major
swap participant may rely on the written representations of a
counterparty to satisfy its due diligence requirements under this
subpart, unless it has information that would cause a reasonable person
to question the accuracy of the representation. If agreed to by the
counterparties, such representations may be contained in counterparty
relationship documentation and may satisfy the relevant requirements of
this subpart for subsequent swaps offered to or entered into with a
counterparty, provided however, that such counterparty undertakes to
timely update any material changes to the representations.
(e) Manner of disclosure. A swap dealer or major swap participant
may provide the information required by this subpart by any reliable
means agreed to in writing by the counterparty; provided however, for
transactions initiated on a designated contract market or swap
execution facility, written agreement by the counterparty regarding the
reliable means of disclosure is not required.
(f) Disclosures in a standard format. If agreed to by a
counterparty, the disclosure of material information that is applicable
to multiple swaps between a swap dealer or major swap participant and a
counterparty may be made in counterparty relationship documentation or
other written agreement between the counterparties.
(g) Record retention. Swap dealers and major swap participants
shall create a record of their compliance with the requirements of this
subpart and shall retain records in accordance with subpart F of this
part and Sec. 1.31 of this chapter and make them available to
applicable prudential regulators upon request.
Sec. Sec. 23.403-23.409 [Reserved]
Sec. 23.410 Prohibition on fraud, manipulation, and other abusive
practices.
(a) It shall be unlawful for a swap dealer or major swap
participant--
(1) To employ any device, scheme, or artifice to defraud any
Special Entity or prospective customer who is a Special Entity;
(2) To engage in any transaction, practice, or course of business
that operates as a fraud or deceit on any Special Entity or prospective
customer who is a Special Entity; or
(3) To engage in any act, practice, or course of business that is
fraudulent, deceptive, or manipulative.
(b) Affirmative defense. It shall be an affirmative defense to an
alleged violation of paragraph (a)(2) or (3) of this section for
failure to comply with any requirement in this subpart if a swap dealer
or major swap participant establishes that the swap dealer or major
swap participant:
(1) Did not act intentionally or recklessly in connection with such
alleged violation; and
(2) Complied in good faith with written policies and procedures
reasonably designed to meet the particular requirement that is the
basis for the alleged violation.
(c) Confidential treatment of counterparty information. (1) It
shall be unlawful for any swap dealer or major swap participant to:
(i) Disclose to any other person any material confidential
information provided by or on behalf of a counterparty to the swap
dealer or major swap participant; or
(ii) Use for its own purposes in any way that would tend to be
materially adverse to the interests of a counterparty, any material
confidential information provided by or on behalf of a counterparty to
the swap dealer or major swap participant.
(2) Notwithstanding paragraph (c)(1) of this section, a swap dealer
or major swap participant may disclose or use material confidential
information provided by or on behalf of a counterparty to the swap
dealer or major swap participant if such disclosure or use is
authorized in writing by the counterparty, or is necessary:
(i) For the effective execution of any swap for or with the
counterparty;
(ii) To hedge or mitigate any exposure created by such swap; or
(iii) To comply with a request of the Commission, Department of
Justice, any self-regulatory organization designated by the Commission,
or an applicable prudential regulator, or is otherwise required by law.
(3) Each swap dealer or major swap participant shall implement
written policies and procedures reasonably designed to protect material
confidential information provided by or on behalf of a counterparty
from disclosure and use in violation of this section by any person
acting for or on behalf of the swap dealer or major swap participant.
[[Page 9824]]
Sec. Sec. 23.411-23.429 [Reserved]
Sec. 23.430 Verification of counterparty eligibility.
(a) Eligibility. A swap dealer or major swap participant shall
verify that a counterparty meets the eligibility standards for an
eligible contract participant, as defined in Section 1a(18) of the Act
and Sec. 1.3 of this chapter, before offering to enter into or
entering into a swap with that counterparty.
(b) Special Entity. In verifying the eligibility of a counterparty
pursuant to paragraph (a) of this section, a swap dealer or major swap
participant shall also verify whether the counterparty is a Special
Entity.
(c) Special Entity election. In verifying the eligibility of a
counterparty pursuant to paragraph (a) of this section, a swap dealer
or major swap participant shall verify whether a counterparty is
eligible to elect to be a Special Entity under Sec. 23.401(c)(6) and,
if so, notify such counterparty of its right to make such an election.
(d) Safe harbor. A swap dealer or major swap participant may rely
on written representations of a counterparty to satisfy the
requirements of this section as provided in Sec. 23.402(d). A swap
dealer or major swap participant will have a reasonable basis to rely
on such written representations for purposes of the requirements in
paragraphs (a) and (b) of this section if the counterparty specifies in
such representations the provision(s) of Section 1a(18) of the Act or
paragraph(s) of Sec. 1.3 of this chapter that describe its status as
an eligible contract participant and, in the case of a Special Entity,
the paragraph(s) of the Special Entity definition in Sec. 23.401(c)
that define its status as a Special Entity.
(e) This section shall not apply with respect to:
(1) A transaction that is initiated on a designated contract
market; or
(2) A transaction initiated on a swap execution facility, if the
swap dealer or major swap participant does not know the identity of the
counterparty to the transaction prior to execution.
Sec. 23.431 Disclosures of material information.
