Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties

Federal RegisterFeb 17, 2012

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 4 and 23

RIN 3038-AD25

Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Final rules.

SUMMARY:

The Commodity Futures Trading Commission (“Commission” or “CFTC”) is adopting final rules to implement Section 4s(h) of the Commodity Exchange Act (“CEA”) pursuant to Section 731 of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). These rules prescribe external business conduct standards for swap dealers and major swap participants.

DATES:

Effective Date:

These final rules will become effective on April 17, 2012.

Compliance Date:

Swap dealers and major swap participants must comply with the rules in subpart H of part 23 on the later of 180 days after the effective date of these rules or the date on which swap dealers or major swap participants are required to apply for registration pursuant to Commission rule 3.10.

FOR FURTHER INFORMATION CONTACT:

Phyllis J. Cela, Chief Counsel, Division of Enforcement; Katherine Scovin Driscoll, Senior Trial Attorney, Division of Enforcement; Theodore M. Kneller, Attorney Advisor, Division of Enforcement; Mary Q. Lutz, Attorney Advisor, Division of Enforcement; Barry McCarty, Attorney Advisor, Division of Enforcement; Michael Solinsky, Chief Trial Attorney, Division of Enforcement; Mark D. Higgins, Counsel, Office of General Counsel; and Peter Sanchez, Special Counsel, Division of Swap Dealer and Intermediary Oversight, Commodity Futures Trading Commission, 1155 21st Street NW., Washington, DC 20581. Telephone number: (202) 418-7642.

SUPPLEMENTARY INFORMATION:

The Commission is adopting final rules §§ 23.400-402, 23.410, 23.430-434, 23.440, and 23.450-451 under Section 4s(h) of the CEA and § 4.6(a)(3) under Section 1a(12) of the CEA.

Table of Contents

I. Introduction

II. Regulatory Intersections

A. Securities and Exchange Commission Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants

B. Department of Labor ERISA Fiduciary Regulations

C. Securities and Exchange Commission Municipal Advisor Registration

D. Commodity Trading Advisor Status for Swap Dealers

III. Final Rules for Swap Dealers and Major Swap Participants Dealing With Counterparties Generally

A. Sections 23.400, 23.401 and 23.402—Scope, Definitions and General Provisions

1. Section 23.400—Scope

a. Proposed § 23.400—Scope

b. Comments and Final § 23.400—Scope

2. Section 23.401—Definitions

a. Proposed § 23.401

b. Comments

c. Final § 23.401

3. Section 23.402—General Provisions

a. Section 23.402(a)—Policies and Procedures to Ensure Compliance and Prevent Evasion

b. Section 23.402(b)—Know Your Counterparty

c. Section 23.402(c)—True Name and Owner

d. Section 23.402(d)—Reasonable Reliance on Representations

e. Section 23.402(e)—Manner of Disclosure

f. Section 23.402(f)—Disclosures in a Standard Format

g. Section 23.402(g)—Record Retention

B. Section 23.410—Prohibition on Fraud, Manipulation and Other Abusive Practices

1. Sections 23.410(a) and (b)

a. Proposed § 23.410(a)

b. Comments

c. Final § 23.410(a) and (b)

2. Section 23.410(c)—Confidential Treatment of Counterparty Information

a. Proposed § 23.410(b)

b. Comments

c. Final § 23.410(c)

3. Proposed Section 23.410(c)—Trading Ahead and Front Running Prohibited—Not Adopted as Final Rule

a. Proposed § 23.410(c)

b. Comments

c. Commission Determination

C. Section 23.430—Verification of Counterparty Eligibility

1. Proposed § 23.430

2. Comments

3. Final § 23.430

D. Section 23.431—Disclosure of Material Risks, Characteristics, Material Incentives and Conflicts of Interest Regarding a Swap

