FR Doc 2010-31588[Federal Register: December 22, 2010 (Volume 75, Number 245)]
[Proposed Rules]
[Page 80637-80663]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22de10-32]
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Part III
Commodity Futures Trading Commission
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17 CFR Parts 23 and 155
Business Conduct Standards for Swap Dealers and Major Swap Participants
With Counterparties; Proposed Rule
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 23 and 155
RIN 3038-AD25
Business Conduct Standards for Swap Dealers and Major Swap
Participants With Counterparties
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rules.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is proposing for comment new rules under Section 4s(h) of the
Commodity Exchange Act (``CEA'') to implement provisions of Title VII
of the Dodd-Frank Wall Street Reform and Consumer Protection Act of
2010 (``Dodd-Frank Act'') relating generally to external business
conduct standards for swap dealers and major swap participants.
DATES: Written comments must be received on or before February 22,
2011.
ADDRESSES: You may submit comments, identified by RIN number 3038-AD25,
by any of the following methods:
Agency Web site, via its Comments Online process: http://
comments.cftc.gov/. Follow the instructions for submitting comments
through the Web site.
Mail: David A. Stawick, Secretary of the Commission,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, NW., Washington, DC 20581.
Hand Delivery/Courier: Same as mail above.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Please submit your comments using only one method.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the Commission to consider
information that you believe is exempt from disclosure under the
Freedom of Information Act, a petition for confidential treatment of
the exempt information may be submitted according to the procedures
established in Sec. 145.9 of the Commission's Regulations.\1\
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\1\ 17 CFR 145.9.
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The Commission reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse or remove any or all of your
submission from http://www.cftc.gov that it may deem to be
inappropriate for publication, such as obscene language. All
submissions that have been redacted or removed that contain comments on
the merits of the rulemaking will be retained in the public comment
file and will be considered as required under the Administrative
Procedure Act and other applicable laws, and may be accessible under
the Freedom of Information Act.
FOR FURTHER INFORMATION CONTACT: Phyllis J. Cela, Deputy Director and
Chief Counsel, Division of Enforcement, or Peter Sanchez, Special
Counsel, Division of Clearing and Intermediary Oversight, Commodity
Futures Trading Commission, 1155 21st Street, NW., Washington, DC
20581. Telephone number: (202) 418-7642.
SUPPLEMENTARY INFORMATION: The Commission is proposing Sec. Sec.
23.400-402, 23.410, 23.430-434, 23.440, 23.450-451, and 155.7 under
Section 4s(h) of the CEA. The Commission is soliciting comments on all
aspects of the proposed rules and will carefully consider any comments
received.
Table of Contents
I. Introduction
A. Business Conduct Standards--Dealing With Counterparties
Generally
B. Business Conduct Standards--Dealing With Counterparties That
Are Special Entities
C. Consultations With Stakeholders
D. Consultation and Coordination With the SEC, Prudential
Regulators and Other Domestic and Foreign Regulatory Authorities
II. Proposed Rules for Swap Dealers and Major Swap Participants
Dealing With Counterparties Generally
A. Proposed Sec. Sec. 23.400, 23.401 and 23.402--Scope,
Definitions and General Provisions
B. Proposed Sec. 23.410--Prohibition on Fraud, Manipulation and
Other Abusive Practices
C. Proposed Sec. 23.430--Verification of Counterparty
Eligibility
D. Proposed Sec. 23.431--Disclosures of Material Risks,
Characteristics, Material Incentives and Conflicts of Interest
Regarding a Swap
1. Timing and Manner of Disclosures
2. Disclosure of Material Risks
3. Scenario Analysis for High-Risk Complex Bilateral Swaps and
Counterparty ``Opt-In'' for Bilateral Swaps Not Available for
Trading on a Designated Contract Market or Swap Execution Facility
4. Material Characteristics
5. Material Incentives and Conflicts of Interest
6. Daily Mark
E. Proposed Sec. 23.432--Clearing
F. Proposed Sec. 23.433--Communications--Fair Dealing
G. Proposed Sec. 23.434--Recommendations to Counterparties--
Institutional Suitability
H. Proposed Sec. 155.7--Execution Standards \2\
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\2\ The proposed swap execution standards Sec. 155.7 would
apply to any Commission registrant, including a swap dealer or major
swap participant, handling an order for a swap that is available for
trading on a designated contract market or a swap execution
facility.
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III. Proposed Rules for Swap Dealers and Major Swap Participants
With Special Entities
A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)
B. Proposed Sec. 23.440--Requirements for Swap Dealers Acting
as Advisors to Special Entities
1. Act as an Advisor to a Special Entity
2. Best Interests
3. Reasonable Efforts
4. Reasonable Reliance To Satisfy the ``Reasonable Efforts''
Obligation
C. Proposed Sec. 23.450--Requirements for Swap Dealers and
Major Swap Participants Acting as Counterparties to Special Entities
1. Qualifications of the Independent Representative
2. Statutory Disqualification
3. Independent
4. Best Interests
5. Makes Appropriate and Timely Disclosures
6. Evaluates Fair Pricing and the Appropriateness of the Swap
7. ERISA Fiduciary
8. Restrictions on Political Contributions by Independent
Representative of a Municipal Entity
9. Unqualified Independent Representative
10. Disclosure of Capacity
11. Inapplicability
D. Proposed Sec. 23.451--Political Contributions by Certain
Swap Dealers and Major Swap Participants
1. Prohibitions
2. Exceptions
3. Exemptions
IV. Request for Comment
A. Generally
B. Consistency With SEC Approach
V. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Cost-Benefit Analysis
I. Introduction
On July 21, 2010, President Obama signed the Dodd-Frank Act.\3\
Title VII of the Dodd-Frank Act amended the CEA \4\ to establish a
comprehensive new regulatory framework for swaps and certain security-
based swaps. The legislation was enacted to reduce risk, increase
transparency, and promote
[[Page 80639]]
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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\3\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010) (``Dodd-Frank Act'').
The text of the Dodd-Frank Act may be accessed at http://
www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
\4\ 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.
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Section 731 of the Dodd-Frank Act amends the CEA by adding Section
4s(h). This section provides the Commission with both mandatory and
discretionary rulemaking authority to impose business conduct
requirements on swap dealers and major swap participants in their
dealings with counterparties, including ``Special Entities.'' \5\ Such
entities are generally defined to include Federal agencies, States and
political subdivisions, employee benefit plans as defined under the
Employee Retirement Income Security Act of 1974 (``ERISA''),
governmental plans as defined under ERISA, and endowments. 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.\6\
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\5\ Congress enacted a virtually identical provision in Dodd-
Frank Act Section 764 which adds Section 15F(h) to the Securities
Exchange Act of 1934 (``Exchange Act'') (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. Section 712(a)(1) of the Dodd-Frank Act
requires that the Commission consult with the Securities and
Exchange Commission and prudential regulators in promulgating rules
pursuant to Section 4s(h).
\6\ 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 this Act''); see also Sections
4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6).
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A. Business Conduct Standards--Dealing With Counterparties Generally
Section 4s(h)(1) grants the Commission authority to promulgate
rules applicable to swap dealers and major swap participants related
to, among other things: Fraud, manipulation and abusive practices
involving swaps; diligent supervision; \7\ and adherence to position
limits.\8\ The proposed rules incorporate the anti-fraud provision for
swap dealers and major swap participants contained in Section 4s(h)(4),
and also would prohibit swap dealers and major swap participants from
disclosing confidential counterparty information, or front running or
trading ahead of counterparty transactions. The Commission also
proposes to adopt certain counterparty-specific supervisory and
compliance duties including a ``know your counterparty'' requirement
and policies and procedures to enforce these business conduct rules and
to prevent evasion of the requirements of the CEA and Commission
Regulations.\9\
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\7\ See also Regulations Establishing and Governing the Duties
of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23,
2010 (proposed Sec. 23.602 imposing additional diligent supervision
requirements on swap dealers and major swap participants).
\8\ Id. (proposed Sec. 23.601 imposing requirements for swap
dealers and major swap participants related to monitoring position
limits).
\9\ Dodd-Frank Act Sections 722(d) (amending CEA Section 2(i)),
723(a)(3) (amending CEA Sections 2(h)(4)(A) and 2(h)(7)(F)) and
741(b)(11) (amending CEA Section 6(e)) amend the CEA by prohibiting
a swap dealer or major swap participant from ``knowingly or
recklessly'' evading certain provisions of the CEA.
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Section 4s(h)(3) directs the Commission to promulgate rules that
would require swap dealers and major swap participants to: Verify the
eligibility of their counterparties; disclose to their counterparties
material information about swaps, including material risks,
characteristics, incentives and conflicts of interest; and provide
counterparties with information concerning the daily mark for swaps.
The Commission also is directed to 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 addition, using its discretionary authority under 4s(h)(3)(D),
the Commission is proposing to require that swap dealers and major swap
participants comply with certain disclosure requirements based on
certain clearing provisions of the Dodd-Frank Act and the CEA.\10\
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\10\ See Sections 2(h)(7)(A) and (B) of the CEA.
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The Commission proposes to use its rulemaking authority under
Section 4s(h) to promulgate several requirements adapted from analogous
standards and practices applicable to certain financial market
professionals. In drafting the proposed rules, the Commission
considered existing requirements for market intermediaries under the
CEA, Commission Regulations and the Federal securities laws, as well as
self-regulatory organization (``SRO'') rules.\11\ The Commission also
considered standards adopted by prudential regulators, industry
recommendations concerning ``best practices'' and requirements
applicable under foreign regulatory regimes.\12\ To the extent
practicable, the Commission has modeled the proposed rules on these
existing rules and standards. Among the proposed requirements that are
based on these analogous rules and standards are: An institutional
suitability requirement for swap dealers and major swap participants
when making recommendations to counterparties; swap execution standards
that would apply to all Commission registrants, including swap dealers,
for swaps available for trading on a designated contract market
(``DCM'') or swap execution facility (``SEF''); and, as part of a swap
dealer's or major swap participant's duty to disclose the material
risks and characteristics of the swap, a duty to provide a scenario
analysis of potential exposure for high-risk complex bilateral swaps,
and on an ``opt-in'' basis scenario analysis for bilateral swaps not
available for trading on a DCM or SEF.\13\ The Commission also is
proposing that both swap dealers and independent representatives of
Special Entities, including those that are registered with the
Commission as
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commodity trading advisors (``CTAs''), be subject to certain
restrictions with respect to political contributions to certain
governmental Special Entities (``pay-to-play'').
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\11\ In this regard, the Commission has looked to the
requirements imposed by the National Futures Association (``NFA''),
CME Group, Inc. (``CME''), IntercontinentalExchange, Inc. (``ICE''),
Financial Industry Regulatory Authority, Inc. (``FINRA'') and the
Municipal Securities Rulemaking Board (``MSRB''). SRO rules, in
particular, provide a useful model because historically the
Commission has relied on SROs to regulate conduct that is unethical
or otherwise undesirable, but may not be fraudulent. See, e.g., NFA
Compliance Rule 2-4, Just and Equitable Principles of Trade.
\12\ See, e.g., International Organization of Securities
Commissions, ``Operational and Financial Risk Management Control
Mechanisms for Over-the-Counter Derivatives Activities of Regulated
Securities Firms'' (Jul. 1994); Derivatives Policy Group,
``Framework for Voluntary Oversight'' (Mar. 1995) (``DPG
Framework''), available at http://www.riskinstitute.ch/137790.htm;
The Counterparty Risk Management Policy Group, ``Improving
Counterparty Risk Management Practices'' (June 1999) (CRMPG is
composed of OTC derivatives dealers including Bank of America, BNP
Paribas, Citigroup, Goldman Sachs, HSBC, JP Morgan and Morgan
Stanley); The Counterparty Risk Management Policy Group, ``Toward
Greater Financial Stability: A Private Sector Perspective--The
Report of the Counterparty Risk Management Policy Group II'' (Jul.
27, 2005); The Counterparty Risk Management Policy Group,
``Containing Systemic Risk: The Road to Reform, The Report of the
CRMPG III (Aug. 6, 2008) (``CRMPG III Report''), available at http:/
/www.crmpolicygroup.org/.
\13\ The CRMPG III Report identifies the characteristics of
high-risk complex bilateral swaps to be: The degree and nature of
leverage, the potential for periods of significantly reduced
liquidity, and the lack of price transparency. The CRMPG III Report,
at 54-57.
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B. Business Conduct Standards--Dealing With Counterparties That Are
Special Entities
Section 4s(h)(4) requires that a swap dealer who ``acts as an
advisor to a Special Entity'' must act in the ``best interests'' of the
Special Entity and undertake ``reasonable efforts'' to obtain
information necessary to determine that a recommended swap is in the
best interests of the Special Entity. The Commission proposes to
incorporate the statutory text in a proposed rule and to specify that
certain swaps-related conduct would be included within the meaning of
the term ``act as an advisor to a Special Entity.''
Section 4s(h)(5) authorizes the Commission to establish duties for
swap dealers and major swap participants that offer swaps or enter into
swaps with Special Entities, including requiring a swap dealer or major
swap participant to have a reasonable basis to believe that the Special
Entity has a representative, independent of the swap dealer or major
swap participant, that meets certain criteria, including having
sufficient knowledge to evaluate the transaction and risks, undertaking
a duty to act in the ``best interests'' of the Special Entity, and
being subject to pay-to-play restrictions. The statute requires swap
dealers and major swap participants to disclose in writing the capacity
in which they are acting before initiating a transaction with a Special
Entity. The Commission is proposing to establish the duties described
in Section 4s(h)(5) for swap dealers and major swap participants
dealing with all categories of Special Entities.
The Dodd-Frank Act requires the Commission to promulgate the
mandatory rules by July 15, 2011.\14\ The Commission requests comment
on all aspects of the proposed rules, as well as comment on the
specific provisions and issues highlighted in the discussion below.
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\14\ See Dodd-Frank Act Sections 712 and 754.
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C. Consultations With Stakeholders
Commission staff held more than two dozen external consultations
\15\ with stakeholders representing a broad spectrum of views on
business conduct standards.\16\ Commission staff conducted many of
these consultations jointly with Securities and Exchange Commission
(``SEC'') staff. The consultations included discussions of the general
nature of counterparty relationships today, counterparty practices
unique to different types of swaps and asset classes, and interpretive
recommendations concerning certain provisions of Section 4s(h).
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\15\ A list of Commission staff consultations in connection with
this proposed rulemaking is posted on the Commission's Web site,
available at http://www.cftc.gov/LawRegulation/DoddFrankAct/
ExternalMeetings/index.htm.
\16\ The Commission received several written submissions from
the public including: National Futures Association, Aug. 25, 2010
(``NFA Letter''); Swap Financial Group, Aug. 9, 2010 (``SFG
Letter''); Swap Financial Group, ``Briefing for SEC/CFTC Joint
Working Group'' Aug. 9, 2010 (``SFG Presentation''); Christopher
Klem, Ropes & Gray LLP, Sept. 2, 2010 (``Ropes & Gray Letter'');
American Benefits Council, Sept. 8, 2010 (``ABC Letter''); American
Benefits Council and the Committee on Investment of Employee Benefit
Assets, Oct. 19, 2010 (``ABC/CIEBA Letter''); and Securities
Industry and Financial Markets Association and International Swaps
and Derivatives Association, Oct. 22, 2010 (``SIFMA/ISDA Letter''),
available at http://www.cftc.gov/LawRegulation/DoddFrankAct/
Rulemakings/OTC_3_BusConductStandardsCP.html.
