# Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2010-31588 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** December 22, 2010 - **Citation:** 75 FR 80638 ## Text 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. 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 § 145.9 of the Commission's Regulations. 1 1 17 CFR 145.9. 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 §§ 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 §§ 23.400, 23.401 and 23.402—Scope, Definitions and General Provisions B. Proposed § 23.410—Prohibition on Fraud, Manipulation and Other Abusive Practices C. Proposed § 23.430—Verification of Counterparty Eligibility D. Proposed § 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 § 23.432—Clearing F. Proposed § 23.433—Communications—Fair Dealing G. Proposed § 23.434—Recommendations to Counterparties—Institutional Suitability H. Proposed § 155.7—Execution Standards 2 2 The proposed swap execution standards § 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. 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 § 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 § 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 § 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 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. 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. 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 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). 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 7 See also Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23, 2010 (proposed § 23.602 imposing additional diligent supervision requirements on swap dealers and major swap participants). 8 Id. (proposed § 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. 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 10 See Sections 2(h)(7)(A) and (B) of the CEA. 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 commodity trading advisors (“CTAs”), be subject to certain restrictions with respect to political contributions to certain governmental Special Entities (“pay-to-play”). 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. 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. 14 See Dodd-Frank Act Sections 712 and 754. 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). 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. 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. 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 * * *.” 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 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. 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. 19 The proposed swap execution § 155.7 would be promulgated in part 155. All the other proposed rules would appear in subpart H of new part 23. A. Proposed §§ 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 § 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 § 23.410, swap dealers and major swap participants will be subject to all other applicable anti-fraud provisions in the CEA and 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 § 23.433 apply to swap dealers and major swap participants with respect to both counterparties and prospective counterparties. 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. 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 § 23.430, to disclose material information under proposed § 23.431, and the duty to verify that a Special Entity has a qualified representative under proposed § 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 § 23.431(c)(2), (3). The Commission also proposes to define several terms for purposes of subpart H in proposed § 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 § 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 § 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 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. 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 § 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. 24 See proposed §§ 23.600 and 23.602, 75 FR 71397, Nov. 23, 2010. Proposed § 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.” 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. Proposed § 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 § 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. 26 17 CFR 1.37(a)(1). Another general provision, under proposed § 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 § 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 § 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 and relevant with respect to the subsequent swaps. 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. Proposed § 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 § 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 § 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 § 1.31 28 of the Commission's Regulations, and would be accessible to applicable prudential regulators. 28 17 CFR 1.31. 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 § 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 § 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 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). The Commission also proposes §§ 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 §§ 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. 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). 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 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 § 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 § 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 § 23.401. 35 “Eligible contract participant” is a defined term in Section 1a(18) of the CEA. 36 See Section 2(e) of the CEA. The Commission contemplates that, in the absence of “red flags,” and as provided in proposed § 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 § 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 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. Finally, as set forth in proposed § 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 39 This rule tracks the statutory language in Section 4s(h)(7). 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 § 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 § 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 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)). 1. Timing and Manner of Disclosures The Dodd-Frank Act does not address the timing and form of the required disclosures. Proposed § 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 § 23.402(f). 41 41 Additionally, under proposed § 23.402(h), swap dealers and major swap participants would be required to maintain a record of their compliance with the proposed rules. 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. 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). 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 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. 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. 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? 48 See NFA Letter, at 2; SIFMA/ISDA Letter, at 12. • 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 § 23.431(a)(1) is modeled on the CRMPG III industry best practices recommendation for high-risk complex financial instruments. 50 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. 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 § 23.431(a)(1). 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. 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. 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. 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. 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 § 23.600(c)(3), 75 FR 71397, Nov. 23, 2010. To ensure fair and balanced communications and to avoid misleading counterparties, swap dealers and major swap participants also would 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. 56 See DPG Framework, at Part V(II)(G); but see SIFMA/ISDA Letter, at 13-14. 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 § 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 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. 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 § 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 § 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 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. 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. 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 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. 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 § 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. 62 SIFMA/ISDA Letter, at 17; NFA Letter, at 3. 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 § 23.432—Clearing For swaps where clearing is mandatory, 63 proposed § 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 § 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. 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. 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 § 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 § 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. 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). 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 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 § 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 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. 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. 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 §§ 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. Proposed § 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. 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. 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 § 23.434, it would need to undertake a suitability analysis as set forth in the rule. 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. 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 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. The Commission notes that swap dealers and major swap participants are likely to be acting as CTAs 83 when they 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 4 o of the CEA, the anti-fraud provision that applies to CTAs and commodity pool operators. 84 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). 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 § 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. 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). 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. 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.”) 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 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 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. 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 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). 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 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). 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. 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. 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? B. Proposed § 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 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. 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 § 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 § 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 § 23.440(b)(2). 103 102 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 § 23.440. 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 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 § 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 § 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. 109 104 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. 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. 110 The criteria for an independent representative based generally on the statute and under proposed § 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 § 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. 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 § 23.450(b) would require that a swap dealer or major swap participant “have a reasonable basis to believe a Special Entity has a 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. 115 113 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. 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 § 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. 116 17 CFR 3.1(a). 4. Best Interests The Commission is not proposing to define what “best interests” means in this context. As the Commission explained regarding proposed § 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. 117 117 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)). 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. 118 118 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. 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 independent representative is documenting its decisions about appropriateness a [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2010-31588. Public record. Not legal advice.