(a) At a reasonably sufficient time prior to entering into a swap,
a swap dealer or major swap participant shall disclose to any
counterparty to the swap (other than a swap dealer, major swap
participant, security-based swap dealer, or major security-based swap
participant) material information concerning the swap in a manner
reasonably designed to allow the counterparty to assess:
(1) The material risks of the particular swap, which may include
market, credit, liquidity, foreign currency, legal, operational, and
any other applicable risks;
(2) The material characteristics of the particular swap, which
shall include the material economic terms of the swap, the terms
relating to the operation of the swap, and the rights and obligations
of the parties during the term of the swap; and
(3) The material incentives and conflicts of interest that the swap
dealer or major swap participant may have in connection with a
particular swap, which shall include:
(i) With respect to disclosure of the price of the swap, the price
of the swap and the mid-market mark of the swap as set forth in
paragraph (d)(2) of this section; and
(ii) Any compensation or other incentive from any source other than
the counterparty that the swap dealer or major swap participant may
receive in connection with the swap.
(b) Scenario Analysis. Prior to entering into a swap with a
counterparty (other than a swap dealer, major swap participant,
security-based swap dealer, or major security-based swap participant)
that is not made available for trading, as provided in Section 2(h)(8)
of the Act, on a designated contract market or swap execution facility,
a swap dealer shall:
(1) Notify the counterparty that it can request and consult on the
design of a scenario analysis to allow the counterparty to assess its
potential exposure in connection with the swap;
(2) Upon request of the counterparty, provide a scenario analysis,
which is designed in consultation with the counterparty and done over a
range of assumptions, including severe downside stress scenarios that
would result in a significant loss;
(3) Disclose all material assumptions and explain the calculation
methodologies used to perform any requested scenario analysis; provided
however, that the swap dealer is not required to disclose confidential,
proprietary information about any model it may use to prepare the
scenario analysis; and
(4) In designing any requested scenario analysis, consider any
relevant analyses that the swap dealer undertakes for its own risk
management purposes, including analyses performed as part of its ``New
Product Policy'' specified in Sec. 23.600(c)(3).
(c) Paragraphs (a) and (b) of this section shall not apply with
respect to a transaction that is:
(1) Initiated on a designated contract market or a swap execution
facility; and
(2) One in which the swap dealer or major swap participant does not
know the identity of the counterparty to the transaction prior to
execution.
(d) Daily mark. A swap dealer or major swap participant shall:
(1) For cleared swaps, notify a counterparty (other than a swap
dealer, major swap participant, security-based swap dealer, or major
security-based swap participant) of the counterparty's right to
receive, upon request, the daily mark from the appropriate derivatives
clearing organization.
(2) For uncleared swaps, provide the counterparty (other than a
swap dealer, major swap participant, security-based swap dealer, or
major security-based swap participant) with a daily mark, which shall
be the mid-market mark of the swap. The mid-market mark of the swap
shall not include amounts for profit, credit reserve, hedging, funding,
liquidity, or any other costs or adjustments. The daily mark shall be
provided to the counterparty during the term of the swap as of the
close of business or such other time as the parties agree in writing.
(3) For uncleared swaps, disclose to the counterparty:
(i) The methodology and assumptions used to prepare the daily mark
and any material changes during the term of the swap; provided however,
that the swap dealer or major swap participant is not required to
disclose to the counterparty confidential, proprietary information
about any model it may use to prepare the daily mark; and
(ii) Additional information concerning the daily mark to ensure a
fair and balanced communication, including, as appropriate, that:
(A) The daily mark may not necessarily be a price at which either
the counterparty or the swap dealer or major swap participant would
agree to replace or terminate the swap;
(B) Depending upon the agreement of the parties, calls for margin
may be based on considerations other than the daily mark provided to
the counterparty; and
(C) The daily mark may not necessarily be the value of the swap
that is marked on the books of the swap dealer or major swap
participant.
Sec. 23.432 Clearing disclosures.
(a) For swaps required to be cleared--right to select derivatives
clearing organization. A swap dealer or major swap participant shall
notify any counterparty (other than a swap dealer, major swap
participant, securities-based swap dealer, or major securities-based
[[Page 9825]]
swap participant) with which it entered into a swap that is subject to
mandatory clearing under Section 2(h) of the Act, that the counterparty
has the sole right to select the derivatives clearing organization at
which the swap will be cleared.
(b) For swaps not required to be cleared--right to clearing. A swap
dealer or major swap participant shall notify any counterparty (other
than a swap dealer, major swap participant, securities-based swap
dealer, or major securities-based swap participant) with which it
entered into a swap that is not subject to the mandatory clearing
requirements under Section 2(h) of the Act that the counterparty:
(1) May elect to require clearing of the swap; and
(2) Shall have the sole right to select the derivatives clearing
organization at which the swap will be cleared.
Sec. 23.433 Communications--fair dealing.
With respect to any communication between a swap dealer or major
swap participant and any counterparty, the swap dealer or major swap
participant shall communicate in a fair and balanced manner based on
principles of fair dealing and good faith.
Sec. 23.434 Recommendations to counterparties--institutional
suitability.
(a) A swap dealer that recommends a swap or trading strategy
involving a swap to a counterparty, other than a swap dealer, major
swap participant, security-based swap dealer, or major security-based
swap participant, must:
(1) Undertake reasonable diligence to understand the potential
risks and rewards associated with the recommended swap or trading
strategy involving a swap; and
(2) Have a reasonable basis to believe that the recommended swap or
trading strategy involving a swap is suitable for the counterparty. To
establish a reasonable basis for a recommendation, a swap dealer must
have or obtain information about the counterparty, including the
counterparty's investment profile, trading objectives, and ability to
absorb potential losses associated with the recommended swap or trading
strategy involving a swap.