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D. Consultation and Coordination With the SEC, Prudential Regulators
and Other Domestic and Foreign Regulatory Authorities
In compliance with Sections 712(a)(1) and 752(a) \17\ of the Dodd-
Frank Act, Commission staff has consulted and coordinated with the SEC,
prudential regulators and foreign authorities. Commission staff has
worked closely with SEC staff in the development of the proposed rules.
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. With respect
to the prudential regulators, Commission staff consulted and considered
certain existing business conduct standards that apply to banks.
Commission staff also consulted informally with staff from the
Department of Labor (``DOL'') and the Internal Revenue Service with
respect to certain Special Entity definitions and the intersection of
their regulatory requirements with the Dodd-Frank Act business conduct
provisions.
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\17\ Dodd-Frank Act Section 752(a) states in part, ``the
Commodity Futures Trading Commission, the Securities and Exchange
Commission, and the prudential regulators (as that term is defined
in section 1a(39) of the [CEA]), as appropriate, shall consult and
coordinate with foreign regulatory authorities on the establishment
of consistent international standards with respect to the regulation
(including fees) of swaps * * *.''
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In addition, Commission staff consulted with foreign authorities,
specifically, European Commission and United Kingdom Financial Services
Authority staff. Staff also considered the existing and ongoing work of
the International Organization of Securities Commissions (``IOSCO'').
Staff consultations with foreign authorities revealed many similarities
in the proposed rules and foreign regulatory requirements.\18\
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\18\ 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, available at http://eur-lex.europa.eu/
LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF;
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, available at http://eur-
lex.europa.eu/LexUriServ/
LexUriServ.do?uri=OJ:L:2003:096:0016:0016:EN:PDF.
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II. Proposed Rules for Swap Dealers and Major Swap Participants Dealing
With Counterparties
The proposed business conduct rules dealing with counterparty
relationships are contained in subpart H of new part 23 of the
Commission's regulations.\19\ While the CEA and other provisions of the
Commission's rules will govern swap transactions and the business of
swap dealers and major swap participants, subpart H will contain the
principal regulations governing sales practices and counterparty
relationships. A section-by-section description of the proposed rules
follows.
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\19\ The proposed swap execution Sec. 155.7 would be
promulgated in part 155. All the other proposed rules would appear
in subpart H of new part 23.
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A. Proposed Sec. Sec. 23.400, 23.401 and 23.402--Scope, Definitions
and General Provisions
These proposed rules set out the scope, definitions and general
provisions that apply, as appropriate, to subpart H of new part 23 of
the Commission's regulations. The ``scope'' provision, under proposed
Sec. 23.400, states that the rules in subpart H apply to swap dealers
and major swap participants and that the rules do not limit the
applicability of other provisions of the CEA, Commission Regulations or
other laws.\20\ So, for example, in addition to the anti-fraud
provision that would apply only to swap dealers and major swap
participants in proposed Sec. 23.410, swap dealers and major swap
participants will be subject to all other applicable anti-fraud
provisions in the CEA and
[[Page 80641]]
Commission Regulations, as appropriate.\21\ The scope section also
provides that, where appropriate, the rules also apply to swaps offered
but not entered into. For example, the fair and balanced communications
and fair dealing requirements in proposed Sec. 23.433 apply to swap
dealers and major swap participants with respect to both counterparties
and prospective counterparties.
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\20\ In addition to its obligations under the proposed rules, to
the extent a swap dealer or major swap participant is required to be
a member of a registered futures association it would be required to
comply as well with the business conduct and other requirements of
NFA and any other applicable SROs.
\21\ See, e.g., Section 4b of the CEA.
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The proposed rules under subpart H will have most applicability
when swap dealers and major swap participants have a pre-trade
relationship with their counterparty, where that relationship includes
discussions and negotiations that would allow a swap dealer or major
swap participant to make appropriate disclosures and conduct due
diligence. Indeed, when a swap is initiated on a DCM or SEF and the
swap dealer or major swap participant does not know the counterparty's
identity prior to execution, disclosure and due diligence obligations,
such as the duties to verify counterparty eligibility under proposed
Sec. 23.430, to disclose material information under proposed Sec.
23.431, and the duty to verify that a Special Entity has a qualified
representative under proposed Sec. 23.450, would not apply because
there would be no basis on which to make those disclosures or
opportunity to engage in discussions. However, when a swap dealer or
major swap participant does not know the counterparty's identity pre-
execution, but does become aware of the counterparty's identity post-
execution of a bilateral swap, the swap dealer or major swap
participant would still have certain specific duties such as the one to
provide a daily mark in proposed Sec. 23.431(c)(2), (3).
The Commission also proposes to define several terms for purposes
of subpart H in proposed Sec. 23.401. The term ``counterparty'' would
include ``prospective counterparty'' as appropriate in the rules. The
terms swap dealer and major swap participant would include anyone
acting for or on behalf of such persons, including associated persons
as defined in Section 1a(4) of the CEA. Proposed Sec. 23.401 adopts
the definition of Special Entity in Section 4s(h)(2). Additional terms
are defined in the proposed rules relating to Special Entities.
The ``general provisions'' for subpart H that are specified in
proposed Sec. 23.402 include a requirement that swap dealers and major
swap participants have policies and procedures reasonably designed to
ensure compliance with the business conduct rules in subpart H and, in
particular, to prevent a swap dealer or major swap participant from
evading any provision of the CEA or Commission Regulations. For
example, for a swap that is subject to mandatory clearing, a swap
dealer or major swap participant should only be offering to enter into
such a swap on an uncleared basis with a counterparty who has qualified
for a valid end-user exception to the mandatory clearing of swaps.\22\
The Commission expects that these policies and procedures would be part
of a swap dealer's or major swap participant's overall system of
supervision, compliance and risk management.\23\
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\22\ Separately, the Commission is proposing rules detailing
when a counterparty may elect to use the exception to mandatory
clearing under section 2(h)(7)(A)(iii) of the CEA.
\23\ Separately, the Commission is proposing rules detailing the
supervision, compliance and risk management obligations for swap
dealers and major swap participants. See 75 FR 71397, Nov. 23, 2010.
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Section 4s(h)(1)(B) gives the Commission the authority to prescribe
rules relating to diligent supervision by swap dealers and major swap
participants. In a separate release containing internal business
conduct rules, the Commission has proposed comprehensive supervision
and risk management program duties on swap dealers and major swap
participants contained in new subpart J of part 23 of the Commission's
Regulations.\24\ Proposed Sec. 23.402(b) would require swap dealers
and major swap participants to diligently supervise their dealings with
counterparties as required under subpart H in accordance with the
diligent supervision requirements of subpart J.
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\24\ See proposed Sec. Sec. 23.600 and 23.602, 75 FR 71397,
Nov. 23, 2010.
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Proposed Sec. 23.402(c) would establish a ``know your
counterparty'' requirement on swap dealers and major swap
participants.\25\ The proposed requirement would include the use of
reasonable due diligence to know and retain a record of the essential
facts concerning the counterparty, including information necessary to
comply with the law, to service the counterparty, to implement a
counterparty's special instructions, and to evaluate the counterparty's
swaps experience and objectives. The proposed rule also 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.''
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\25\ This rule is based in part on 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. See NFA Interpretive
Notice 9013.
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Proposed Sec. 23.402(d) would require swap dealers and major swap
participants to keep a record showing the true name and address of each
counterparty, as well as a counterparty's address and the same
information for any other person guaranteeing the counterparty's
performance or controlling the counterparty's positions. This proposed
rule is based on existing Sec. 1.37(a)(1) \26\ of the Commission's
Regulations which applies to futures commission merchants, introducing
brokers and members of a designated contract market.
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\26\ 17 CFR 1.37(a)(1).
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Another general provision, under proposed Sec. 23.402(e), states
that swap dealers and major swap participants that seek to rely on the
representations of their counterparties to satisfy any requirements in
the proposed rules must have a reasonable basis to believe that the
representations are reliable under the circumstances. In addition, the
representations must be sufficiently detailed to enable the swap dealer
or major swap participant to reasonably conclude that the particular
requirement is satisfied. Proposed Sec. 23.402(e) would allow the
parties to a swap to agree that such representations can be included in
a master agreement \27\ 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. For example,
particular counterparty representations about its sophistication or
financial wherewithal relevant to the institutional suitability
obligation imposed on swap dealers and major swap participants in
proposed Sec. 23.434 may be contained in a master agreement, if agreed
by the parties, and may be applied to subsequent swaps between the
parties if the representations continue to be accurate
[[Page 80642]]
and relevant with respect to the subsequent swaps.
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\27\ The Commission understands that swaps are generally
governed by a master agreement and confirmation setting forth the
relationship of the counterparties and the particulars of the
transaction. Master agreements, which have typically been standard
form agreements prepared by industry associations like the
International Swaps and Derivatives Association (``ISDA''), include
basic representations and covenants that are subject to negotiation
by the parties and are supplemented with modifications to account
for their specific interests. Master agreements contain terms that
govern all succeeding swaps between the counterparties, and
generally include provisions applicable to all swaps including:
Payment netting, events of default, cross-default provisions, early
termination events and closeout netting.
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Proposed Sec. 23.402(f) would provide flexibility to swap dealers,
major swap participants and their counterparties to agree to a reliable
means for making disclosures of material information. Furthermore,
proposed Sec. 23.402(g) would also allow 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 other written agreement between the parties, if agreed to by
the parties. While standardized disclosures may be appropriate to meet
certain disclosure obligations relating to the risks, characteristics,
incentives and conflicts of interest related to a particular swap, it
is unlikely that they would be adequate to meet all such disclosure
duties. Swap dealers and major swap participants are cautioned to
consider their disclosure obligations under the CEA and proposed rules
with respect to each swap that they offer or enter into with a
counterparty.
Finally, proposed Sec. 23.402(h) would require swap dealers and
major swap participants to create and retain a written record of their
compliance with the requirements in subpart H. Such requirements would
be part of the overall recordkeeping obligations imposed on swap
dealers and major swap participants in the CEA and part 23 supbart F of
the Commission's Regulations, would be maintained in accordance with
Sec. 1.31 \28\ of the Commission's Regulations, and would be
accessible to applicable prudential regulators.
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\28\ 17 CFR 1.31.
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding scope, general provisions and
definitions, and specifically on the following specific issues:
Should the Commission adopt any of the guidance from SRO
rules relating to know your customer requirements? Is other guidance
necessary in this area?
Are there additional terms that should be defined by the
Commission? If so, how should such terms be defined and why?
Do any proposed requirements conflict with any requirement
imposed by an SRO such that it would be impracticable or impossible for
a swap dealer or major swap participant that is a member of an SRO to
meet both obligations? If so, which ones and why?
Should the Commission specify any particular restrictions
or prohibitions to further protect against evasion?
B. Proposed Sec. 23.410--Prohibition on Fraud, Manipulation and Other
Abusive Practices
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.\29\ To implement this provision the Commission proposes to
adopt the anti-fraud provision in Section 4s(h)(4)(A) as Sec. 23.410,
which prohibits fraudulent, deceptive and manipulative practices by
swap dealers and major swap participants.\30\ While the heading of
Section 4s(h)(4) states ``Special Requirements for Swap Dealers Acting
as Advisors,'' the anti-fraud provision that follows in Section
4s(h)(4)(A) is not so limited. The proposed rule follows the statutory
text and applies to swap dealers and major swap participants acting in
any capacity, e.g., as an advisor, counterparty or other market
participant in relation to counterparties generally. The first two
paragraphs of the rule focus on Special Entities and prohibit 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 is not
limited to Special Entities and prohibits swap dealers and major swap
participants from engaging in any act, practice, or course of business
that is fraudulent, deceptive or manipulative.\31\
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\29\ On October 26, 2010, the Commission proposed rules to
implement new anti-manipulation authority in Section 753 of the
Dodd-Frank Act. The proposed rules expand and codify the
Commission's authority to prohibit manipulation. 75 FR 67657, Nov.
3, 2010. The same day, the Commission issued an advance notice of
proposed rulemaking seeking comment on Section 747 of the Dodd-Frank
Act, which amends Section 4c(a) of the CEA to expressly prohibit
certain trading practices deemed disruptive of fair and equitable
trading. 75 FR 67301, Nov. 2, 2010.
\30\ In addition to the proposed anti-fraud rule, swap dealers
and major swap participants will be 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), (3)
and 9(a)(2) of the CEA).
\31\ This language mirrors 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 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 * * *.'') (citations
omitted).
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The Commission also proposes Sec. Sec. 23.410(b) and 23.410(c),
which would prohibit swap dealers and major swap participants from
disclosing confidential counterparty information and front running or
trading ahead of counterparty swap transactions.\32\ These rules are
based on trading standards applicable to futures commission merchants
and introducing brokers that prohibit trading ahead of a customer and
protect the confidentiality of customer orders.\33\ Such abuses are
considered fraudulent practices.\34\ Viewed together, proposed
Sec. Sec. 23. 410(b) and 23.410(c) build on the code of ethics
requirements and informational barriers in proposed subpart J which add
substantial protections for counterparties from abuse of their
confidential information and business opportunities.
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\32\ 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. Jul. 15, 2010) (statement of Sen. Lincoln). In
consultations with stakeholders, Commission staff has learned that
these concerns apply more generally to all counterparties, rather
than exclusively to Special Entities. Thus, the Commission proposes
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.
\33\ See, e.g., 17 CFR 155.3-4; cf. Market Abuse Directive, at
Para. 19, Art. 1(1) (prohibiting the misuse of confidential customer
information and front running). The proposed rule would make clear
that the confidentiality requirements do not apply when disclosure
is made upon request of the Commission, Department of Justice or an
applicable prudential regulator.
\34\ See, e.g., United States v. Dial, 757 F.2d 163, 168 (7th
Cir. 1985).
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding fraud, manipulation, and abusive
practices, and on the following specific issues:
Should a swap dealer or major swap participant be required
to disclose to a counterparty its pre-existing positions in a type of
swap prior to entering into the same type of swap with the
counterparty?
Should the prohibitions on trading ahead of a counterparty
transaction and disclosure of confidential counterparty information be
limited in any way not already provided in the proposed rule? For
example, if a counterparty discusses a potential swap but does not
immediately enter into it with the swap
[[Page 80643]]
dealer or major swap participant, should there be a limit on the time
during which the swap dealer or major swap participant must refrain
from trading on or otherwise disclosing the counterparty's information?
Are there other specific fraudulent, manipulative or
abusive practices by swap dealers and major swap participants that
should be prohibited in these proposed rules? If so, how would they
assist in protecting swap markets and counterparties? Are there gaps in
the existing requirements that should be filled here?
C. Proposed Sec. 23.430--Verification of Counterparty Eligibility
The Dodd-Frank Act makes it unlawful for any person, other than an
eligible contract participant (``ECP''),\35\ to enter into a swap
unless it is executed on or subject to the rules of a designated
contract market.\36\ Section 4s(h)(3)(A) also requires the Commission
to establish a duty for a swap dealer or major swap participant to
verify that any counterparty meets the eligibility standards for an
ECP. Proposed Sec. 23.430 would require swap dealers and major swap
participants to verify that a counterparty meets the definition of an
ECP prior to offering or entering into a swap. The proposed rule also
would require a swap dealer or major swap participant to determine
whether the counterparty is a Special Entity as defined in Section
4s(h)(2) and proposed Sec. 23.401.
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\35\ ``Eligible contract participant'' is a defined term in
Section 1a(18) of the CEA.
\36\ See Section 2(e) of the CEA.
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The Commission contemplates 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.\37\ 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 by the parties, could be
deemed to be renewed with each subsequent swap transaction, absent any
facts or circumstances to the contrary.\38\
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\37\ This position is consistent with industry comment. See,
e.g., NFA Letter, at 2 (recommending the Commission adopt a rule
modeled after NFA Compliance Rule 2-23, which permits NFA members to
rely on information provided by the customer to satisfy the member's
know-your-customer obligations).