1. Proposed § 23.431—Generally

2. Comments—Generally

3. Final § 23.431—Generally

a. Section 23.431(a)(1)—Material Risk Disclosure

b. Section 23.431(b)—Scenario Analysis

c. Section 23.431(a)(2)—Material Characteristics

d. Section 23.431(a)(3)—Material Incentives and Conflicts of Interest

e. Section 23.431(d)—Daily Mark

E. Section § 23.432—Clearing Disclosures

1. Proposed § 23.432

2. Comments

3. Final § 23.432

F. Section 23.433—Communications—Fair Dealing

1. Proposed § 23.433

2. Comments

3. Final § 23.433

G. Section 23.434—Recommendations to Counterparties—Institutional Suitability

1. Proposed § 23.434

2. Comments

3. Final § 23.434

IV. Final Rules for Swap Dealers and Major Swap Participants Dealing With Special Entities

A. Definition of “Special Entity” Under Section 4s(h)(2)(C)

1. Section 23.401—Proposed Definition of “Special Entity”

2. Comments

a. State and Municipal Special Entities

b. Employee Benefit Plans and Governmental Plans

c. Master Trusts

d. Endowments

e. Collective Investment Vehicles: The “look through” Issue

3. Final § 23.401(c) Special Entity Definitions

a. Federal Agency

b. State and Municipal Special Entities

c. Employee Benefit Plans and Governmental Plans

d. Endowment

e. Collective Investment Vehicles: The “look through” Issue

B. Section 23.440—Requirements for Swap Dealers Acting as Advisors to Special Entities

1. Proposed § 23.440

2. Comments

a. Scope of the Proposed “Acts as an Advisor to a Special Entity” and “Recommendation” Definitions

b. Meaning of “Best Interests”

c. Comments on § 23.440(b)(2)—Duty to Make Reasonable Efforts

3. Final § 23.440

a. Acts as an Advisor to a Special Entity

b. Commenters' Alternative Approaches

c. Best Interests

d. Commenters' Alternative “Best Interests” Approaches

e. Final § 23.440(c)(2)—Duty to Make Reasonable Efforts

f. Final § 23.440(d)—Reasonable Reliance on Representations

C. Section 23.450—Requirements for Swap Dealers and Major Swap Participants Acting as Counterparties to Special Entities

1. Proposed § 23.450

2. Comments

a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)

b. Duty to Assess the Qualifications of a Special Entity's Representative

c. Representative Qualifications

d. Reasonable Reliance on Representations

e. Unqualified Representatives

f. Disclosure of Capacity

g. Transaction Costs and Risks

3. Final § 23.450

a. Types of Special Entities Included in Section 4s(h)(5)(A)(i)

b. ERISA Plan Representatives That Are ERISA Fiduciaries

c. Duty to Assess the Qualifications of a Special Entity's Representative

d. Representative Qualifications

e. Reasonable Reliance on Representations

f. Chief Compliance Officer Review

g. Disclosure of Capacity

D. Section 23.451—Political Contributions by Certain Swap Dealers

1. Proposed § 23.451

2. Comments

3. Final § 23.451

V. Implementation

A. Effective Dates and Compliance Dates

B. Comments

C. Commission Determination

VI. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

C. Cost-Benefit Considerations

I. Introduction

On July 21, 2010, President Obama signed the Dodd-Frank Act.

Title VII of the Dodd-Frank Act amended the CEA

to establish a comprehensive new regulatory framework for 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.

See

Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

7 U.S.C. 1

et seq.,

as amended by the Dodd-Frank Act. All references to the CEA are to the CEA as amended by the Dodd-Frank Act except where otherwise noted.

Title VII of the Dodd-Frank Act also amended the federal securities laws to establish a similar comprehensive new regulatory framework for security-based swaps.

On December 22, 2010, the Commission published in the

Federal Register

proposed subpart H of part 23 of the Commission's Regulations to implement new Section 4s(h) of the CEA pursuant to Section 731 of the Dodd-Frank Act (the “proposed rules” or “proposing release”).

There was a 60-day period for the public to comment on the proposing release, which ended on February 22, 2011. On May 4, 2011, the Commission published in the

Federal Register

a notice to re-open the public comment period for an additional 30 days, which ended on June 3, 2011.