(b) Safe Harbor. A swap dealer may fulfill its obligations under
paragraph (a)(2) of this section with respect to a particular
counterparty if:
(1) The swap dealer reasonably determines that the counterparty, or
an agent to which the counterparty has delegated decision-making
authority, is capable of independently evaluating investment risks with
regard to the relevant swap or trading strategy involving a swap;
(2) The counterparty or its agent represents in writing that it is
exercising independent judgment in evaluating the recommendations of
the swap dealer with regard to the relevant swap or trading strategy
involving a swap;
(3) The swap dealer discloses in writing that it is acting in its
capacity as a counterparty and is not undertaking to assess the
suitability of the swap or trading strategy involving a swap for the
counterparty; and
(4) In the case of a counterparty that is a Special Entity, the
swap dealer complies with Sec. 23.440 where the recommendation would
cause the swap dealer to act as an advisor to a Special Entity within
the meaning of Sec. 23.440(a).
(c) A swap dealer will satisfy the requirements of paragraph (b)(1)
of this section if it receives written representations, as provided in
Sec. 23.402(d), that:
(1) In the case of a counterparty that is not a Special Entity, the
counterparty has complied in good faith with written policies and
procedures that are reasonably designed to ensure that the persons
responsible for evaluating the recommendation and making trading
decisions on behalf of the counterparty are capable of doing so; or
(2) In the case of a counterparty that is a Special Entity, satisfy
the terms of the safe harbor in Sec. 23.450(d).
Sec. Sec. 23.435-23.439 [Reserved]
Sec. 23.440 Requirements for swap dealers acting as advisors to
Special Entities.
(a) Acts as an advisor to a Special Entity. For purposes of this
section, a swap dealer ``acts as an advisor to a Special Entity'' when
the swap dealer recommends a swap or trading strategy involving a swap
that is tailored to the particular needs or characteristics of the
Special Entity.
(b) Safe harbors. A swap dealer will not ``act as an advisor to a
Special Entity'' within the meaning of paragraph (a) of this section
if:
(1) With respect to a Special Entity that is an employee benefit
plan as defined in Sec. 23.401(c)(3):
(i) The Special Entity represents in writing that it has a
fiduciary as defined in Section 3 of the Employee Retirement Income
Security Act of 1974 (29 U.S.C. 1002) that is responsible for
representing the Special Entity in connection with the swap
transaction;
(ii) The fiduciary represents in writing that it will not rely on
recommendations provided by the swap dealer; and
(iii) The Special Entity represents in writing:
(A) That it will comply in good faith with written policies and
procedures reasonably designed to ensure that any recommendation the
Special Entity receives from the swap dealer materially affecting a
swap transaction is evaluated by a fiduciary before the transaction
occurs; or
(B) That any recommendation the Special Entity receives from the
swap dealer materially affecting a swap transaction will be evaluated
by a fiduciary before that transaction occurs; or
(2) With respect to any Special Entity:
(i) The swap dealer does not express an opinion as to whether the
Special Entity should enter into a recommended swap or trading strategy
involving a swap that is tailored to the particular needs or
characteristics of the Special Entity;
(ii) The Special Entity represents in writing that:
(A) The Special Entity will not rely on recommendations provided by
the swap dealer; and
(B) The Special Entity will rely on advice from a qualified
independent representative within the meaning of Sec. 23.450; and
(iii) The swap dealer discloses to the Special Entity that it is
not undertaking to act in the best interests of the Special Entity as
otherwise required by this section.
(c) A swap dealer that acts as an advisor to a Special Entity shall
comply with the following requirements:
(1) Duty. Any swap dealer that acts as an advisor to a Special
Entity shall have a duty to make a reasonable determination that any
swap or trading strategy involving a swap recommended by the swap
dealer is in the best interests of the Special Entity.
(2) Reasonable efforts. Any swap dealer that acts as an advisor to
a Special Entity shall make reasonable efforts to obtain such
information as is necessary to make a reasonable determination that any
swap or trading strategy involving a swap recommended by the swap
dealer is in the best interests of the Special Entity, including
information relating to:
(i) The financial status of the Special Entity, as well as the
Special Entity's future funding needs;
(ii) The tax status of the Special Entity;
(iii) The hedging, investment, financing, or other objectives of
the Special Entity;
(iv) The experience of the Special Entity with respect to entering
into swaps, generally, and swaps of the type and complexity being
recommended;
(v) Whether the Special Entity has the financial capability to
withstand
[[Page 9826]]
changes in market conditions during the term of the swap; and
(vi) Such other information as is relevant to the particular facts
and circumstances of the Special Entity, market conditions, and the
type of swap or trading strategy involving a swap being recommended.
(d) Reasonable reliance on representations of the Special Entity.
As provided in Sec. 23.402(d), the swap dealer may rely on written
representations of the Special Entity to satisfy its requirement in
paragraph (c)(2) of this section to make ``reasonable efforts'' to
obtain necessary information.
Sec. Sec. 23.441-23.449 [Reserved]
Sec. 23.450 Requirements for swap dealers and major swap participants
acting as counterparties to Special Entities.
(a) Definitions. For purposes of this section:
(1) The term ``principal relationship'' means where a swap dealer
or major swap participant is a principal of the representative of a
Special Entity or the representative of a Special Entity is a principal
of the swap dealer or major swap participant. The term ``principal''
means any person listed in Sec. 3.1(a)(1) through(3) of this chapter.