\38\ Certain industry comments support this approach. See, e.g.,
NFA Letter, at 2; SIFMA/ISDA Letter, at 12.
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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.\39\
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\39\ This rule tracks the statutory language in Section
4s(h)(7).
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding verification of counterparties as
ECPs and Special Entities, and on the following specific issues:
Should there be an ongoing, affirmative duty to verify
eligibility? If so, how would it be met? Would the swap dealer or major
swap participant's duty change in any way if the ECP status of the
counterparty changes after the swap has been entered into?
Are there particular ``red flags'' that should indicate a
need for a swap dealer or major swap participant to obtain additional
information about the status of the counterparty as an ECP or Special
Entity?
D. Proposed Sec. 23.431--Disclosure of Material Risks,
Characteristics, Material Incentives and Conflicts of Interest
Regarding a Swap
Section 4(s)(h)(3)(B) requires swap dealers and major swap
participants to disclose to their counterparties material information
about the risks, characteristics, incentives and conflicts of interest
regarding a swap. The requirements do not apply if both counterparties
are any of the following: Swap dealer, major swap participant,
security-based swap dealer or major security-based swap participant.
Proposed Sec. 23.431 would implement the statutory disclosure
requirements and provide specificity with respect to certain material
information that must be disclosed under the rule. Information is
material if there is a substantial likelihood that a reasonable
counterparty would consider it important in making a swap related
decision.\40\
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\40\ 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)).
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1. Timing and Manner of Disclosures
The Dodd-Frank Act does not address the timing and form of the
required disclosures. Proposed Sec. 23.431(a) would require that the
disclosures be made before entering into a swap and in a manner
reasonably designed to allow the counterparty to assess the
disclosures. To satisfy its obligation, the swap dealer or major swap
participant would also be required to make such disclosures at a time
prior to entering into the swap that was reasonably sufficient to allow
the counterparty to assess the disclosures. Swap dealers and major swap
participants would have flexibility to make these disclosures using
reliable means agreed to by the parties, as provided in proposed Sec.
23.402(f).\41\
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\41\ Additionally, under proposed Sec. 23.402(h), swap dealers
and major swap participants would be required to maintain a record
of their compliance with the proposed rules.
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Standardized disclosure of some required information may be
appropriate if the information is applicable to multiple swaps of a
particular type and class.\42\ As discussed below, the Commission
believes that most bespoke transactions, however, will require some
combination of standardized and particularized disclosures.
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\42\ Cf. SIFMA/ISDA 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).
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2. Disclosure of Material Risks
The proposed rule tracks the statutory obligations under Section
4s(h)(3)(B)(i) and would require 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 anticipates
that swap dealers and major swap participants typically will rely on a
combination of general and more particularized disclosures to satisfy
this requirement. The Commission understands that there are certain
types of risks that are associated with swaps generally, including
market,\43\ credit,\44\ operational,\45\ and liquidity risks.\46\
Required risk disclosure would include sufficient information to enable
a
[[Page 80644]]
counterparty to assess its potential exposure during the term of the
swap and at expiration or upon early termination. 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.\47\ 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.
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\43\ Market risk refers to the risk to a counterparty's
financial condition resulting from adverse movements in the level or
volatility of market prices.
\44\ Credit risk refers to the risk that a party to a swap will
fail to perform on an obligation under the swap.
\45\ Operational risk refers to the risk that deficiencies in
information systems or internal controls, including human error,
will result in unexpected loss.
\46\ 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.
\47\ See CRMPG III Report, at 60.
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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.
Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding material risk disclosures for swaps
and on the following specific issues:
Are there specific material risks that the Commission
should require a swap dealer or major swap participant to disclose to a
counterparty? Are there specific risks that should be disclosed with
respect to particular types of swaps, asset classes and trading venues?
NFA and SIFMA/ISDA submitted letters that have suggested
that the Commission develop a standard form risk disclosure statement
for certain generic-type disclosures, similar to those used today for
futures, options and retail foreign currency transactions.\48\ Should
the Commission undertake such an effort? Should the Commission
encourage the industry or SROs to develop such disclosures, in
addition, or instead? If it would be beneficial to have such forms, why
has the industry not developed such a standard form to date? Would
standard form disclosure be inconsistent with the requirement that
disclosures be based on the facts and circumstances presented by each
swap and counterparty?
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\48\ See NFA Letter, at 2; SIFMA/ISDA Letter, at 12.
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Are there other ways for the Commission to describe the
risk disclosure duty required by the CEA that would provide additional
guidance or clarify the obligation?
Should the rule distinguish explicitly risk disclosure
requirements for SEF or DCM traded swaps versus bilateral swaps?
3. Scenario Analysis for High-Risk Complex Bilateral Swaps and
Counterparty ``Opt-In'' for Bilateral Swaps Not Available for Trading
on a Designated Contract Market or Swap Execution Facility
The Commission is proposing that swap dealers and major swap
participants be required to provide scenario analyses when they offer
to enter into high-risk complex bilateral swaps to allow the
counterparty to assess its potential exposure in connection with the
swap.\49\ In addition, the rule would allow counterparties to elect to
receive scenario analysis when offered bilateral swaps that are not
available for trading on a DCM or SEF. The elective aspect of the rule
reflects the expectation that there may be circumstances where scenario
analysis may be helpful for certain counterparties, even for swaps that
are not high-risk complex. Proposed Sec. 23.431(a)(1) is modeled on
the CRMPG III industry best practices recommendation for high-risk
complex financial instruments.\50\
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\49\ Scenario analysis is in addition to required disclosures
for swaps which do not qualify as high-risk complex. Such required
disclosures include a clear explanation of the economics of the
instrument.
\50\ CRMPG III Report, at 60-61.
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a. High-Risk Complex Bilateral Swap: Characteristics
The rule's mandatory scenario analysis delivery requirement would
apply only when ``high-risk complex bilateral swaps'' are offered or
recommended. Like the industry ``best practice'' recommendation, the
term ``high-risk complex bilateral swap'' is not defined in the
proposed rule; rather, certain flexible characteristics are identified
to avoid over inclusive and under inclusive concerns. The
characteristics are: The degree and nature of leverage,\51\ the
potential for periods of significantly reduced liquidity, and the lack
of price transparency.\52\ The proposed rule would require 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).
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\51\ The leverage characteristic is particularly relevant when
the swap includes an embedded option, including one in which the
counterparty is ``short'' or selling volatility. Such features can
significantly increase counterparty risk exposure in ways that are
not transparent.
\52\ CRMPG III Report states that:
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. CRMPG III Report, at 56.
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b. Market Risk Disclosures: Scenario Analysis
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.\53\ 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 would require 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
would require that all material assumptions underlying a given scenario
and its impact on swap valuation be disclosed.\54\ In requiring such
disclosures, however, the Commission does not propose to require swap
dealers or major swap participants to disclose proprietary information
about any pricing models.
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\53\ 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.
\54\ Material assumptions include: (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.
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The Commission does not propose to define the parameters of the
scenario analysis in order to provide flexibility to the parties to
design the analyses in accordance with the characteristics of the
bespoke swap at issue, as well as any criteria developed in
consultations with the counterparty. Further, the proposed rule would
require swap dealers and major swap participants to consider relevant
internal risk analyses including any new product reviews when designing
the analyses.\55\ As for the format, the proposed rule would require
both narrative and tabular expressions of the analyses.
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\55\ The Commission has proposed that swap dealers and major
swap participants adopt policies and procedures regarding a new
product policy as part of the risk management system. See proposed
Sec. 23.600(c)(3), 75 FR 71397, Nov. 23, 2010.
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To ensure fair and balanced communications and to avoid misleading
counterparties, swap dealers and major swap participants also would
[[Page 80645]]
be 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's proposed rule is aligned with longstanding
industry best practice recommendations,\56\ and indeed, several large
swap dealers told Commission staff that they provide scenario analysis
upon request and without separate charge to counterparties today.
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\56\ See DPG Framework, at Part V(II)(G); but see SIFMA/ISDA
Letter, at 13-14.
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding required scenario analysis for
high-risk complex bilateral swaps and opt-in scenario analysis for
swaps not available for trading on a DCM or SEF and on the following
specific issues:
Regarding high-risk complex bilateral swaps, should other
characteristics be added to the rule? Should any of the proposed high-
risk complex bilateral swap characteristics be deleted or modified?
Instead of high-risk complex bilateral swaps, should the
Commission require scenario analysis for all swaps that are: (1) Not
accepted or listed for clearing on a derivatives clearing organization
(``DCO''), or alternatively, (2) uncleared? What are the costs/benefits
of changing the requirement to option one or option two?
Regarding scenario analysis, should a swap dealer/major
swap participant be required to provide such analysis for any swap upon
reasonable request by any counterparty? Would there be a charge to
counterparties that elect to ``opt-in''? How much on average would it
cost? If the cost varies by swap type or asset class, provide an
average cost by category. What are the costs and benefits to swap
dealers and major swap participants and counterparties associated with
scenario analysis?
Are there certain types of counterparties for which a
scenario analysis should always be provided? If so, which ones and why?
Should swap dealers and major swap participants be able to
avoid their duty to provide scenario analysis if a counterparty opts
out of receiving it?
Should a Value at Risk (``VaR'') type analysis be part of
the mandatory scenario analysis?
In the event that a swap dealer or major swap participant
elects to disclose a VaR type analysis, should any minimum parameters
apply? For instance, should there be any required confidence levels
such as 95 percent or 99 percent? Should there be any minimum standards
regarding the type of VaR model chosen? Should there be a required time
horizon such as the time between payments, the expected time to
liquidate the position, or something else?
4. Material Characteristics
The proposed rule would require swap dealers and major swap
participants to include in their disclosures of material
characteristics, 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 Commission intends that the material characteristics
would include the material terms of the swap that would be included in
any ``confirmation'' of any swap sent by the swap dealer or major swap
participant to the counterparty upon execution.
5. Material Incentives and Conflicts of Interest
The proposed rule tracks the statutory language under Section
4s(h)(3)(B)(ii) and would require 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 the particular swap. Several stakeholders
recommended that the Commission require added transparency concerning
the components that make up the price of a transaction. In response,
the Commission proposes that swap dealers and major swap participants
be required to include with the price of a 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 would be required to disclose any
compensation or benefit that they receive from any third party in
connection with the swap. In connection with any recommended swap, swap
dealers and major swap participants would be 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. With respect to conflicts
of interest, the Commission expects such disclosure to include the
inherent conflicts in a counterparty relationship, particularly when
the swap dealer or major swap participant recommends the transaction.
The Commission also expects 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 conflict of interests that require
disclosure.\57\
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\57\ This may exist, for example, when the swap dealer or major
swap participant acts both as an underwriter in a bond offering and
as a 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.
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding material incentives and conflicts
of interest and on the following specific issues:
Should the Commission impose more specific requirements
concerning the content of the required disclosures generally?
Should the Commission require swap dealers and major swap
participants to disclose their profit? If so, how should a swap dealer
or major swap participant be required to compute profitability for
purposes of the rule?
6. Daily Mark
Section 4s(h)(3)(B) directs the Commission to adopt rules that
require: (1) For cleared swaps, upon request of the counterparty,
receipt of the daily mark from the appropriate DCO; and (2) for
uncleared swaps, receipt of the daily mark of the swap from the swap
dealer or major swap participant. The term ``daily mark'' is not
defined in the statute, and the Commission understands that the term
``mark'' is used colloquially to refer to various types of valuation
information.
a. Cleared Swaps
For a cleared swap, proposed Sec. 23.431(c)(1) would require the
swap dealer or major swap participant to notify a counterparty of their
right to receive, upon request, the daily mark from the appropriate
DCO.
b. Uncleared Swaps
For uncleared swaps, proposed Sec. 23.431(c)(2) and (3) would
require a swap dealer or major swap participant to provide a daily mark
to its counterparty 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 is proposing to define daily mark for uncleared
swaps as the mid-market value of the swap,\58\ which shall
[[Page 80646]]
not include amounts for profit, credit reserve, hedging, funding,
liquidity or any other costs or adjustments.\59\ Based on staff
consultations, the consensus was that mid-market value is a transparent
measure that would assist counterparties in calculating valuations for
their own internal risk management purposes. Further, the Commission is
proposing 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 understands that the daily mark for certain
bespoke swaps may be generated using proprietary models. The proposed
rule does not require the swap dealer or major swap participant to
disclose proprietary information relating to its model.
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\58\ Cf. SIFMA and ISDA assert that ``[b]y market convention and
often by contract, parties generally agree to utilize a mid-market
level for margin purposes. Counterparties understand that this level
does not represent a valuation at which a transaction may be entered
into or terminated and accordingly may differ from actual market
prices. We recommend that the Commissions endorse this use of mid-
market levels for margin purposes as a uniform market practice.''
SIFMA/ISDA Letter, at 17.
\59\ 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.
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Lastly, the Commission proposes that swap dealers and major swap
participants provide appropriate clarifying statements relating to the
daily mark. Such disclosures may 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; \60\ nor (3) the value of
the swap that is marked on the books of the swap dealer or major swap
participant.\61\
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\60\ But see SIFMA/ISDA Letter at 17 (asserting that mid-market
level is market convention for margin purposes and not a quote for
entering into a transaction or terminating the swap).
\61\ See also Trading & Capital-Markets Activities Manual,
section 2150.1 (Bd. of Gov. Fed. Reserve Sys. Jan. 2009) (``Trading
& Capital-Markets Activities Manual'') (``When providing a quote to
a counterparty, institutions should be careful that the counterparty
does not confuse indicative quotes with firm prices. Firms receiving
dealer quotes should be aware that these values may not be the same
as those used by the dealer for its internal purposes and may not
represent other `market' or model-based valuations.''), available at
http://www.federalreserve.gov/boarddocs/supmanual/trading/200901/
0901trading.pdf.
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Industry representatives have asked whether swap dealers and major
swap participants may satisfy their obligations to provide daily marks
for uncleared swaps by making the relevant information available to
counterparties through password protected access to a webpage
containing the relevant information.\62\ Proposed Sec. 23.402(f) would
permit swap dealers and major swap participants to provide daily marks
by any reliable means agreed to in writing by the counterparty.
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\62\ SIFMA/ISDA Letter, at 17; NFA Letter, at 3.
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Request for Comment: The Commission requests comments generally on
the daily mark and on the following specific issues:
Should the Commission define the daily mark for uncleared
swaps as proposed, on a different basis, or should it be subject to
negotiation by the parties? If so, why?
In addition to the daily mark as defined in the proposed
rule, should the Commission require that swap dealers or major swap
participants provide executable quotes to counterparties upon request?
Should this be left to negotiations between the parties?
E. Proposed Sec. 23.432--Clearing
For swaps where clearing is mandatory,\63\ proposed Sec. 23.432(a)
would require that a swap dealer or major swap participant notify the
counterparty that the counterparty has the sole right to select the DCO
that will 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 must 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.\64\ Neither of these notification
provisions would apply where the counterparty is a registered swap
dealer, major swap participant, security-based swap dealer, or major
security-based swap participant.
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\63\ See Section 2(h) of the CEA.
\64\ With respect to these proposed disclosure requirements, the
Commission notes that, as between the parties, the counterparty is
entitled to choose whether and where to clear, but that no DCM or
SEF must make clearing available through any DCO. In other words, it
would be up to the parties to take the swap to a DCM or SEF that
provides for clearing through the counterparty's preferred DCO.
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding clearing, and on the following
specific issues:
Are there additional disclosures that a swap dealer or
major swap participant should be required to make with respect to
clearing of swaps?