The Commission has determined to adopt the proposed rules with a few exceptions and with certain modifications, discussed below, to address the comments the Commission received. One rule that the Commission has determined not to adopt at this time is proposed § 155.7, which would have required Commission registrants to comply with swap execution standards.

Should the Commission determine to consider execution standards at a later date, it would re-propose such rules.

Proposed Rules for Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 75 FR 80638, Dec. 22, 2010 (“proposing release”).

Reopening and Extension of Comment Periods for Rulemakings Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act, 76 FR 25274, May 4, 2011 (“Extension of Comment Periods”). As reflected in the public comment file, the Commission continued to receive comments and meet with commenters after the comment period officially closed.

Proposing release, 75 FR at 80648-49 and 80662.

Section 731 of the Dodd-Frank Act amends the CEA by adding Section 4s(h).

Section 4s(h) provides the Commission with both mandatory and discretionary rulemaking authority to impose business conduct standards on swap dealers and major swap participants in their dealings with counterparties, including Special Entities.

The proposing release included rules mandated by Section 4s(h) as well as discretionary rules that the Commission determined were appropriate in the public interest, for the protection of investors and in furtherance of the purposes of the CEA.

7 U.S.C. 6s(h).

Section 4s(h)(2)(C) defines Special Entity as: “(i) A Federal Agency; (ii) a State, State agency, city, county, municipality, or other political subdivision of a State; (iii) an employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); (iv) any governmental plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974; or (v) any endowment, including an endowment that is an organization described in section 501(c)(3) of the Internal Revenue Code of 1986.”

See

Section 4s(h)(3)(D) (“Business conduct requirements adopted by the Commission shall establish such other standards and requirements as the Commission may determine are appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of [the CEA.]”);

see also

Sections 4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6). The proposed and final rules are informed by existing requirements for market intermediaries under the CEA and Commission Regulations, the federal securities laws, self-regulatory organization (“SRO”) rules, prudential regulator standards for banks, industry “best practices” and requirements applicable under foreign regulatory regimes.

See

proposing release, 75 FR at 80639 for further discussion of the sources the Commission considered in drafting the proposing release.

In compliance with Sections 712(a)(1) and 752(a)

of the Dodd-Frank Act, Commission staff consulted and coordinated with the Securities and Exchange Commission (“SEC”),

prudential regulators and foreign authorities. Commission staff also consulted informally with staff from the Department of Labor (“DOL”) and the Internal Revenue Service (“IRS”) with respect to certain Special Entity definitions and the intersection of their regulatory requirements with the Dodd-Frank Act business conduct standards provisions. This ongoing consultation and coordination effort is described more fully in Section II of this adopting release.

Section 712(a)(1) of the Dodd-Frank Act requires that the Commission consult with SEC and prudential regulators in promulgating rules pursuant to Section 4s(h). Section 752(a) of the Dodd-Frank Act states in part, that the Commission, SEC, and the prudential regulators “shall consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation (including fees) of swaps * * *.”

See

proposing release, 75 FR at 80640 for further discussion of the Commission's consultation and coordination with the SEC before issuing the proposing release.

In addition, Commission staff consulted with foreign authorities, specifically European Commission and United Kingdom Financial Services Authority staff. Commission staff also considered the existing and ongoing work of the International Organization of Securities Commissions (“IOSCO”). Staff consultations with foreign authorities revealed similarities in the proposed rules and foreign regulatory requirements.

See

proposing release, 75 FR at 80640 for further discussion of the Commission's consultation with foreign authorities.

See generally

European Union Markets in Financial Instruments Directive (“MiFID”), Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments;

see also

European Union Market Abuse Directive (“Market Abuse Directive”), Directive 2006/6/EC of the European Parliament and of the Council of 28 January 2003 on market abuse; Proposal for a Directive of the European Parliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC, COM (2011) 656 final (Oct. 20, 2011) (“MiFID II Proposal”).

The Commission received more than 120 written submissions on the proposing release from a range of commenters.