(2) The term ``statutory disqualification'' means grounds for
refusal to register or to revoke, condition, or restrict the
registration of any registrant or applicant for registration as set
forth in Sections 8a(2) and 8a(3) of the Act.
(b)(1) Any swap dealer or major swap participant that offers to
enter or enters into a swap with a Special Entity, other than a Special
Entity defined in Sec. 23.401(c)(3), shall have a reasonable basis to
believe that the Special Entity has a representative that:
(i) Has sufficient knowledge to evaluate the transaction and risks;
(ii) Is not subject to a statutory disqualification;
(iii) Is independent of the swap dealer or major swap participant;
(iv) Undertakes a duty to act in the best interests of the Special
Entity it represents;
(v) Makes appropriate and timely disclosures to the Special Entity;
(vi) Evaluates, consistent with any guidelines provided by the
Special Entity, fair pricing and the appropriateness of the swap; and
(vii) In the case of a Special Entity as defined in Sec.
23.401(c)(2) or (4), is subject to restrictions on certain political
contributions imposed by the Commission, the Securities and Exchange
Commission, or a self-regulatory organization subject to the
jurisdiction of the Commission or the Securities and Exchange
Commission; provided however, that this paragraph (b)(1)(vii) of this
section shall not apply if the representative is an employee of the
Special Entity.
(2) Any swap dealer or major swap participant that offers to enter
or enters into a swap with a Special Entity as defined in Sec.
23.401(c)(3) shall have a reasonable basis to believe that the Special
Entity has a representative that is a fiduciary as defined in Section 3
of the Employee Retirement Income Security Act of 1974 (29 U.S.C.
1002).
(c) Independent. For purposes of paragraph (b)(1)(iii) of this
section, a representative of a Special Entity will be deemed to be
independent of the swap dealer or major swap participant if:
(1) The representative is not and, within one year of representing
the Special Entity in connection with the swap, was not an associated
person of the swap dealer or major swap participant within the meaning
of Section 1a(4) of the Act;
(2) There is no principal relationship between the representative
of the Special Entity and the swap dealer or major swap participant;
(3) The representative:
(i) Provides timely and effective disclosures to the Special Entity
of all material conflicts of interest that could reasonably affect the
judgment or decision making of the representative with respect to its
obligations to the Special Entity; and
(ii) Complies with policies and procedures reasonably designed to
manage and mitigate such material conflicts of interest;
(4) The representative is not directly or indirectly, through one
or more persons, controlled by, in control of, or under common control
with the swap dealer or major swap participant; and
(5) The swap dealer or major swap participant did not refer,
recommend, or introduce the representative to the Special Entity within
one year of the representative's representation of the Special Entity
in connection with the swap.
(d) Safe Harbor. (1) A swap dealer or major swap participant shall
be deemed to have a reasonable basis to believe that the Special
Entity, other than a Special Entity defined in Sec. 23.401(c)(3), has
a representative that satisfies the applicable requirements of
paragraph (b)(1) of this section, provided that:
(i) The Special Entity represents in writing to the swap dealer or
major swap participant that it has complied in good faith with written
policies and procedures reasonably designed to ensure that it has
selected a representative that satisfies the applicable requirements of
paragraph (b) of this section, and that such policies and procedures
provide for ongoing monitoring of the performance of such
representative consistent with the requirements of paragraph (b) of
this section; and
(ii) The representative represents in writing to the Special Entity
and swap dealer or major swap participant that the representative:
(A) Has policies and procedures reasonably designed to ensure that
it satisfies the applicable requirements of paragraph (b) of this
section;
(B) Meets the independence test in paragraph (c) of this section;
and
(C) Is legally obligated to comply with the applicable requirements
of paragraph (b) of this section by agreement, condition of employment,
law, rule, regulation, or other enforceable duty.
(2) A swap dealer or major swap participant shall be deemed to have
a reasonable basis to believe that a Special Entity defined in Sec.
23.401(c)(3) has a representative that satisfies the applicable
requirements in paragraph (b)(2) of this section, provided that the
Special Entity provides in writing to the swap dealer or major swap
participant the representative's name and contact information, and
represents in writing that the representative is a fiduciary as defined
in Section 3 of the Employee Retirement Income Security Act of 1974 (29
U.S.C. 1002).
(e) Reasonable reliance on representations of the Special Entity. A
swap dealer or major swap participant may rely on written
representations of a Special Entity and, as applicable under this
section, the Special Entity's representative to satisfy any requirement
of this section as provided in Sec. 23.402(d).
(f) Chief compliance officer review. If a swap dealer or major swap
participant initially determines that it does not have a reasonable
basis to believe that the representative of a Special Entity meets the
criteria established in this section, the swap dealer or major swap
participant shall make a written record of the basis for such
determination and submit such determination to its chief compliance
officer for review to ensure that the swap dealer or major swap
participant has a substantial, unbiased basis for the determination.
(g) Before the initiation of a swap, a swap dealer or major swap
participant shall disclose to the Special Entity in writing:
(1) The capacity in which it is acting in connection with the swap;
and
[[Page 9827]]
(2) If the swap dealer or major swap participant engages in
business with the Special Entity in more than one capacity, the swap
dealer or major swap participant shall disclose the material
differences between such capacities.
(h) This section shall not apply with respect to a transaction that
is:
(1) Initiated on a designated contract market or swap execution
facility; and
(2) One in which the swap dealer or major swap participant does not
know the identity of the counterparty to the transaction prior to
execution.