F. Proposed Sec. 23.433--Communications--Fair Dealing
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 would establish such a duty and, consistent with
statutory language, would apply broadly to all swap dealer and major
swap participant communications with counterparties. These principles
are well established in the futures and securities markets,
particularly through SRO rules.\65\ For example, the duty to
communicate in a fair and balanced manner is one of the primary
requirements of the NFA customer communication rule \66\ 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 expects that a swap dealer or major
swap participant would consider factors such as whether the
communication: (1) Provides a sound basis for evaluating the facts with
respect to any swap; \67\ (2) avoids making exaggerated or unwarranted
claims, opinions or forecasts; \68\ and (3) balances any statement that
refers to the potential opportunities or advantages presented by a swap
with statements of corresponding risks. The Commission also would
expect that to deal fairly would require the swap dealer or major swap
participant to treat counterparties in such a way so as not to
advantage one counterparty or group of counterparties over another.
Additionally, communications would be subject to the specific anti-
fraud provisions of the CEA and Commission Regulations, as well as
applicable SRO rules, if swap dealers and major swap participants are
required to be SRO members.
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\65\ 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.
\66\ See, e.g., NFA Compliance Rule 2-29(b)(2), (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).
\67\ 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 * * *'').
\68\ See, e.g., NFA Compliance Rule 2-29(b)(4)-(5).
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Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding fair and balanced communications,
and on the following specific issues:
Should the Commission specify in its final rule any
additional
[[Page 80647]]
requirements necessary to satisfy the duty? If so, what?
Should the Commission specify additional considerations in
the rule to guide compliance with the rule? Should the Commission adopt
interpretive guidance, instead or in addition?
G. Proposed Sec. 23.434--Recommendations to Counterparties--
Institutional Suitability
To determine whether the Commission should use its discretionary
authority under new Section 4s(h), the Commission considered
requirements for professionals in other markets and in other
jurisdictions. One common requirement is a suitability obligation which
is imposed when a market professional recommends a product to a
customer, including institutional or sophisticated customers. For
example, federally regulated banks acting as broker-dealers for
government securities have an institutional suitability obligation when
making recommendations to institutional customers.\69\ Securities
broker-dealers are also subject to a suitability obligation when
recommending any securities to an institutional customer.\70\ Municipal
securities dealers have a suitability obligation for any municipal
security offered to a ``sophisticated municipal market professional.''
\71\ And, in the European Union, investment services firms have a
suitability obligation with respect to financial instruments
recommended to ``professional clients'' under MiFID.\72\
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\69\ See, e.g., 12 CFR 13.4; Trading & Capital-Markets
Activities Manual, Section 2150.
\70\ See NASD Rule 2310, Recommendations to Customers
(Suitability); see also proposed FINRA Rule 2111 (Suitability), 75
FR 53562, Aug. 26, 2010.
\71\ See Municipal Securities Rulemaking Board Rule G-19,
Suitability of Recommendations and Transactions; Discretionary
Accounts.
\72\ MiFID Art. 19(3). ``Professional clients'' under MiFID
include certain financial institutions, insurance companies, pension
funds, and other entities. See MiFID Art. 19(4), Annex II.
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In light of its broad application in other markets and
jurisdictions, the Commission proposes 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. The Commission recognizes that futures market
professionals have not been subject to an explicit ``suitability''
obligation.\73\ Instead, such professionals have been required to meet
a variety of related requirements, including NFA ``know your customer''
duties,\74\ mandatory standard form risk disclosure,\75\ NFA's fair and
balanced communication rules and just and equitable principles,\76\ and
general anti-fraud provisions.\77\ These requirements developed to
address the risks and characteristics of standardized exchange-traded
futures and options contracts. Because the definition of swap includes
a variety of different types of financial instruments and those
instruments can be customized to have a wide range of risk/reward
profiles, the Commission believes that standard risk disclosure, alone,
may not be sufficient to ensure that counterparties understand their
potential exposure. The Commission also has considered that many swap
dealers and major swap participants already are, or will be, subject to
institutional suitability obligations by virtue of their status as
banks, broker-dealers or security-based swap dealers. Thus, to promote
regulatory consistency \78\ and to take account of the nature of swaps,
the Commission proposes to adopt an institutional suitability
obligation for swap dealers and major swap participants, modeled, in
part, on existing obligations for banks and broker-dealers dealing with
institutional clients.
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\73\ The proposed institutional suitability obligation would
apply only to swap dealers and major swap participants, and only
when they make swap recommendations, not futures.
\74\ NFA Compliance Rule 2-30, Customer Information and Risk
Disclosure; NFA Interpretive Notice 901--NFA Compliance Rule 2-30:
Customer Information and Risk Disclosure.
\75\ 17 CFR 1.55.
\76\ NFA Compliance Rules 2-29, 2-36, Requirements for Forex
Transactions.
\77\ See, e.g., Section 4b of the CEA and Sec. Sec. 32.9, 33.10
of the Commission's Regulations (17 CFR 32.9, 33.10).
\78\ See, e.g., 12 CFR 13.4; Trading & Capital-Markets
Activities Manual, section 2150.
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Proposed Sec. 23.434 would require a swap dealer or major swap
participant to have reasonable grounds to believe that any
recommendation for a swap or trading strategy involving swaps is
suitable for its counterparty.\79\ A suitability determination would be
based upon information the swap dealer or major swap participant
obtains 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.
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\79\ The rule would not apply to recommendations made to
counterparties that are swap dealers, major swap participants,
security-based swap dealers or major security-based swap
participants.
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A swap dealer or major swap participant could rely on counterparty
representations to satisfy its suitability obligations if: (1) It had a
reasonable basis to believe that the counterparty was capable of
independently evaluating relevant risks with regard to the particular
swap or trading strategy; (2) the counterparty had affirmatively
indicated that it was exercising independent judgment in evaluating any
recommendations; \80\ and (3) the swap dealer or major swap participant
had a reasonable basis to believe that the counterparty had the
capacity to absorb potential losses related to the recommended swap or
swap trading strategy. To the extent that a swap dealer or major swap
participant cannot rely on a counterparty's representations as
contemplated by proposed Sec. 23.434, it would need to undertake a
suitability analysis as set forth in the rule.
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\80\ A counterparty may indicate that it is exercising
independent judgment on one or more particular swaps or types of
swaps, or in terms of all swaps.
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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, 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.\81\ In implementing the proposed institutional
suitability rule, the Commission intends to consult relevant precedents
and interpretive guidance under Federal securities and banking
requirements in the United States.\82\
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\81\ NASD Notice to Members 01-23 (April 2001); FINRA Proposed
Suitability Rule, 75 FR 52562, 52564-69, Aug. 26, 2010.
\82\ See, e.g., 12 CFR 13.4, 208.25(d), 368.4. In 1997, the
Federal banking agencies offered the following guidance regarding
recommendations in the context of government securities sales
practices: ``While the agencies do not believe it is appropriate to
define the term `recommendation,' they note that they would not view
the provision of general market information, including market
observations, forecasts about interest rates, and price quotations,
as making a recommendation under the rule, absent other conduct.''
62 FR 13276, 13280, Mar. 19, 1997.
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The Commission notes that swap dealers and major swap participants
are likely to be acting as CTAs \83\ when they
[[Page 80648]]
make recommendations, particularly recommendations tailored to the
needs of their counterparty. As such, they would be subject to any
additional duties that might be applicable to CTAs under the CEA and
Commission Regulations, including registration requirements and Section
4o of the CEA, the anti-fraud provision that applies to CTAs and
commodity pool operators.\84\
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\83\ Section 1a(12) of the CEA defines a commodity trading
advisor, in relevant part, as any person who, for compensation or
profit, trades, or advises (either directly or through publications,
writings, or electronic media) as to the value of, or the
advisability of trading in, a commodity for future delivery, or
swap. Section 1a(12)(B) of the CEA excludes from the definition of
commodity trading advisor a variety of persons, but only if a
person's commodity advice is solely incidental to the conduct of its
principal business or profession. The excluded persons include (i)
banks and trust companies and their employees, (ii) news reporters,
news columnists, and news editors of print or electronic media,
(iii) lawyers, accountants, and teachers, (iv) floor brokers and
futures commission merchants, (v) publishers and producers of any
print or electronic data of general and regular dissemination,
including their employees, (vi) fiduciaries of defined benefit plans
subject to ERISA, (vii) contract markets, and (viii) other persons
that the CFTC, by rule, regulation, or order, may exclude as ``not
within the intent of'' the definition. The revised definition does
not exclude swap dealers whose advice is solely incidental to their
swap dealer activities. Therefore, any ``advisory'' activities by a
swap dealer could bring it within the statutory definition of a
commodity trading advisor.
\84\ Depending on the nature of the relationship, swap dealers
might also have common law fiduciary duties to their counterparties.
Cf. Commodity Trend Serv., Inc. v. CFTC, 233 F.3d 981, 990 (7th Cir.
2000).
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Request for Comment: The Commission requests comments generally on
the proposed rules regarding recommendations and the following specific
issues:
Should the Commission adopt a suitability obligation for
swaps in the absence of such an explicit requirement for exchange
traded futures and options? Have securities-style suitability
obligations for institutional customers had demonstrable benefits for
such customers? If so, provide examples.
Are there additional factors that swap dealers or major
swap participants should consider in determining whether a particular
swap is suitable for a particular counterparty?
Should the Commission specify additional considerations in
the rule to guide compliance with the rule? Should the Commission adopt
interpretive guidance, similar to that provided by the prudential
regulators in connection with sales of government securities instead or
in addition?
Should swap dealers be subject to an explicit fiduciary
duty when making a recommendation to a counterparty?
H. Proposed Sec. 155.7--Execution Standards
The Commission is proposing a swap execution standard rule that
would apply to swaps available for trading on a DCM or SEF to ensure
fair dealing and protect against fraud and other abusive practices. The
proposed execution standard rule would require Commission registrants,
with respect to any swap that is available for trading on a DCM or SEF,
to execute the swap on terms that have a ``reasonable relationship'' to
the best terms available.\85\ In addition, the registrant would be
required, prior to execution of the order, to disclose the DCMs and
SEFs on which the swap is available for trading, and on which markets
the registrant has trading privileges. The swap execution standards
would apply to all Commission registrants executing customer orders for
swaps made available for trading on a DCM or SEF, whether execution
occurs on or through a DCM, SEF or bilaterally.\86\ The Commission
notes that bilateral execution of swaps available for trading on a DCM
or a SEF would only occur pursuant to the ``end user'' exemption
provided under Section 2(h)(7)(A) of the CEA.
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\85\ The term ``reasonable relationship'' has been used in
evaluating execution standards over several decades in the
securities industry. In an early securities law case, the Second
Circuit stated that ``[i]n its interpretation of Sec. 17(a) of the
Securities Act, the Commission has consistently held that a dealer
cannot charge prices not reasonably related to the prevailing market
price without disclosing that fact.'' Charles Hughes & Co. v. SEC,
139 F.2d 434, 437 (2d Cir. 1943). The SEC issued a release in 1987,
``Notice to broker-dealers concerning disclosure requirements for
mark-ups on zero-coupon securities,'' which stated that the ``duty
of fair dealing includes the implied representation that the price a
firm charges bears a reasonable relationship to the prevailing
market price.'' 52 FR 15575, 15576, Apr. 21, 1987 (citing Charles
Hughes, 139 F.2d at 437). In IM-2440-1 the former NASD stated that
``It shall be deemed a violation of Rule 2110 [recommendations] and
Rule 2440 [fair prices and commissions] for a member to enter into
any transaction with a customer in any security at any price not
reasonably related to the current market price of the security or to
charge a commission which is not reasonable.'' Although Rule 2440
and IM-2440-1 related to OTC transactions, FINRA expanded the
principle to include fees charged in exchange-traded transactions.
See FINRA Regulatory Notice 08-36.
\86\ The duty under the proposed rule would apply whether the
Commission registrant was acting as agent or principal in the
transaction. This is consistent with existing duties for broker-
dealers under the Federal securities laws. See Newton v. Merrill,
Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270 n. 1 (3d Cir.
1988) (``[T]he best execution duty `does not dissolve when the
broker/dealer acts in its capacity as a principal.''') (citations
omitted). Accord E.F. Hutton & Co., Release No. 34-25887, 49 S.E.C.
829, 832 (1988); NASD Rule 2320(e).
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In determining what constitutes a ``reasonable relationship,'' the
Commission registrant should consider whether the terms offered to the
customer are fair and consistent with principles of fair dealing,\87\
good faith, and, when acting as an agent for the customer, the duty of
loyalty.\88\ To have a reasonable relationship to the best terms
available, the terms must be fair and not excessive in light of all
other relevant circumstances. Additionally, whether the terms of any
swap executed on behalf of a customer satisfy the ``reasonable
relationship'' duty would be analyzed in connection with the specific
anti-fraud provisions of the CEA and Commission Regulations and would
be considered in connection with the course of dealing between the
registrant and the customer.
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\87\ Supra at footnote 85. The ``duty of fair dealing includes
the implied representation that the price a firm charges bears a
reasonable relationship to the prevailing market price.'' 52 FR
15575, 15576, Apr. 21, 1987.
\88\ See Newton, 135 F.3d at 270 (``The duty of best execution *
* * has its roots in the common law agency obligations of undivided
loyalty and reasonable care that an agent owes to his principal.'')
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To satisfy its reasonable relationship obligation, a Commission
registrant would be expected to exercise reasonable diligence to
ascertain which DCM or SEF offers the best terms available for the
transaction. To meet their reasonable diligence duty, Commission
registrants would have to survey a sufficient number of DCMs or SEFs to
be able to make a reasonable determination as to whether the terms they
offer their clients bear a reasonable relationship to the best terms
available. Such a survey would not necessarily be confined to markets
on which the registrant has trading privileges and would include
reviewing available bids and offers, requests for quotes, and real time
reporting of trades executed within a reasonable period of time prior
to execution of the order. In proposing this execution standard, the
Commission notes that in separate rulemakings the Commission is
proposing rules requiring DCMs and SEFs to provide market participants
with open access to their trading platforms and that current pre-trade
price and quote information will be available to all persons with
access to DCMs and SEFs. Post-trade data also will be available to
registrants on a real-time reporting basis. The Commission's proposed
rule lists a number of factors that the Commission would consider in
determining compliance with the rule which include an evaluation of the
characteristics unique to the customer's swap order as well as the
prevailing market conditions.
As swaps trading transitions to and develops on DCMs and SEFs,
technology and other innovations are
[[Page 80649]]
likely to affect how Commission registrants determine whether the terms
they offer their customers are reasonably related to the ``best terms
available'' for purposes of satisfying the proposed execution
standards. For example, registrants' survey obligations may be
satisfied by consulting, where available, information aggregators that
facilitate the collection of information about current trading activity
across markets. The proposed rule is intended to be sufficiently
flexible to take account of such innovations and developments which
should further the quality of executions.
Request for Comment: The Commission requests comments generally on
the proposed rules regarding the swap execution standard and the
following specific issues:
For the purpose of meeting the duty to use reasonable
diligence to determine whether the terms it offers are reasonably
related to the best terms available for execution of a swap that is
available for trading on a DCM or SEF, should the Commission prescribe
a certain percentage of DCMs or SEFs that must be reviewed/considered
by the Commission registrant? If so, what percentage is appropriate?
Should the Commission define what it means for the terms
of execution to have a ``reasonable relationship to the best terms
available''? If so, how should the Commission define the phrase?
Should the Commission require any additional disclosures
to the customer, including for example, the best terms available for
execution of the swap order and the difference between the best terms
and the terms on which the swap was executed?
III. Proposed Rules for Swap Dealers and Major Swap Participants
Dealing With Special Entities
In Section 4s(h), Congress created a separate category of swap
counterparty called Special Entities, and imposed heightened duties and
requirements for swap dealers that act as advisors to them, and for
swap dealers and major swap participants that are their counterparties.
A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)
Section 4s(h)(2)(C) defines 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; \89\ (iv) any governmental
plan, as defined in Section 3 of ERISA; \90\ or (v) any endowment,
including an endowment that is an organization described in Section
501(c)(3) of the Internal Revenue Code of 1986.\91\
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\89\ 29 U.S.C. 1002. The term ``Special Entities'' includes
employee benefit plans defined in section 3 of ERISA. This class of
employee benefit plans is broader than the category of plans that
are ``subject to'' ERISA for purposes of Section
4s(h)(5)(A)(i)(VII). Employee benefit plans not ``subject to''
regulation under ERISA include: (1) Governmental plans; (2) church
plans; (3) plans maintained solely for the purpose of complying with
applicable workmen's compensation laws or unemployment compensation
or disability insurance laws; (4) plans maintained outside the U.S.
primarily for the benefit of persons substantially all of whom are
nonresident aliens; or (5) unfunded excess benefit plans. See 29
U.S.C. 1003(b).
\90\ Section 3(32) of ERISA defines ``governmental plan'' as a
``plan established or maintained for its employees by the Government
of the United States, by the government of any State or political
subdivision thereof, or by any agency or instrumentality of any of
the foregoing.'' 29 U.S.C. 1002(32).
\91\ The term ``endowment'' is not defined in the Dodd-Frank Act
or in the CEA.
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The Commission has received a number of letters from stakeholders
identifying a variety of ambiguities in the definition of Special
Entity in Section 4s(h)(2)(C) and suggesting clarifications. For
example, under Section 4s(h)(2)(C)(iii), the term Special Entity
includes employee benefit plans as defined in Section 3 of ERISA.\92\
Industry representatives have raised issues concerning whether the
definition requires ``looking through'' investment vehicles to
determine whether the vehicle is a Special Entity, including master
trusts holding the assets of one or more pension plans of a single
employer, and collective investment vehicles in which Special Entities
invest.\93\
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\92\ 29 U.S.C. 1002.
\93\ See, e.g., SIFMA/ISDA Letter, at 5 (investment vehicle
which 25 percent or more of its equity interest is owned by benefit
plan investors and is subject to DOL plan assets rules (29 CFR
2510.3-101) for purposes of ERISA).
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Stakeholders similarly have raised issues with respect to whether
plans defined in but not subject to ERISA (unless they are covered by
another applicable prong of the Special Entity definition) are Special
Entities,\94\ and whether only those plans subject to the fiduciary
responsibility provisions of ERISA should be included within the
Special Entity definition.\95\
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\94\ See, e.g., SIFMA/ISDA Letter, at 2.
\95\ SIFMA/ISDA Letter, at 5 (``This would exclude such plans as
(i) unfunded plans for highly compensated employees; (ii) foreign
pension plans (including foreign-based governmental plans); (iii)
church plans that have elected not to subject themselves to ERISA;
(iv) Section 403(b) plans that accept only employee contributions;
and (v) Section 401(a), 403(b) and 457 plans sponsored by
governmental entities.'') (citations omitted).
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Under Section 4s(h)(2)(C)(v), the term Special Entity includes any
endowment, including an endowment that is an organization described in
Section 501(c)(3) of the Internal Revenue Code of 1986.\96\ Non-profit
organizations that enter into swaps have asked whether they will be
treated as Special Entities if their endowment is pledged as collateral
or is used to make payments on those swaps or whether the definition of
endowment is limited to those endowments that are the named
counterparty to the swap.\97\ Others have suggested that the phrase
``any endowment'' be limited to endowments that are non-profit
organizations described in Section 501(c) of the Internal Revenue Code
or are established for the benefit of such an organization.
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\96\ 26 U.S.C. 501(c)(3). Section 501(c)(3) lists tax exempt
organizations including: ``Corporations, and any community chest,
fund, or foundation, organized and operated exclusively for
religious, charitable, scientific, testing for public safety,
literary, or educational purposes * * *.''
\97\ SIFMA/ISDA Letter, at 6; SFG Presentation, at 8.
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Given the range of issues surrounding the definition of Special
Entity, the Commission is not proposing to clarify the definition at
this time but, instead, is seeking comment on whether clarification is
necessary.
Request for Comment: The Commission requests comments on the
definition of Special Entity in general and on the following specific
issues:
Should the definition of State, State agency, city,
county, municipality, or other political subdivision of a State be
clarified in any way?
Should the definition ``employee benefit plans, as defined
in Section 3 of ERISA'' be clarified in any way?
Should the definition ``employee benefit plans, as defined
in Section 3 of ERISA'' be limited to plans subject to regulation under
ERISA?
Should the Commission ``look through'' an entity to
determine whether it is a Special Entity for the purposes of these
rules? If so, why? If not, why not? If so, should the Commission
clarify that master trusts, or similar entities, that hold assets of
more than one pension plan from the same plan sponsor are within the
definition of Special Entity?
Should the Commission clarify in any way the definition of
governmental plan under Section 4s(h)(C)(iv)?
Should the Commission clarify the definition of endowment
to include or exclude charitable organizations that enter into swaps
but whose endowments have contractual obligations regarding that swap?
Should the Commission clarify the definition of endowment
to include or exclude foreign endowments? If so, why? If not, why not?
[[Page 80650]]
B. Proposed Sec. 23.440--Requirements for Swap Dealers Acting as
Advisors to Special Entities
Section 4s(h)(4) provides that a swap dealer that ``acts as an
advisor to a Special Entity'' must act in the ``best interests'' of the
Special Entity and undertake ``reasonable efforts'' to obtain
information necessary to determine that a recommended swap is in the
best interests of the Special Entity. These terms are not defined in
the statute. The Commission's proposed rules incorporate the statutory
language and clarify that ``acts as an advisor to a Special Entity''
includes to make a swap recommendation to a Special Entity.
1. Act as an Advisor to a Special Entity
With respect to what it means to ``act as an advisor to a Special
Entity,'' the Commission proposes to clarify that a swap dealer that
makes a recommendation to a Special Entity falls within the definition.
The Commission also proposes to clarify that a swap dealer that merely
provides to a Special Entity general transaction, financial, or market
information or that provides swap terms as part of a response to a
competitive bid request from the Special Entity does not fall within
the definition. 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.
2. Best Interests
The proposed rule would not define the term ``best interests.''
There are 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 Commission believes that those best
interest 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, and to employ reasonable care that any recommendation
given to a Special Entity is designed to further the purposes of the
Special Entity.\98\ The Commission's proposal is guided by the
statutory language in Sections 4s(h)(4) and (5) and Congressional
intent that swap dealers could act both as an advisor to a Special
Entity when recommending a swap and then as a counterparty by entering
into the same swap with the Special Entity, where the Special Entity
has a representative independent of the swap dealer on which it can
rely.\99\ The proposed rules are intended to allow existing business
relationships to continue, albeit subject to the new, higher statutory
standards of care.\100\ Thus, the proposed rule is not intended to
preclude, per se, a swap dealer from both recommending a swap to a
Special Entity and entering into that swap with the same Special Entity
where the parties abide by the requirements of Sections 4s(h)(4) and
(5) and the Commission's proposed regulations.\101\
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\98\ There is similar language in SEC v. Capital Gains Research
Bureau, Inc., 375 U.S. 180, 191-94 (1963) in which the Supreme Court
construed Advisers Act Section 206 (15 U.S.C. 80b-6) as creating an
enforcement mechanism for violations of fiduciary duties under the
common law. The fiduciary duty imposes upon investment advisers the
``affirmative duty of `utmost good faith, and full and fair
disclosure of all material facts,' as well as an affirmative
obligation to `employ reasonable care to avoid misleading' '' their
clients.
\99\ Senator Blanche Lincoln stated in a floor colloquy that:
[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). However, swap dealers have an obligation to ensure
that any Special Entity counterparty is represented by a
sophisticated representative, independent of the swap dealer, when
the swap dealer is acting both as an advisor and as counterparty to
the Special Entity. (Section 4s(h)(5)).
\100\ The Commission anticipates that swap dealers and Special
Entities will continue to rely on representations to inform the
nature of their relationships, including, for example,
representations that the Special Entity: (1) Is not relying on the
swap dealer; (2) has an independent representative that, by virtue
of their relationship, is legally obligated to act in the best
interests of the Special Entity; and (3) is relying on the
independent representative's advice in evaluating any recommendation
from a swap dealer. The parties' agreement, however, does not bind
the Commission or override the protections granted to market
participants under the CEA. Cf. Complaint at ] 18, SEC v. Barclays
Bank, 07-CV-04427 (S.D.N.Y. May 30, 2007) (so-called ``Big Boy''
letters may not insulate parties from enforcement actions brought by
the SEC for insider trading); SEC v. Barclays Bank, SEC Litig.
Release No. 20132 (May 30, 2007) (Barclays Bank settles insider
trading charges).
\101\ The Commission staff has consulted with DOL staff, who has
advised that any determination of status under the Dodd-Frank Act is
separate and distinct from the determination of whether an entity is
a fiduciary under ERISA.
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3. Reasonable Efforts
Section 4s(h)(4)(C) requires swap dealers to undertake ``reasonable
efforts'' to obtain information necessary to determine that a
recommended swap is in the best interests of the Special Entity. Such
information includes the financial and tax status of the Special Entity
and the financing objectives of the Special Entity. The statute grants
the Commission discretionary authority to prescribe additional types of
information. The Commission proposes to add: (1) The authority of the
Special Entity to enter into a swap; (2) future funding needs of the
Special Entity; (3) the experience of the Special Entity with respect
to entering into swaps, generally, and swaps of the type and complexity
being recommended; (4) whether the Special Entity has a representative
as provided in proposed Sec. 23.450 and Section 4s(h)(5) that is
capable of evaluating the recommended swap in light of the needs and
circumstances of the Special Entity; and (5) whether the Special Entity
has the financial capability to withstand changes in market conditions
during the term of the swap. The Commission believes that this non-
exclusive list would assist a swap dealer in meeting its duty to act in
the ``best interests'' of a Special Entity in recommending a swap or
swap trading strategy.
4. Reasonable Reliance To Satisfy the ``Reasonable Efforts'' Obligation
Proposed Sec. 23.440(c) would allow a swap dealer to rely on the
Special Entity's representations to satisfy its ``reasonable efforts''
obligations. The Commission understands from stakeholders, including a
number of Special Entities, that Special Entities are sometimes
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. To address this
circumstance, the Commission proposes to allow a swap dealer to meet
its ``reasonable efforts'' duty by relying on representations of the
Special Entity \102\ and any other information known by the swap
dealer. In such circumstances, the swap dealer would be expected to
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 as provided in Section 4s(h)(4)(C) and proposed Sec.
23.440(b)(2).\103\
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\102\ Certain Special Entity trade associations supported this
approach. See ABC Letter, at 6-7; ABC/CIEBA Letter, at 3.
\103\ In the absence of sufficient representations from the
Special Entity, and if a swap dealer's reasonable efforts produce
incomplete information, the swap dealer would be required to assess
whether it is able to make a swap recommendation that is in the best
interests of the Special Entity as required by proposed Sec.
23.440.
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To rely, the swap dealer must have a reasonable basis to believe
that the representations of the Special Entity are reliable based on
the facts and
[[Page 80651]]
circumstances of the particular swap and the Special Entity. The
representations themselves must be detailed and include information
regarding the Special Entity's ability to: evaluate the recommended
transaction; exercise independent judgment; and absorb potential losses
associated with the swap. The Special Entity also would have to have a
representative that meets the criteria in Section 4s(h)(5) and proposed
Sec. 23.450. This mechanism would not relieve a swap dealer of its
duty to act in the ``best interests'' of the Special Entity.
Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding swap dealers that act as advisors
to Special Entities, and on the following specific issues:
Is the proposed clarification of the term ``acts as an
advisor to a Special Entity'' appropriate? Should the Commission
further define the term?
Should the Commission define ``best interests'' in this
context, and if so, what should the definition be?
Because a swap dealer has an inherent conflict of interest
when it acts as both an advisor and a counterparty to Special Entity,
are there additional disclosures that a swap dealer should have to make
that could mitigate the conflicts of interest?
When acting as both an advisor and a counterparty to a
Special Entity, should a swap dealer have to disclose any positions it
holds from which it may profit should the swap in question move against
the Special Entity?
Should swap dealers have to disclose to a Special Entity
the profit it expects to make on swaps it enters into with the Special
Entity.
Should swap dealers be subject to an explicit fiduciary
duty when acting as an advisor to a Special Entity?
Would the proposed rule preclude swap dealers from
continuing their current practice of both recommending and entering
into swaps with Special Entities? If so, why?
Should the Commission prescribe additional information
that would be relevant to a swap dealer's ``reasonable efforts'' and
``best interests'' duties under the proposed rule?
C. Proposed Sec. 23.450--Requirements for Swap Dealers and Major Swap
Participants Acting as Counterparties to Special Entities
Section 4s(h)(5) requires that swap dealers and major swap
participants \104\ that offer swaps to or enter into swaps with Special
Entities comply with any duty established by the Commission that
requires them to have a reasonable basis to believe that the Special
Entity has an independent representative that meets certain
criteria.\105\ The Commission interprets the statute as imposing this
duty on swap dealers and major swap participants when they are
counterparties to any Special Entity.\106\ In making this determination
the Commission considered staff's consultations with staff at other
Federal regulators, stakeholders, letters from the public,\107\ as well
as legislative history.\108\ To meet their duties under the proposed
rule, swap dealers and major swap participants would be able to rely on
reasonable, detailed representations of the Special Entity concerning
the qualifications of the independent representative.\109\
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\104\ 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 proposes to apply the counterparty requirements to major
swap participants as well as to swap dealers.
\105\ Pursuant to Section 4s(h)(7), the duty would not apply to
transactions initiated on a DCM or SEF where the swap dealer or
major swap participant does not know the counterparty to the
transaction.
\106\ 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).
\107\ See, e.g., Ropes & Gray Letter, at 1; ABC/CIEBA Statement
letter, at 2; SIFMA/ISDA Letter, at 11.
\108\ 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.'').
\109\ See, e.g., ABC Letter, at 4; ABC/CIEBA Letter, at 2;
SIFMA/ISDA Letter, at 11. Stakeholders have asserted that, even if
Congress did intend for Section 4s(h)(5)(A) to apply to non-
governmental Special Entities, it did not intend for it to apply to
ERISA plans. Stakeholders further assert that, even if Section
4s(h)(5)(A) applies to ERISA plans, swap dealers and major swap
participants should only be expected to verify that the independent
representative satisfies the criteria of Section
4s(h)(5)(A)(i)(VII)--that the independent representative is a
fiduciary as defined in Section 3 of ERISA (29 U.S.C. 1002)--and not
the criteria of Section 4s(h)(5)(A)(i)(I)-(VI). They contend that
verification of the duty under Section 4s(h)(5)(A)(i)(VII) is the
equivalent of verification of Section 4s(h)(5)(A)(i)(I)-(VI) and
that to require verification of all the criteria would lead to
regulatory conflicts under ERISA and the CEA.
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1. Qualifications of the Independent Representative
The proposed rule would require swap dealers and major swap
participants to have a reasonable basis to believe that a Special
Entity has a representative that satisfies the enumerated
criteria.\110\ The proposed rule provides that relevant considerations
would include: (1) The nature of the Special Entity-representative
relationship; (2) the representative's capability of making hedging or
trading decisions; (3) use of consultants or, with respect to employee
benefit plans subject to ERISA, use of a Qualified Professional Asset
Manager \111\ or In-House Asset Manager; \112\ (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.