Sec. 23.451 Political contributions by certain swap dealers.
(a) Definitions. For the purposes of this section:
(1) The term ``contribution'' means any gift, subscription, loan,
advance, or deposit of money or anything of value made:
(i) For the purpose of influencing any election for federal, state,
or local office;
(ii) For payment of debt incurred in connection with any such
election; or
(iii) For transition or inaugural expenses incurred by the
successful candidate for federal, state, or local office.
(2) The term ``covered associate'' means:
(i) Any general partner, managing member, or executive officer, or
other person with a similar status or function;
(ii) Any employee who solicits a governmental Special Entity for
the swap dealer and any person who supervises, directly or indirectly,
such employee; and
(iii) Any political action committee controlled by the swap dealer
or by any person described in paragraphs (a)(2)(i) and (a)(2)(ii) of
this section.
(3) The term ``governmental Special Entity'' means any Special
Entity defined in Sec. 23.401(c)(2) or (4).
(4) The term ``official'' of a governmental Special Entity means
any person (including any election committee for such person) who was,
at the time of the contribution, an incumbent, candidate, or successful
candidate for elective office of a governmental Special Entity, if the
office:
(i) Is directly or indirectly responsible for, or can influence the
outcome of, the selection of a swap dealer by a governmental Special
Entity; or
(ii) Has authority to appoint any person who is directly or
indirectly responsible for, or can influence the outcome of, the
selection of a swap dealer by a governmental Special Entity.
(5) The term ``payment'' means any gift, subscription, loan,
advance, or deposit of money or anything of value.
(6) The term ``regulated person'' means:
(i) A person that is subject to restrictions on certain political
contributions imposed by the Commission, the Securities and Exchange
Commission, or a self-regulatory agency subject to the jurisdiction of
the Commission or the Securities and Exchange Commission;
(ii) A general partner, managing member, or executive officer of
such person, or other individual with a similar status or function; or
(iii) An employee of such person who solicits a governmental
Special Entity for the swap dealer and any person who supervises,
directly or indirectly, such employee.
(7) The term ``solicit'' means a direct or indirect communication
by any person with a governmental Special Entity for the purpose of
obtaining or retaining an engagement related to a swap.
(b) Prohibitions and exceptions. (1) As a means reasonably designed
to prevent fraud, no swap dealer shall offer to enter into or enter
into a swap or a trading strategy involving a swap with a governmental
Special Entity within two years after any contribution to an official
of such governmental Special Entity was made by the swap dealer or by
any covered associate of the swap dealer; provided however, that:
(2) This prohibition does not apply:
(i) If the only contributions made by the swap dealer to an
official of such governmental Special Entity were made by a covered
associate:
(A) To officials for whom the covered associate was entitled to
vote at the time of the contributions, provided that the contributions
in the aggregate do not exceed $350 to any one official per election;
or
(B) To officials for whom the covered associate was not entitled to
vote at the time of the contributions, provided that the contributions
in the aggregate do not exceed $150 to any one official per election;
(ii) To a swap dealer as a result of a contribution made by a
natural person more than six months prior to becoming a covered
associate of the swap dealer, provided that this exclusion shall not
apply if the natural person, after becoming a covered associate,
solicits the governmental Special Entity on behalf of the swap dealer
to offer to enter into or to enter into a swap or trading strategy
involving a swap; or
(iii) To a swap that is:
(A) Initiated on a designated contract market or swap execution
facility; and
(B) One in which the swap dealer does not know the identity of the
counterparty to the transaction prior to execution.
(3) No swap dealer or any covered associate of the swap dealer
shall:
(i) Provide or agree to provide, directly or indirectly, payment to
any person to solicit a governmental Special Entity to offer to enter
into, or to enter into, a swap with that swap dealer unless such person
is a regulated person; or
(ii) Coordinate, or solicit any person or political action
committee to make, any:
(A) Contribution to an official of a governmental Special Entity
with which the swap dealer is offering to enter into, or has entered
into, a swap; or
(B) Payment to a political party of a state or locality with which
the swap dealer is offering to enter into or has entered into a swap or
a trading strategy involving a swap.
(c) Circumvention of rule. No swap dealer shall, directly or
indirectly, through or by any other person or means, do any act that
would result in a violation of paragraph (b) of this section.
(d) Requests for exemption. The Commission, upon application, may
conditionally or unconditionally exempt a swap dealer from the
prohibition under paragraph (b) of this section. In determining whether
to grant an exemption, the Commission will consider, among other
factors:
(1) Whether the exemption is necessary or appropriate in the public
interest and consistent with the protection of investors and the
purposes of the Act;
(2) Whether the swap dealer:
(i) Before the contribution resulting in the prohibition was made,
implemented policies and procedures reasonably designed to prevent
violations of this section;
(ii) Prior to or at the time the contribution which resulted in
such prohibition was made, had no actual knowledge of the contribution;
and
(iii) After learning of the contribution:
(A) Has taken all available steps to cause the contributor involved
in making the contribution which resulted in such prohibition to obtain
a return of the contribution; and
(B) Has taken such other remedial or preventive measures as may be
appropriate under the circumstances;
(3) Whether, at the time of the contribution, the contributor was a
covered associate or otherwise an employee of the swap dealer, or was
seeking such employment;
(4) The timing and amount of the contribution which resulted in the
prohibition;
[[Page 9828]]
(5) The nature of the election (e.g., federal, state or local); and
(6) The contributor's apparent intent or motive in making the
contribution that resulted in the prohibition, as evidenced by the
facts and circumstances surrounding the contribution.