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\110\ The criteria for an independent representative based
generally on the statute and under proposed Sec. 23.450 would be:
(1) Sufficient knowledge to evaluate the transaction and risks; (2)
not subject to a statutory disqualification; (3) independent of the
swap dealer or major swap participant; (4) undertakes a duty to act
in the best interests of the Special Entity it represents; (5) makes
appropriate and timely disclosures to the Special Entity; (6)
evaluates, consistent with any guidelines provided by the Special
Entity, fair pricing and the appropriateness of the swap; (7) in the
case of employee benefit plans subject to the ERISA, is a fiduciary
as defined in Section 3 of ERISA (29 U.S.C. 1002); and 8) in the
case of a municipal entity as defined in proposed Sec. 23.451,
whether the representative is subject to restrictions on certain
political contributions imposed by the Commission, the SEC or a
self-regulatory organization subject to the jurisdiction of the
Commission or the SEC. Criterion 8 is not in the statutory text
under Section 4s(h)(5)(A)(i)(I)-(VII). The Commission is proposing
this criterion using its discretionary authority under Section
4s(h)(5)(B).
\111\ See DOL Prohibited Transaction Exemption (``PTE'') 84-14,
70 FR 49305, Aug. 23, 2005.
\112\ See DOL PTE 96-23, 61 FR 15975, Apr. 10, 1996; Proposed
Amendment to PTE 96-23, 75 FR 33642, June 14, 2010.
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2. Statutory Disqualification
To guide swap dealers and major swap participants, the proposed
rule defines ``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.
3. Independent
Proposed Sec. 23.450(b) would require that a swap dealer or major
swap participant ``have a reasonable basis to believe a Special Entity
has a
[[Page 80652]]
representative that * * * is independent of the swap dealer or major
swap participant * * * '' \113\ This formulation of the duty is
intended to clarify that ``independent'' as it relates to a
representative of a Special Entity means independent of the swap dealer
or major swap participant,\114\ not independent of the Special
Entity.\115\
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\113\ Section 4s(h)(5)(A)(i) provides in relevant part:
``reasonable basis to believe that the counterparty that is a
Special Entity has an independent representative that * * * (III) is
independent of the swap dealer or major swap participant * * *'' By
including the word ``independent'' twice, an ambiguity was created
as to whether the representative had to be independent of both the
swap dealer or major swap participant and the Special Entity. The
legislative history indicates that was not the intent of Congress.
Thus, the proposed rule drops the first ``independent'' to clarify
that the representative of a Special Entity only needs to be
independent of the swap dealer or major swap participant.
\114\ See, e.g., ABC Letter, at 6; ABC/CIEBA Letter, at 3; Ropes
& Gray Letter, at 2; SIFMA/ISDA Letter, at 12; NFA Letter, at 6.
\115\ See 156 Cong. Rec. S5903 (daily ed. Jul. 15, 2010)
(statements of Sens. Lincoln and Harkin):
Mrs. LINCOLN Our intention in imposing the independent
representative requirement was to ensure that there was always
someone independent of the swap dealer or the security-based swap
dealer reviewing and approving swap or security-based swap
transactions. However, we did not intend to require that the special
entity hire an investment manager independent of the special entity.
Is that your understanding, Senator Harkin?
Mr. HARKIN. Yes, that is correct. We certainly understand that
many special entities have internal managers that may meet the
independent representative requirement. For example, many public
electric and gas systems have employees whose job is to handle the
day-to-day hedging operations of the system, and we intended to
allow them to continue to rely on those in-house managers to
evaluate and approve swap and security-based swap transactions,
provided that the manager remained independent of the swap dealer or
the security-based swap dealer and meet the other conditions of the
provision. Similarly, the named fiduciary or in-house asset manager-
INHAM-for a pension plan may continue to approve swap and security-
based swap transactions.
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As to what it means for the representative to be independent of the
swap dealer or major swap participant, the Commission's proposed rule
provides that a representative would be deemed to be independent if:
(1) It is 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 is no ``principal'' relationship between
the representative and the swap dealer or major swap participant within
the meaning of Sec. 3.1(a)\116\ of the Commission's Regulations; and
(3) the representative does not have a material business relationship
with the swap dealer or major swap participant. 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. The proposed rule defines 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.
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\116\ 17 CFR 3.1(a).
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4. Best Interests
The Commission is not proposing to define what ``best interests''
means in this context. As the Commission explained regarding proposed
Sec. 23.440, the scope of the duty will be related to the nature of
the relationship between the independent representative and the Special
Entity. There are established principles in case law which will inform
the meaning of the term on a case-by-case basis.\117\
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\117\ Under the CEA, a commodity trading advisor will have a
fiduciary duty towards its customer when it offers personalized
advice. See Savage v. CFTC, 548 F.2d 192, 194 (7th Cir. 1977);
Commodity Trend Serv., 233 F.3d at 990 (``the party in [Savage]
offered personalized advice and so would be considered a fiduciary
under the common law'') (citing Capital Gains, 375 U.S. at 194).
Under the Advisers Act, an adviser is a fiduciary whose duty is to
serve the best interests of its clients, which includes an
obligation not to subrogate clients' interests to its own. An
adviser must deal fairly with clients and prospective clients, seek
to avoid conflicts with its clients and, at a minimum, make full
disclosure of any material conflict or potential conflict.
``Amendments to Form ADV,'' Release No. IA-3060 (Aug. 12, 2010)
(citing Capital Gains, 375 U.S. at 191-94). Under ERISA, ``a
fiduciary shall discharge his duties with respect to a plan solely
in the interest of the participants and beneficiaries and * * * for
the exclusive purpose of: (i) providing benefits to participants and
their beneficiaries; and (ii) defraying reasonable expenses of
administering the plan'' (29 U.S.C. 1104(a)(1)(A)) and act ``with
the care, skill, prudence, and diligence under the circumstances
then prevailing that a prudent man acting in a like capacity and
familiar with such matters would use in the conduct of an enterprise
of a like character and with like aims * * *'' (29 U.S.C.
1104(a)(1)(B)).
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We would expect that, 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's entering into
the transaction.\118\
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\118\ The description of the duties under Section
4s(h)(5)(A)(i)(IV) is drawn from a description of ERISA fiduciary
obligations in connection with the use of derivatives in the
management of a portfolio of assets of a pension plan that is
subject to ERISA. See Letter of Olena Berg, DOL, to Honorable Eugene
A. Ludwig, Comptroller of the Currency (March 21, 1996), available
at, http://www.dol.gov/ebsa/programs/ori/advisory96/driv4ltr.htm.
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5. Makes Appropriate and Timely Disclosures
The proposed rule refines the criterion under Section
4s(h)(5)(A)(i)(V), ``appropriate disclosures,'' to mean ``appropriate
and timely disclosures.'' A swap dealer or major swap participant would
have to have a reasonable basis to believe that a representative makes
appropriate and timely disclosures to the Special Entity for the
representative to meet the requirements of the proposed rule.
6. Evaluates Fair Pricing and the Appropriateness of the Swap
The Commission has received a number of questions regarding the
statutory criterion in Section 4s(h)(5)(A)(i)(VI) which states that the
representative will provide ``written representations to the Special
Entity regarding fair pricing and the appropriateness of the
transaction.'' \119\ The Commission's proposed rule refines the
statutory language to say that the representative ``evaluates,
consistent with any guidelines provided by the Special Entity, fair
pricing and the appropriateness of the swap.'' The Commission proposes
to allow swap dealers and major swap participants to 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 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 should also have a reasonable
basis to believe that the
[[Page 80653]]
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.\120\
This approach would apply to in-house independent representatives as
well.
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\119\ See, e.g., ABC Letter, at 8; SFG Letter, at 1.
\120\ For example, CTAs are required to maintain books and
records for 5 years pursuant to Sec. 1.31 of the Commission's
regulations. (17 CFR 1.31).
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7. ERISA Fiduciary
The proposed rule tracks the statutory language that in the case of
employee benefit plans subject to ERISA, the independent representative
is a fiduciary as defined in Section 3 of that Act.\121\ Certain ERISA
plans, fiduciaries and their trade associations, have urged the
Commission to interpret the statute to mean that the independent
representative of a plan subject to ERISA would not have to satisfy the
additional criteria in Section 4s(h)(5)(A)(i)(I)-(VI), because such
criteria would be duplicative of or inconsistent with ERISA
requirements.\122\ After consultations with DOL staff, the Commission
is inclined, at this time, to treat ERISA fiduciaries like other
independent representatives of Special Entities with respect to the
criteria in Section 4s(h)(5)(A)(i)(I)-(VI). The Commission would expect
that such ERISA fiduciaries and plans would be able to provide adequate
representations to swap dealers and major swap participants to meet the
additional criteria without incurring significant costs. The Commission
seeks further comment from interested parties as to this approach,
particularly with respect to whether the additional criteria, as
proposed in the rule, are inconsistent in any way with the requirements
under ERISA.
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\121\ 29 U.S.C. 1002.
\122\ See, e.g., ABC Letter, at 4-5; ABC/CIEBA Letter, at 2-5.
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8. Restrictions on Political Contributions by Independent
Representative of a Municipal Entity
As part of the process of determining the qualifications of an
independent representative of a Special Entity that is a municipal
entity,\123\ the Commission proposes \124\ to require swap dealers and
major swap participants to ensure that the independent representative
is subject to restrictions on certain political contributions, known as
``pay-to-play'' rules.\125\ The requirement would not apply to in-house
independent representatives of a municipal entity.\126\
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\123\ Proposed Sec. 23.451.
\124\ The Commission proposes this requirement pursuant to its
discretionary authority in Section 4s(h) of the CEA, including in
particular Section 4s(h)(5)(B).
\125\ See, e.g., SEC Rule 206(4)-5 under the Advisers Act (17
CFR 275.206(4)-5); MSRB Rule G-37: Political Contributions and
Prohibitions on Municipal Securities Business. The Commission
proposes to impose comparable requirements on swap dealers and major
swap participants that act as advisors or counterparties to Special
Entities. See proposed Sec. 23.432. In a separate release, the
Commission will also propose comparable requirements on registered
commodity trading advisors when they advise municipal entities.
\126\ The definition of ``municipal advisor'' in Section 15B of
the Exchange Act (15 U.S.C. 78o-4) excludes employees of a municipal
entity.
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9. Unqualified Independent Representative
Some stakeholders have expressed concern that the independent
representative requirement places undue influence in the hands of the
swap dealer or major swap participant by allowing it to use Section
4s(h)(5)(A)(i) to control who qualifies as an independent
representative.\127\ Thus, the proposed rule also provides that, if a
swap dealer or major swap participant were to determine that the
independent representative of a Special Entity did not meet the
criteria established in this provision, 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 to ensure that the swap dealer or major
swap participant had a substantial, unbiased basis for the
determination.
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\127\ E.g., ABC Letter, at 8.
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10. Disclosure of Capacity
Section 4s(h)(5)(A)(ii) requires swap dealers and major swap
participants to disclose in writing to Special Entities the capacity in
which they are acting before initiation of a swap transaction. The
Commission proposes to adopt the statutory standard in a rule, and to
require that, 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. This would apply, for example, when
the swap dealer acts both as an advisor and as a counterparty to the
Special Entity, or when firms act both as underwriters in a bond
offering and as counterparties in swaps used to hedge such financing.
In these circumstances, the swap dealers' or major swap participants'
duties to the Special Entities would vary depending on the capacities
in which they are operating.
11. Inapplicability
Proposed Sec. 23.450 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.
Request for Comment: The Commission requests comment generally on
all of the proposed rules regarding swap dealers and major swap
participants that act as counterparties to Special Entities, and on the
following specific issues:
Should the rule clarify the statutory language to give
more guidance to the criteria in Section 4s(h)(5)(A)(i)(I)-(VI)? If,
yes, how?
Are there any specific qualifications that should be
considered in forming a reasonable basis regarding whether the
independent representative has sufficient knowledge to evaluate the
transaction and risks?
Should the criterion in Section 4s(h)(5)(A)(i)(VII) be the
only criterion that applies to employee benefit plans subject to ERISA?
Why or why not? Are the criteria in Section 4s(h)(5)(A)(i)(I)-(VI)
inconsistent with a fiduciary's duties under ERISA? Do the criteria in
Section 4s(h)(5)(A)(i)(I)-(VI) add any protections for plans subject to
ERISA that are not otherwise provided under ERISA?
To resolve the ambiguity in the statutory text referenced
in footnote 106, should the rule be limited to certain types of Special
Entities? Why or why not? Which types should be included or excluded
from coverage under the proposed rule?
Should the rule define what it means for the independent
representative to be independent of the swap dealer or major swap
participant? If yes, should independence be measured in relation to
ownership and control, material business relationships, or another
measure? Should any ``independence'' test apply to employees of the
independent representative, as well as to the representative, itself?
Should the Commission specify a de minimis threshold below
wh ich an independent representative will not be deemed to have a
material business relationship with the swap dealer or major swap
participant? If so, what would be an appropriate threshold?
D. Proposed Sec. 23.451--Political Contributions by Certain Swap
Dealers and Major Swap Participants
Using its discretionary rulemaking authority under Section 4s(h) to
impose business conduct requirements in the
[[Page 80654]]
public interest,\128\ the Commission is proposing to prohibit swap
dealers and major swap participants from entering into swaps with
``municipal entities'' if they make certain political contributions to
officials of such entities.\129\ The proposed rule is intended to
complement existing pay-to-play prohibitions imposed by Federal
securities regulators to deter undue influence and other fraudulent
practices that harm the public. The Commission's proposed rule would
promote consistency in the business conduct standards that apply to
financial market professionals dealing with municipal entities.
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\128\ Section 4s(h)(5)(B).
\129\ See proposed Sec. 23.451(a)(3). The proposed definition
of ``municipal entity'' is based on Exchange Act Section 15B(e)(8)
(15 U.S.C. 78o-4(e)(8)) and means any State, political subdivision
of a State, or municipal corporate instrumentality of a State,
including--
(A) Any agency, authority, or instrumentality of the State,
political subdivision, 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.
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The existing restrictions on pay-to-play practices are contained in
SEC Rule 206(4)-5 under the Investment Advisers Act of 1940,\130\ which
prohibits certain political contributions by investment advisers
providing or seeking to provide investment advisory services to public
pension plans and other government investors,\131\ and under the
Municipal Securities Rule Making Board (``MSRB'') Rules G-37 and G-
38,\132\ which impose pay-to-play restrictions on municipal securities
dealers and broker-dealers engaging or seeking to engage in the
municipal securities business. The proposed rule is intended to deter
swap dealers and major swap participants from engaging in pay-to-play
practices.
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\130\ 17 CFR 275.206(4)-5 (``SEC Advisers Act Rule 206(4)-5'').
\131\ See ``Political Contributions by Certain Investment
Advisers,'' Release No. IA-3043 (Jul. 1, 2010), 75 FR 41018, Jul.
14, 2010 (adopting a rule that prohibits certain political
contributions by investment advisers providing or seeking to provide
investment advisory services to public pension plans and other
government investors).
\132\ 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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1. Prohibitions
Proposed Sec. 23.451, generally, would make 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 would prohibit 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 pay-to-play restriction under applicable law.\133\ The
proposed rule also would ban 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. These proposed prohibitions are similar to those contained in SEC
Advisers Act Rule 206(4)-5 and MSRB Rules G-37 and G-38.
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\133\ The Commission is proposing to define ``regulated
person,'' for purposes of the rule, to mean generally a person that
is subject to rules of the SEC, the MSRB, a self-regulatory
organization, or the Commission prohibiting it from engaging in
specified activities if certain political contributions have been
made, or its officers or employees.
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The proposed rule also includes 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.
a. Two-Year ``Time Out''
The proposed rule would prohibit swap dealers and major swap
participants from offering to enter into or entering into a swap with a
municipal entity within two years after a contribution to an official
of such municipal entity was made by the swap dealer or major swap
participant or any of its covered associates. The two-year time out is
consistent with the time out provisions contained in SEC Advisers Act
Rule 206(4)-5 and MSRB Rule G-37.
b. Covered Associates
Political contributions made to influence the firm selection
process are typically made not by the firm itself, but by officers and
employees of the firm who have a stake in the business relationship
with the municipal client. For this reason, contributions by such
persons, which the rule defines as ``covered associates,'' would
trigger the two-year time out. A ``covered associate'' of a swap dealer
or major swap participant is defined 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. This definition mirrors a
similar provision in SEC Advisers Act Rule 206(4)-5.
Because the proposed rule attributes to a firm contributions made
by a person even prior to becoming a covered associate of the firm,
swap dealers and major swap participants must ``look back'' in time to
determine whether the time out applies when an employee becomes a
covered associate. For example, if the contribution was made less than
two years (or six months, as applicable) before an individual becomes a
covered associate, the proposed rule would prohibit the firm from
entering into a swap with the relevant municipal entity until the two-
year time out period has expired.
2. Exceptions
a. De Minimis Contributions
The proposed rule would permit 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 for 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. The Commission believes this two-tiered de minimis approach is
reasonable because of the more remote interest an individual is likely
to have in contributing to a person for whom such individual is not
entitled to vote. This provision is similar to the one contained in SEC
Advisers Act Rule 206(4)-5.
b. New Covered Associates
The prohibitions of the proposed rule would 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.
c. Exchange and SEF Transactions
The prohibitions of the proposed rule would 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.
[[Page 80655]]
3. Exemptions
A swap dealer or major swap participant would be exempt from the
prohibitions of the proposed rule where the contribution that was made
by a covered associate did not exceed $150 or $350, as applicable, was
discovered by the swap dealer or major swap participant within four
months of the date of contribution, and was returned to the contributor
within 60 calendar days of the date of discovery. This automatic
exemption mirrors similar provisions contained in SEC Advisers Act Rule
206(4)-5 and MSRB Rule G-37.
In addition, the Commission proposes a provision under which a swap
dealer or major swap participant may apply to the Commission for an
exemption from the two-year ban. In determining whether to grant the
exemption, the Commission would consider, among other factors: (i)
Whether the exemption is necessary or appropriate in the public
interest and consistent with the protection of investors and the
purposes of the CEA; (ii) whether the swap dealer or major swap
participant, before the contribution resulting in a prohibition was
made, had adopted and implemented policies and procedures reasonably
designed to prevent violations of the proposed rule, prior to or at the
time of the contribution, had any actual knowledge of the contribution,
and, after learning of the contribution, has taken all available steps
to cause the contributor to obtain return of the contribution and such
other remedial or preventative measures as may be appropriate under the
circumstances; (iii) whether, at the time of the contribution, the
contributor was a covered associate or otherwise an employee of the
swap dealer or major swap participant, or was seeking such employment;
(iv) the timing and amount of the contribution; (v) the nature of the
election (e.g., Federal, State or local); and (vi) the contributor's
intent or motive in making the contribution, as evidenced by the facts
and circumstances surrounding the contribution.\134\ This exemption is
similar to automatic exemption provisions contained in SEC Rule 206(4)-
5 and MSRB Rule G-37.
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\134\ Proposed Sec. 23.451(d).
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Request for Comment: The Commission requests comments generally on
the proposed rules regarding restrictions on certain political
contributions by swap dealers and major swap participants and the
following specific issues:
Is the term ``municipal entity'' appropriately defined? If
not, should the Commission refer to ``a State, State agency, city,
county, municipality, or other political subdivision of a State, or any
governmental plan, as defined in Section 3 of [ERISA] (29 U.S.C.
1002)'' within the meaning of Section 4s(h)(2)(C)? Should the
Commission use the definition of ``government entity'' from SEC
Advisers Act Rule 206(4)-5? \135\ Should the Commission instead follow
the approach of MSRB Rule G-37? \136\
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\135\ As used in SEC Advisers Act Rule 206(4)-5(f)(5) (17 CFR
275.206(4)-5(f)(5)), the term ``government entity'' means any State
or political subdivision of a State, including:
(i) Any agency, authority, or instrumentality of the State or
political subdivision;
(ii) A pool of assets sponsored or established by the State or
political subdivision or any agency, authority or instrumentality
thereof, including, but not limited to a ``defined benefit plan'' as
defined in section 414(j) of the Internal Revenue Code (26 U.S.C.
414(j)), or a State general fund;
(iii) A plan or program of a government entity; and
(iv) Officers, agents, or employees of the State or political
subdivision or any agency, authority or instrumentality thereof,
acting in their official capacity.
\136\ MSRB Rule G-37(g)(ii) references ``the governmental issuer
specified in section 3(a)(29) of the [Exchange] Act'' which includes
``a State or any political subdivision thereof, or any agency or
instrumentality of a State or any political subdivision thereof, or
any municipal corporate instrumentality of one more States * * *''
(15 U.S.C. 78c(29)).
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Should the proposed rule apply not to all swap dealers and
major swap participants, but instead to only swap dealers? If so, why?
IV. Request for Comment
A. Generally
The Commission requests comment on all aspects of the proposed
rules. In addition, the Commission seeks comment on the following
specific issues:
Should any proposed requirements be modified or deemed
satisfied with respect to swaps that are traded and/or cleared on a
registered entity? If so, which requirements should be modified or
deemed satisfied, and why?
Should the Commission use its discretionary authority,
where applicable, to distinguish among swap dealers depending on their
size and the nature of their business? If so, under what circumstances
and how?
Should any additional business conduct requirements be
imposed on swap dealers and/or major swap participants? If so, which
requirements should be imposed, and why?
Should the Commission delay the effective date of any of
the proposed requirements to allow additional time to comply with the
requirements? If so, which requirements, and what is the compliance
burden that should merit a delay?
B. Consistency With SEC Approach
The SEC is proposing rules related to business conduct standards
for swap dealers and major swap participants as required under Section
764 of the Dodd-Frank Act. Understanding that the Commission and the
SEC regulate different products and markets and thus, appropriately may
be proposing alternative regulatory requirements, we request comments
generally on the impact of any differences between the Commission and
SEC approaches to business conduct regulation in this area.
Do the regulatory approaches proposed by the Commission
and the SEC result in duplicative or inconsistent business conduct
standards for market participants subject to both regulatory regimes?
Do the approaches result in gaps or different levels of regulation
between those regimes? If so, in what ways do commenters believe that
such duplication, inconsistencies, or gaps should be minimized?
Do commenters believe there are ways that would make the
approaches more consistent?
V. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA)\137\ requires that agencies
consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities and, if so,
provide a regulatory flexibility analysis respecting the impact.\138\
The business conduct rules proposed by the Commission generally will
affect swap dealers and major swap participants. Prior to Dodd-Frank,
the Commission did not have jurisdiction over swaps, swap dealers and
major swap participants. Thus, the Commission has not previously
addressed the question of whether swap dealers and major swap
participants are, in fact, ``small entities'' for purposes of the RFA.
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\137\ 5 U.S.C. 601 et seq.
\138\ Id.
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However, the Commission has previously established certain
definitions for small entities to be used by the Commission in
evaluating the impact of its regulations on small entities in
accordance with the RFA.\139\ For example, the Commission has
previously determined that futures commission merchants (``FCMs'') are
not small entities for the purpose of the
[[Page 80656]]
RFA\140\ based upon, among other things, the requirements that FCMs
meet certain minimum financial requirements that enhance the protection
of customers' segregated funds and protect the financial condition of
FCMs generally. The analogy to FCMs is appropriate in that we
anticipate that swap dealers and major swap participants may have to
register as FCMs depending on the nature of their business. Moreover,
swap dealers and major swap participants will be subject to minimum
capital and margin requirements, and are expected to comprise the
largest global financial firms. Entities that engage in a de minimis
quantity of swap dealing in connection with transactions with or on
behalf of customers are exempt from the definition of swap dealers and
major swap participants. Accordingly, the Commission is hereby
determining that swap dealers and major swap participants not be
considered to be ``small entities'' for essentially the same reasons
that FCMs have previously been determined not to be small entities.
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\139\ 47 FR 18618, Apr. 30, 1982.
\140\ Id. at 18619.
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Similarly, the Commission has also previously determined that large
traders are not ``small entities'' for RFA purposes.\141\ The
Commission considered the size of a trader's position to be the only
appropriate test for purposes of large trader reporting.\142\ Major
swap participants maintain 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, the Commission is hereby determining
that major swap participants not be considered ``small entities'' for
essentially the same reasons that large traders have previously been
determined not to be small entities. Therefore, the Chairman, on behalf
of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that
the proposed rules will not have a significant economic impact on a
substantial number of small entities.
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\141\ Id. at 18620.
\142\ Id.
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B. Paperwork Reduction Act
The Paperwork Reduction Act (``PRA'') provides that 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 from the Office of Management and Budget (``OMB''). \143\
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\143\ 44 U.S.C. 3501 et seq.
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This rulemaking contains collections of information, notably the
proposed rules that will require swap dealers and major swap
participants to make records, document processes, and make disclosures
to counterparties with whom they propose to enter into swaps. OMB has
not yet assigned a control number to the new collections. OMB has not
yet assigned a control number to the new collection.
The collections of information contained herein overlap the
requirements that are being proposed by the Commission in other
rulemakings implementing the Dodd-Frank Act. The Commission is seeking
or will seek control numbers from OMB for these collections in
association with the other rulemakings. The other proposed rulemakings
are being issued contemporaneously within the CFTC's Business Conduct
Standard-Internal related rulemakings\144\ implementing the Dodd-Frank
Act. The Commission invites public comment on the accuracy of its
estimate that no additional recordkeeping or information collection
requirements or changes to existing collection requirements would
result from the rules proposed herein.
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\144\ The Business Conduct Standard-Internal Rulemakings are:
Regulations Establishing and Governing the Duties of Swap Dealers
and Major Swap Participants, 75 FR 71397, Nov. 23, 2010; 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; and Implementation of
Conflict-of-Interest Standards by Swap Dealers and Major Swap
Participants, 75 FR 71391, Nov. 23, 2010. In addition, the
Commission will be issuing proposed rules regarding recordkeeping,
reporting and daily trading records for swap transactions consistent
with Sec. 1.31 of the Commission's Regulations. (17 CFR Sec.
1.31).
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C. Cost-Benefit Analysis
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its actions before issuing a rulemaking under the
CEA. By its terms, Section 15(a) does not require the Commission to
quantify the costs and benefits of an order or to determine whether the
benefits of the order outweigh its costs; rather, it requires that the
Commission ``consider'' the costs and benefits of its actions. Section
15(a) further specifies that the costs and benefits shall be evaluated
in light of five broad areas of market and public concern: (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 may in its discretion give
greater weight to any one of the five enumerated areas and could in its
discretion determine that, notwithstanding its costs, a particular
order is necessary or appropriate to protect the public interest or to
effectuate any of the provisions or accomplish any of the purposes of
the CEA.
Summary of proposed requirements. The proposed regulations would
implement Section 4s(h) which requires the Commission to promulgate
rules to establish business conduct standards for swap dealers and
major swap participants governing their relationships with
counterparties including special requirements with respect to Special
Entities. Among other things, the statute mandates that the Commission
adopt rules requiring swap dealers and major swap participants to
verify that counterparties meet eligibility criteria, disclose material
information about the contemplated swaps to counterparties, including
material risks, characteristics, incentives and conflicts of interest;
and an ongoing duty to provide counterparties a daily mark for swaps.
The Commission also is directed to 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.
Costs. The Commission's proposed rules implement new Section 4s(h)
and enhance transparency, protect counterparties from fraud and abuse,
bolster confidence in markets, reduce risk, and allow regulators to
better monitor and manage our financial system. With respect to
efficiency, the Commission has determined that adhering to the new
requirements under the proposed rules will not be unduly burdensome for
swap dealers and major swap participants. Indeed, the proposed rules,
in part, reflect existing regulatory requirements in other markets as
well as current industry practices in the swaps market.\145\ In
addition, the Commission has determined that the cost to market
participants and the public if these rules are not adopted could be
substantial. Significantly, without these rules to promote transparency
and fair dealing, the financial integrity and stability of the swaps
markets could be undermined.
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\145\ See, e.g., Trading & Capital-Markets Activities Manual,
Section 2150; CRMPG III Report.
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Benefits. With respect to benefits, the Commission has determined
that the proposed regulations would require a swap dealer or major swap
participant to transact with market participants according to the
principles of fair
[[Page 80657]]
dealing and good faith in a manner intended to heighten the protection
of market participants and the public. The additional protections for
Special Entities reduces the overall risk to institutions critical to
the public interest and the stability of the financial system by
providing tools and safeguards to market participants in order to
accurately assess risk, make informed decisions, and avoid crises. The
proposed rules, if adopted, will result in greater certainty, reduced
risk, increased transparency and market integrity in the swap market.
Therefore, the Commission believes it is prudent to issue these
business conduct requirements for swap dealers and major swap
participants.
The Commission invites public comment on its cost-benefit
considerations. Commenters are also are invited to submit any data or
other information that they may have quantifying or qualifying the
costs and benefits of the proposed regulations with their comment
letters.
List of Subjects in 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.
List of Subjects in 17 CFR Part 155
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements, Swaps.
For the reasons presented above, the Commodity Futures Trading
Commission proposes to amend part 23 (as proposed to be added by FR Doc
2010-29024, published on November 23, 2010, 75 FR 71379) and part 155
of Title 17 of the Code of Federal Regulations as follows:
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
Authority and Issuance
1. 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).
2. 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.
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 and major
swap participants.
Sec. 23.400 Scope.
(a) Scope. The sections of this subpart shall apply to swap dealers
and 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.
Counterparty. The term ``counterparty,'' as appropriate in this
subpart, includes any person who is a prospective counterparty to a
swap.
Major swap participant. The term ``major swap participant'' means
any person defined in Section 1a(33) of the Act and Sec. 1.33(bbb) 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.
Special Entity. The term Special Entity means:
(1) A Federal agency;
(2) A State, State agency, city, county, municipality, or other
political subdivision of a State or;
(3) Any employee benefit plan, as defined in Section 3 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 Income Security Act of 1974 (29 U.S.C. 1002); or
(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)).
Swap dealer. The term ``swap dealer'' means any person defined in
Section 1a(49) of the Act and Sec. 1.3(aaa) 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 of the Requirements of this Subpart.
(1) Swap dealers and major swap participants shall have 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) Diligent Supervision. Swap dealers and major swap participants
shall diligently supervise their compliance with the requirements of
this subpart in accordance with the diligent supervision requirements
of subpart J of this part.
(c) Know your counterparty. Each swap dealer or major swap
participant shall 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.
(d) True name and owner. Each swap dealer or major swap participant
shall keep a record which shall show the true name and address of each
counterparty, the principal occupation or business of such counterparty
as well as the name and address of any other person
[[Page 80658]]
guaranteeing the performance of such counterparty and any person
exercising any control with respect to the positions of such
counterparty.