(e) Prohibitions inapplicable. (1) The prohibitions under paragraph
(b) of this section shall not apply to a contribution made by a covered
associate of the swap dealer if:
(i) The swap dealer discovered the contribution within 120 calendar
days of the date of such contribution;
(ii) The contribution did not exceed the amounts permitted by
paragraphs (b)(2)(i)(A) or (B) of this section; and
(iii) The covered associate obtained a return of the contribution
within 60 calendar days of the date of discovery of the contribution by
the swap dealer.
(2) A swap dealer may not rely on paragraph (e)(1) of this section
more than twice in any 12-month period.
(3) A swap dealer may not rely on paragraph (e)(1) of this section
more than once for any covered associate, regardless of the time
between contributions.
Appendix A--Guidance on the Application of Sec. Sec. 23.434 and 23.440
for Swap Dealers That Make Recommendations to Counterparties or Special
Entities
The following provides guidance on the application of Sec. Sec.
23.434 and 23.440 to swap dealers that make recommendations to
counterparties or Special Entities.
Section 23.434--Recommendations to Counterparties--Institutional
Suitability
A swap dealer that recommends a swap or trading strategy
involving a swap to a counterparty, other than a swap dealer, major
swap participant, security-based swap dealer or major security-based
swap participant, must undertake reasonable diligence to understand
the potential risks and rewards associated with the recommended swap
or trading strategy involving a swap--general suitability (Sec.
23.434(a)(1))--and have a reasonable basis to believe that the
recommended swap or trading strategy involving a swap is suitable
for the counterparty--specific suitability (Sec. 23.434(a)(2)). To
satisfy the general suitability obligation, a swap dealer must
undertake reasonable diligence that will vary depending on, among
other things, the complexity of and risks associated with the swap
or swap trading strategy and the swap dealer's familiarity with the
swap or swap trading strategy. At a minimum, a swap dealer's
reasonable diligence must provide it with an understanding of the
potential risks and rewards associated with the recommended swap or
swap trading strategy.
Recommendation. Whether a communication between a swap dealer
and a counterparty is a recommendation will turn on the facts and
circumstances of the particular situation. There are, however,
certain factors the Commission will consider in reaching such a
determination. The facts and circumstances determination of whether
a communication is a ``recommendation'' requires an analysis of the
content, context, and presentation of the particular communication
or set of communications. The determination of whether a
``recommendation'' has been made, moreover, is an objective rather
than a subjective inquiry. An important factor in this regard is
whether, given its content, context, and manner of presentation, a
particular communication from a swap dealer to a counterparty
reasonably would be viewed as a ``call to action,'' or suggestion
that the counterparty enter into a swap. An analysis of the content,
context, and manner of presentation of a communication requires
examination of the underlying substantive information transmitted to
the counterparty and consideration of any other facts and
circumstances, such as any accompanying explanatory message from the
swap dealer. Additionally, the more individually tailored the
communication to a specific counterparty or a targeted group of
counterparties about a swap, group of swaps or trading strategy
involving the use of a swap, the greater the likelihood that the
communication may be viewed as a ``recommendation.''
Safe harbor. A swap dealer may satisfy the safe harbor
requirements of Sec. 23.434(b) to fulfill its counterparty-specific
suitability duty under Sec. 23.434(a)(2) if: (1) The swap dealer
reasonably determines that the counterparty, or an agent to which
the counterparty has delegated decision-making authority, is capable
of independently evaluating investment risks with regard to the
relevant swap or trading strategy involving a swap; (2) the
counterparty or its agent represents in writing that it is
exercising independent judgment in evaluating the recommendations of
the swap dealer; (3) the swap dealer discloses in writing that it is
acting in its capacity as a counterparty and is not undertaking to
assess the suitability of the recommendation; and (4) in the case of
a counterparty that is a Special Entity, the swap dealer complies
with Sec. 23.440 where the recommendation would cause the swap
dealer to act as an advisor to a Special Entity within the meaning
of Sec. 23.440(a).
To reasonably determine that the counterparty, or an agent to
which the counterparty has delegated decision-making authority, is
capable of independently evaluating investment risks of a
recommendation, the swap dealer can rely on the written
representations of the counterparty, as provided in Sec. 23.434(c).
Section 23.434(c)(1) provides that a swap dealer will satisfy Sec.
23.434(b)(1)'s requirement with respect to a counterparty other than
a Special Entity if it receives representations that the
counterparty has complied in good faith with the counterparty's
policies and procedures that are reasonably designed to ensure that
the persons responsible for evaluating the recommendation and making
trading decisions on behalf of the counterparty are capable of doing
so. Section Sec. 23.434(c)(2) provides that a swap dealer will
satisfy Sec. 23.434(b)(1)'s requirement with respect to a Special
Entity if it receives representations that satisfy the terms of
Sec. 23.450(d) regarding a Special Entity's qualified independent
representative.
Prong (4) of the safe harbor clarifies that Sec. 23.434's
application is broader than Sec. 23.440--Requirements for Swap
Dealers Acting as Advisors to Special Entities. Section 23.434 is
triggered when a swap dealer recommends any swap or trading strategy
that involves a swap to any counterparty. However, Sec. 23.440 is
limited to a swap dealer's recommendations (1) to a Special Entity
(2) of swaps that are tailored to the particular needs or
characteristics of the Special Entity. Thus, a swap dealer that
recommends a swap to a Special Entity that is tailored to the
particular needs or characteristics of the Special Entity may comply
with its suitability obligation by satisfying the safe harbor in
Sec. 23.434(b); however, the swap dealer must also comply with
Sec. 23.440 in such circumstances.
Section 23.440--Requirements for Swap Dealers Acting as Advisors to
Special Entities
A swap dealer ``acts as an advisor to a Special Entity'' under
Sec. 23.440 when the swap dealer recommends a swap or trading
strategy involving a swap that is tailored to the particular needs
or characteristics of the Special Entity. A swap dealer that ``acts
as an advisor to a Special Entity'' has a duty to make a reasonable
determination that a recommendation is in the ``best interests'' of
the Special Entities and must undertake ``reasonable efforts'' to
obtain information necessary to make such a determination.
Whether a swap dealer ``acts as an advisor to a Special Entity''
will depend on: (1) Whether the swap dealer has made a
recommendation to a Special Entity; and (2) whether the
recommendation concerns a swap or trading strategy involving a swap
that is tailored to the particular needs or characteristics of the
Special Entity. To determine whether a communication between a swap
dealer and counterparty is a recommendation, the Commission will
apply the same factors as under Sec. 23.434, the suitability rule.
However, unlike the suitability rule, which covers recommendations
regarding any type of swap or trading strategy involving a swap, the
``acts as an advisor rule'' and ``best interests'' duty will be
triggered only if the recommendation is of a swap or trading
strategy involving a swap that is ``tailored to the particular needs
or characteristics of the Special Entity.''
Whether a swap is tailored to the particular needs or
characteristics of the Special Entity will depend on the facts and
circumstances. Swaps with terms that are tailored or customized to a
specific Special Entity's needs or objectives, or swaps with terms
that are designed for a targeted group of Special Entities that
share common characteristics, e.g., school districts, are likely to
be viewed as tailored to the particular needs or characteristics of
the Special Entity. Generally, however, the Commission would
[[Page 9829]]
not view a swap that is ``made available for trading'' on a
designated contract market or swap execution facility, as provided
in Section 2(h)(8) of the Act, as tailored to the particular needs
or characteristics of the Special Entity.
Safe harbor. Under Sec. 23.440(b)(2), when dealing with a
Special Entity (including a Special Entity that is an employee
benefit plan as defined in Sec. 23.401(c)(3)),\1\ a swap dealer
will not ``act as an advisor to a Special Entity'' if: (1) The swap
dealer does not express an opinion as to whether the Special Entity
should enter into a recommended swap or swap trading strategy that
is tailored to the particular needs or characteristics of the
Special Entity; (2) the Special Entity represents in writing, in
accordance with Sec. 23.402(d), that it will not rely on the swap
dealer's recommendations and will rely on advice from a qualified
independent representative within the meaning of Sec. 23.450; and
(3) the swap dealer discloses that it is not undertaking to act in
the best interests of the Special Entity.
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\1\ The guidance in this appendix regarding the safe harbor to
Sec. 23.440 is limited to the safe harbor for any Special Entity
under Sec. 23.440(b)(2). A swap dealer may separately comply with
the safe harbor under Sec. 23.440(b)(1) for its communications to a
Special Entity that is an employee benefit plan as defined in Sec.
23.401(c)(3).
---------------------------------------------------------------------------
A swap dealer that elects to communicate within the safe harbor
to avoid triggering the ``best interests'' duty must appropriately
manage its communications. To clarify the type of communications
that they will make under the safe harbor, the Commission expects
that swap dealers may specifically represent that they will not
express an opinion as to whether the Special Entity should enter
into a recommended swap or trading strategy, and that for such
advice the Special Entity should consult its own advisor. Nothing in
the final rule would preclude such a representation from being
included in counterparty relationship documentation. However, such a
representation would not act as a safe harbor under the rule where,
contrary to the representation, the swap dealer does express an
opinion to the Special Entity as to whether it should enter into a
recommended swap or trading strategy.
If a swap dealer complies with the terms of the safe harbor, the
following types of communications would not be subject to the ``best
interests'' duty: \2\ (1) Providing information that is general
transaction, financial, educational, or market information; (2)
offering a swap or trading strategy involving a swap, including
swaps that are tailored to the needs or characteristics of a Special
Entity; (3) providing a term sheet, including terms for swaps that
are tailored to the needs or characteristics of a Special Entity;
(4) responding to a request for a quote from a Special Entity; (5)
providing trading ideas for swaps or swap trading strategies,
including swaps that are tailored to the needs or characteristics of
a Special Entity; and (6) providing marketing materials upon request
or on an unsolicited basis about swaps or swap trading strategies,
including swaps that are tailored to the needs or characteristics of
a Special Entity. This list of communications is not exclusive and
should not create a negative implication that other types of
communications are subject to a ``best interests'' duty.
---------------------------------------------------------------------------
\2\ Communications on the list that are not within the meaning
of the term ``acts as an advisor to a Special Entity'' are outside
the requirements of Sec. 23.440. By including such communications
on the list, the Commission does not intend to suggest that they are
``recommendations.'' Thus, a swap dealer that does not ``act as an
advisor to a Special Entity'' within the meaning of Sec. 23.440(a)
is not required to comply with the safe harbor to avoid the ``best
interests'' duty with respect to its communications.