(e) Reasonable Reliance on Representations. A swap dealer or major
swap participant that seeks to rely on the written representations of a
counterparty with respect to any requirements under this subpart must
have a reasonable basis to believe that the representations are
reliable taking into consideration the facts and circumstances of the
particular relationship, assessed in the context of the particular
transaction. The representations shall include information sufficiently
detailed for the swap dealer or major swap participant reasonably to
conclude that the relevant requirement is satisfied. If agreed to by
the counterparties, such representations may be contained in a master
or other written agreement between the counterparties and may satisfy
the relevant requirements of this subpart for subsequent swaps offered
to or entered into with a counterparty, unless the representations are
inadequate to meet the requirements of this subpart with respect to any
subsequent swap.
(f) 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.
(g) 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 a standard format, including in a master
or other written agreement between the counterparties.
(h) Record Retention. Swap dealers and major swap participants
shall create a record of their compliance with the requirements in this
subpart and shall retain such 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) Confidential treatment of counterparty information. It shall be
unlawful for any swap dealer or major swap participant to disclose to
any other person any material confidential information obtained from a
counterparty, unless such disclosure is necessary for the effective
execution of any swap for or with the counterparty or to hedge any
exposure created by such swap, and the counterparty specifically
consents to such disclosure, or such disclosure is made upon request of
the Commission, Department of Justice or an applicable prudential
regulator.
(c) Trading ahead and front running prohibited. It shall be
unlawful for any swap dealer or major swap participant knowingly to
enter into a transaction for its own benefit ahead of:
(1) Any executable order for a swap received from a counterparty,
or
(2) Any swap that is the subject of negotiation with a
counterparty, unless the counterparty specifically consents to the
prior execution of such swap transaction.
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(m) 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) This section shall not apply with respect to a transaction that
is:
(1) Initiated on 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.
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. In addition to the disclosures of material
risks required in paragraph (a) of this section:
(i) Prior to entering into a bilateral swap that is not available
for trading on a designated contract market or swap execution facility,
swap dealers and major swap participants shall notify the counterparty
that it can request a scenario analysis as provided in paragraph (a)(1)
of this section. Swap dealers and major swap participants shall, upon
request of such counterparty, provide such scenario analysis.
(ii) For a high-risk complex bilateral swap with a counterparty, a
swap dealer or major swap participant shall provide a scenario analysis
designed in consultation with the counterparty to allow the
counterparty to assess its potential exposure in connection with the
swap. The scenario analysis shall be done over a range of assumptions,
including severe downside stress scenarios that would result in a
significant loss.
(iii) For the purposes of paragraph (a)(1)(ii) of this section, a
swap dealer or major swap participant shall use reasonable policies and
procedures to determine whether a bilateral swap is a high-risk complex
swap based on the material characteristics of the swap including, but
not limited to, one or more of the following criteria:
(A) The degree and nature of leverage;
(B) The potential for periods of significantly reduced liquidity;
and
(C) The lack of price transparency.
(iv) The scenario analysis required by paragraphs (a)(1)(i) and
(a)(1)(ii) of this section shall be provided by the swap dealer or
major swap participant in both tabular and narrative formats. The swap
dealer or major swap participant shall disclose all material
assumptions and explain the calculation methodologies used to perform
the required analysis; provided that, the swap dealer or major swap
participant is not required to disclose confidential, proprietary
information about any model it may use to value the swap.
(v) In designing the scenario analysis required by paragraphs
(a)(1)(i) and (a)(1)(ii) of this section, a swap dealer or major swap
participant shall consider any relevant analyses that it undertakes for
its own risk management purposes, including analyses performed as part
of its ``New Product Policy'' specified in Sec. 23.600(c)(3);
[[Page 80659]]
(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 the
particular swap, which shall include:
(i) With respect to disclosure of the price of a swap, the price of
the swap and the mid-market value of the swap as defined in paragraph
(c)(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) Paragraph (a) 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.
(c) Daily mark. A swap dealer or major swap participant shall:
(1) For cleared swaps, notify a counterparty of the counterparty's
right to receive, upon request, the daily mark from the appropriate
derivatives clearing organization; and
(2) For uncleared swaps, provide the counterparty with a daily mark
which shall be the mid-market value of the swap. The mid-market value
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 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.
(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 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.
(ii) Additional information concerning the daily mark to ensure a
fair and balanced communication, including, as appropriate:
(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.
(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 registered swap dealer,
securities-based swap dealer, major swap participant or major
securities-based swap participant) that enters into a swap or is
offered to enter 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 registered swap dealer, securities-based swap dealer, major swap
participant or major securities-based swap participant) that enters
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 or major swap participant shall have a reasonable
basis to believe that any swap or trading strategy involving swaps
recommended to a counterparty is suitable for the counterparty based on
information obtained through reasonable due diligence concerning 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.
(b)(1) A swap dealer or major swap participant will fulfill its
obligations under paragraph (a) of this section if:
(i) The swap dealer has a reasonable basis to believe that the
counterparty is capable of evaluating, independently, the risks related
to a particular swap or trading strategy involving swaps recommended to
the counterparty;
(ii) The counterparty affirmatively indicates that it is exercising
independent judgment in evaluating the recommendations; and
(iii) The swap dealer has a reasonable basis to believe that the
counterparty has the capacity to absorb potential losses related to the
recommended swap or trading strategy involving swaps.
(2) Provided that, where a counterparty has delegated discretionary
authority to another person, such as a registered commodity trading
advisor, the factors contained in paragraphs (b)(1)(i) and (b)(1)(ii)
of this section shall be applied to such person.
(c) This section shall not apply:
(1) To any recommendations made to another swap dealer, major swap
participant, security-based swap dealer, or major security-based swap
participant; or
(2) Where a swap dealer or major swap participant provides:
(i) Information that is general transaction, financial, or market
information; or
(ii) Swap terms in response to a competitive bid request from the
counterparty.
Sec. Sec. 23.435-23.439 [Reserved]
Sec. 23.440 Requirements for swap dealers acting as advisors to
special entities.
(a) For purposes of this section the term ``acts as an advisor to a
Special Entity'' shall include where a swap dealer recommends a swap or
trading strategy that involves the use of swaps to a Special Entity.
The term shall 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 the
Special Entity.
(b) A swap dealer that acts as an advisor to a Special Entity
regarding a swap 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 act in the best interests of the Special
Entity.
(2) Reasonable Efforts. Any swap dealer that acts as an advisor to
a
[[Page 80660]]
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. This information shall
include information relating to:
(i) The authority of the Special Entity to enter into a swap;
(ii) The financial status of the Special Entity, as well as future
funding needs;
(iii) The tax status of the Special Entity;
(iv) The investment or financing objectives of the Special Entity
(including review of any written derivatives, financing and investment
policies, plans or similar documents);
(v) The experience of the Special Entity with respect to entering
into swaps, generally, and swaps of the type and complexity being
recommended;
(vi) Whether the Special Entity has an independent representative
that meets the criteria enumerated in Sec. 23.450(b);
(vii) Whether the Special Entity has the financial capability to
withstand potential market-related changes in the value of the swap
during the term of the swap; and
(viii) Such other information as is relevant to the particular
facts and circumstances of the Special Entity, market conditions and
the type of swap recommended.
(c) Reasonable reliance on representations of the Special Entity.
The swap dealer may rely on written representations of the Special
Entity to satisfy its requirement in paragraph (b) of this section to
make ``reasonable efforts'' to obtain necessary information, provided
that:
(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).
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 ``material business relationship'' means 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, provided however,
that material business relationship does not include payment of fees by
the swap dealer or major swap participant to the representative at the
written direction of the Special Entity for services provided by the
representative in connection with the swap executed between the Special
Entity and the swap dealer or major swap participant. The term
``material business relationship'' shall be subject to a one-year look
back; and
(2) 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, as the term ``principal''
is defined in Sec. 3.1(a) of this chapter;
(3) 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) Any swap dealer or major swap participant that offers to or
enters into a swap with a Special Entity shall have a reasonable basis
to believe that the Special Entity has a representative that:
(1) Has sufficient knowledge to evaluate the transaction and risks;
(2) Is not subject to a statutory disqualification;
(3) Is independent of the swap dealer or major swap participant;
(4) Undertakes a duty to act in the best interests of the Special
Entity it represents;
(5) Makes appropriate and timely disclosures to the Special Entity;
(6) Evaluates, consistent with any guidelines provided by the
Special Entity, fair pricing and the appropriateness of the swap;
(7) In the case of employee benefit plans subject to the Employee
Retirement Income Security Act of 1974, is a fiduciary as defined in
Section 3 of that Act (29 U.S.C. 1002); and
(8) In the case of a municipal entity as defined in Sec. 23.451,
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 that, this
paragraph shall not apply if the representative is an employee of the
Special Entity.
(c) For purposes of paragraph (b)(3) 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, 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;
and
(3) The representative does not have a material business
relationship with the swap dealer or major swap participant, provided
however, that if the representative received any compensation from the
swap dealer or major swap participant, the swap dealer or major swap
participant must ensure that the Special Entity is informed of the
compensation and the Special Entity agrees in writing, in consultation
with the representative, that the compensation does not constitute a
material business relationship.
(d) Reasonable reliance on representations of the Special Entity. A
swap dealer may rely on written representations of a Special Entity to
satisfy its obligation to have a reasonable basis to believe that the
Special Entity has a representative that satisfies the criteria in
paragraph (b) of this section provided that:
(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 Special Entity-representative
relationship, assessed in the context of a particular transaction;
(2) The representations include information sufficiently detailed
for the swap dealer reasonably to conclude that the representative
satisfies the criteria in paragraph (b) of this section. Relevant
considerations would include:
(i) The nature of the relationship between the Special Entity and
the representative and the duties of the representative, including the
obligation of the representative to act in the best interests of the
Special Entity;
(ii) The representative's capability to make hedging or trading
decisions, and the resources available to the
[[Page 80661]]
representative to make informed decisions;
(iii) The use by the representative of one or more consultants;
(iv) 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;
(v) The representative's ability to understand the economic
features of the swap involved;
(vi) The representative's ability to evaluate how market
developments would affect the swap; and
(vii) The complexity of the swap or swaps involved.
(e) Unqualified representative. If a swap dealer or major swap
participant determines that the representative of a Special Entity does
not meet 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.
(f) 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
(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 in connection with the swap and any
other financial transaction or service involving the Special Entity.
(g) 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.
Sec. 23.451 Political contributions by certain swap dealers and major
swap participants.
(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 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 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 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 by any person described in paragraphs
(a)(2)(i) and (a)(2)(ii) of this section.
(3) The term ``municipal entity'' means any State, political
subdivision of a State, or municipal corporate instrumentality of a
State, including--
(i) Any agency, authority, or instrumentality of the State,
political subdivision, or municipal corporate instrumentality;
(ii) 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 any other issuer of municipal securities.
(4) The term ``official'' of a municipal 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 municipal entity, if the office:
(i) Is directly or indirectly responsible for, or can influence the
outcome of, the selection of a swap dealer or major swap participant by
a municipal 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 or major swap participant by a municipal
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 municipal entity
for the swap dealer or major swap participant 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 municipal 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
or major swap participant shall offer to enter into or enter into a
swap or a trading strategy involving a swap with a municipal entity
within two years after any contribution to an official of such
municipal entity was made by the swap dealer or major swap participant,
or by any covered associate of the swap dealer or major swap
participant, provided however, that:
(2) This prohibition does not apply:
(i) If the only contributions made by the swap dealer or major swap
participant to an official of such municipal 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 or major swap participant 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 or major swap
participant, provided that this exclusion shall not apply if the
natural person, after becoming a covered associate, solicits the
municipal entity on behalf of the swap dealer or major swap participant
to offer to enter into or to enter into a swap or trading strategy
involving; or
(iii) With respect to a swap that is initiated on a designated
contract market or swap execution facility if the swap dealer or major
swap participant does not know the identity of the counterparty to the
transaction at the time of the transaction.
(3) No swap dealer or major swap participant or any covered
associate of the swap dealer or major swap participant shall:
(i) Provide or agree to provide, directly or indirectly, payment to
any person to solicit a municipal entity to offer to enter into, or to
enter into, a swap with that swap dealer or major swap participant
unless such person is a regulated person; or
[[Page 80662]]
(ii) Coordinate, or solicit any person or political action
committee to make, any:
(A) Contribution to an official of a municipal entity with which
the swap dealer or major swap participant 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 or major swap participant 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 or major swap participant
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 or major swap
participant 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 or major swap participant:
(i) Before the contribution resulting in the prohibition was made,
adopted and 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 major
swap participant, or was seeking such employment;
(4) The timing and amount of the contribution which resulted in the
prohibition;
(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 or major swap participant if:
(i) The swap dealer or major swap participant 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 or major swap participant.
(2) A swap dealer or major swap participant may not rely on
paragraph (e)(1) of this section more than twice in any 12-month
period.
(3) A swap dealer or major swap participant may not rely on
paragraph (e)(1) of this section more than once for any covered
associate, regardless of the time between contributions.
PART 155--TRADING STANDARDS
Authority and Issuance
3. The authority citation for part 155 shall be revised to read as
follows:
Authority: 7 U.S.C. 6b, 6c, 6g, 6j, 6s, and 12a as amended by
Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Pub. L. 111-203, 124 Stat. 1376 (Jul. 21, 2010).
4. Add Sec. 155.7 to read as follows:
Sec. 155.7 Execution standards.
(a) In connection with any customer order to enter into a swap
where such swap is available for trading on one or more designated
contract markets or swap execution facilities, a Commission registrant
shall:
(1) Prior to execution of the swap, disclose to the customer:
(i) The designated contract markets and swap execution facilities
on which the swap is available for trading; and
(ii) The designated contract markets and swap execution facilities
on which the registrant has trading privileges.
(2) Execute the order on terms that have a reasonable relationship
to the best terms available for such swap on designated contract
markets or swap execution facilities trading such swap.
(b) As part of the execution requirements in paragraph (a) of this
section, the registrant shall use reasonable diligence to ascertain the
best terms available. Among the factors that will be considered in
determining whether a Commission registrant has used ``reasonable
diligence'' are:
(1) The character of the market for the swap, including price,
volatility, speed, certainty of execution, and liquidity;
(2) The size and type of transaction;
(3) The number of markets checked;
(4) Accessibility of quotations; and
(5) The terms and conditions of the order which results in the
transaction, as communicated to the Commission registrant.
By the Commission, this 9th day of December 2010.
David A. Stawick,
Secretary.
Appendices to Business Conduct Standards for Swap Dealers and Major
Swap Participants With Counterparties--Commission Voting Summary and
Statements of Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Dunn,
Sommers, Chilton and O'Malia voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the proposed rulemaking to establish business conduct
standards for swap dealers and major swap participants in their
dealings with counterparties. Today's proposal implements important
new authorities that Congress granted the Commission to establish
and enforce robust sales practices in the swap markets. The proposed
rule will level the playing field and bring needed transparency. It
will strengthen confidence in the market to benefit hedgers and
other market participants.
The proposed rule would prohibit fraud and certain abusive
practices. It also would implement requirements for swap dealers and
major swap participants to deal fairly with customers, provide
balanced communications and disclose conflicts of interest and
material incentives before entering into a swap. The rule also would
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 proposed rule is intended to ensure that swaps customers get
fair treatment in the execution of their transactions. It would
require swap dealers to disclose what access they have to swap
execution facilities and designated contract markets. These rules
also prohibit a swap dealer from defrauding a customer by executing
a transaction on terms that have no ``reasonable relationship'' to
the market. The proposed rule provides flexibility to accommodate
developments in
[[Page 80663]]
the swaps markets while also protecting customers.
[FR Doc. 2010-31588 Filed 12-21-10; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: December 22, 2010