---------------------------------------------------------------------------
The safe harbor in Sec. 23.440(b)(2) allows a wide range of
communications and interactions between swap dealers and Special
Entities without invoking the ``best interests'' duty, including
discussions of the advantages or disadvantages of different swaps or
trading strategies. The Commission notes, however, that depending on
the facts and circumstances, some of the examples on the list could
be ``recommendations'' that would trigger a suitability obligation
under Sec. 23.434. However, the Commission has determined that such
activities would not, by themselves, prompt the ``best interests''
duty in Sec. 23.440, provided that the parties comply with the
other requirements of Sec. 23.440(b)(2). All of the swap dealer's
communications, however, must be made in a fair and balanced manner
based on principles of fair dealing and good faith in compliance
with Sec. 23.433.
Swap dealers engage in a wide variety of communications with
counterparties in the normal course of business, including but not
limited to the six types of communications listed above. Whether any
particular communication will be deemed to be a ``recommendation''
within the meaning of Sec. Sec. 23.434 or 23.440 will depend on the
facts and circumstances of the particular communication considered
in light of the guidance in this appendix with respect to the
meaning of the term ``recommendation.'' Swap dealers that choose to
manage their communications to comply with the safe harbors provided
in Sec. Sec. 23.434 and 23.440 will be able to limit the duty they
owe to counterparties, including Special Entities, provided that the
parties exchange the appropriate representations.
By the Commission, this 11th day of January 2012.
David A. Stawick,
Secretary.
Appendices to the Final Rules for Implementing the Business Conduct
Standards for Swap Dealers and Major Swap Participants With
Counterparties--Table of Comment Letters, Statement of the Department
of Labor, Commission Voting Summary, and Statements of Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
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BILLING CODE 6351-01-C
Appendix 2--Statement of the Department of Labor
U.S. Department of Labor
Assistant Secretary for Employee Benefits Security Administration,
Washington, DC 20210
JAN 17 2012
Honorable Gary Gensler
The Honorable Jill Sommers
The Honorable Bart Chilton
The Honorable Scott D. O'Malia
The Honorable Mark Wetjen
U.S. Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Re: Final Business Conduct Standards Rules Adopted January 11, 2012
Dear Chairman Gensler and Commissioners Sommers, Chilton,
O'Malia and Wetjen:
The Department of Labor has reviewed the final draft of the
Commodity Futures Trading Commission's (``CFTC's'') rules to
implement Section 4s(h) of the Commodity Exchange Act pursuant to
Section 731 of Title VII of the Dodd-Frank Wall Street Reform and
The Consumer Protection Act of 2010. These rules prescribe external
business conduct standards for swap dealers and major swap
participants and will have a direct impact on ERISA-covered plans
and plan fiduciaries. I very much appreciate the care that the CFTC
has taken to coordinate its work on this project with the Department
of Labor in light of the Department's regulatory and enforcement
responsibilities with respect to ERISA fiduciaries. As we have
worked with your staff, we have paid particular attention to the
interaction between the original business conduct proposal and the
Department's own fiduciary regulations and proposals.
The Department of Labor has reviewed these final business
conduct standards and concluded that they do not require swap
dealers or major swap participants to engage in activities that
would make them fiduciaries under the Department of Labor's current
five-part test defining fiduciary advice 29 CFR Sec. 2510.3-21(c).
In the Department's view, the CFTC's final business conduct
standards neither conflict with the Department's existing
regulations, nor compel swap dealers or major swap participants to
engage in fiduciary conduct. Moreover, the Department states that it
is fully committed to ensuring that any changes to the current ERISA
fiduciary advice regulation are carefully harmonized with the final
business conduct standards, as adopted by the CFTC and the SEC, so
that there are no unintended consequences for swap dealers and major
swap participants who comply with these business conduct standards.
We look forward to continuing to work with you on these
important projects and are grateful for your staff's thoughtful
efforts to harmonize our work.
Sincerely,
Phyllis C. Borzi
Assistant Secretary, Employee Benefits Security Administration
Appendix 3--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Chilton,
O'Malia and Wetjen voted in the affirmative; Commissioner Sommers
voted in the negative.
Appendix 4--Statement of Chairman Gensler
I support the final rules to establish business conduct
standards for swap dealers and major swap participants in their
dealings with counterparties, or external business conduct. Today's
final rules implement important new authorities in the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) for
the Commodity Futures Trading Commission to establish and enforce
robust sales practices in the swaps markets. Dealers will have to
tell their counterparties the mid-market mark of their outstanding
bilateral swaps every day, bringing transparency to the markets and
helping to level the playing field for market participants.
The rules prohibit fraud and certain other abusive practices.
They also implement requirements for swap dealers and major swap
participants to deal fairly with customers, provide balanced
communications, and disclose material risks, conflicts of interest
and material incentives before entering into a swap.
The rules include restrictions on certain political
contributions from swap dealers to municipal officials, known as
``pay to play'' prohibitions.
The rules also implement the Dodd-Frank heightened duties on
swap dealers and major swap participants when they deal with certain
entities, such as pension plans, governmental entities and
endowments.
The rules were carefully tailored to include safe harbors to
ensure that special entities, such as pension plans subject to the
Employee Retirement Income Security Act, will continue to be able to
access these markets and hedge their risks.
The final rules benefitted substantially from the input of
members of the public who met with staff and Commissioners and those
who submitted thoughtful, detailed letters. The Securities and
Exchange Commission, prudential regulators and the Department of
Labor also provided helpful feedback.
[FR Doc. 2012-1244 Filed 2-16-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: February 17, 2012
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