Commission staff also met with representatives from at least 33 of the commenters and other members of the public. Commenters included members of Congress, dealers, advisors, large asset managers, consumer advocacy groups and pension beneficiaries, end-users, trade or professional organizations and Special Entities such as State and municipal

governmental entities, ERISA pension plan sponsors and administrators, government pension plan administrators and endowments. These comments and meetings were in addition to seven written submissions received by the Commission and at least 33 meetings held by Commission staff with commenters and other members of the public prior to the publication of the proposing release.

The proposed rules included a scope provision,

definitions,

general compliance provisions,

rules that would apply to dealings with all counterparties

and rules that would apply to dealings with Special Entities.

While the comments touched on all aspects of the proposing release, many of them concerned the proposed requirements for swap dealers and major swap participants in their dealings with Special Entities.

Subsequent to the issuance of the proposing release, the Commission received written submissions from the public, available in the comment file on

www.cftc.gov,

including, but not limited to those listed in the table in Appendix 1 to this adopting release.

Prior to the publication of the proposing release, the Commission received several written submissions from the public, available in the comment file on

www.cftc.gov,

including, but not limited to: American Benefits Council letter, dated Sept. 8, 2010; American Benefits Council and the Committee on the Investment of Employee Benefit Assets letter, dated Oct. 19, 2010; National Futures Association letter, dated Aug. 25, 2010 (“NFA Aug. 25, 2010 Letter”); New York City Bar Association letter, dated Nov. 29, 2010; Ropes & Gray letter, dated Sept. 2, 2010; Securities Industry and Financial Markets Association and International Swaps and Derivatives Association letter, dated Oct. 22, 2010 (“SIFMA/ISDA Oct. 22, 2010 Letter”); Swap Financial Group letter, dated Aug. 9, 2010; Swap Financial Group presentation entitled “Briefing for SEC/CFTC Joint Working Group,” dated Aug. 9, 2010; and Morgan Stanley letter, dated Dec. 3, 2010.

See

proposed § 23.400.

See

proposed § 23.401.

See

proposed § 23.402.

See

proposed §§ 23.410, 23.430, 23.431, 23.432, 23.433, and 23.434.

See

proposed §§ 23.440, 23.450 and 23.451.

The Commission has reviewed and considered the comments and, in Sections III and IV below, has endeavored to address both the primary themes running throughout the comment letters and the significant points made by individual commenters. The final rules, like the statute and proposed rules, are principles based and generally follow the framework of the proposed rules.

The text has been clarified in a number of respects to take into account the comments received by the Commission and to harmonize with the SEC's and DOL's regulatory approaches. The Commission discusses each of the final rules in separate sections below, which address the changes from the proposed rules, if any, and the content of the final rules.

The discussions address comments concerning costs and benefits, as well as alternative approaches proposed by commenters. The Commission also provides guidance, where appropriate, to assist swap dealers and major swap participants in complying with their new duties. The Commission also states that it does not view the business conduct standards statutory provisions or rules in subpart H of part 23 to impose a fiduciary duty on a swap dealer or major swap participant with respect to any other party.

The requirements under Section 4s(h), generally, do not distinguish between swap dealers and major swap participants. However, the Commission has considered the nature of the business done by swap dealers and major swap participants and determined that certain of the final rules will not apply to major swap participants. In particular, major swap participants will not be subject to the institutional suitability, “know your counterparty” and scenario analysis requirements, or to a pay-to-play restriction. This is discussed further in the sections below addressing those rules.

The Commission is not adopting a diligent supervision rule in this rulemaking, finding that such a rule would be duplicative of the proposed diligent supervision rule in a separate rulemaking.

See

Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23, 2010 (“Governing the Duties of Swap Dealers”) (proposed § 23.602 imposing additional diligent supervision requirements on swap dealers and major swap participants). The final rules also do not include a free standing prohibition against front running or trading ahead of counterparty transactions as proposed in § 23.410(c) because the Commission has determined that such trading, depending on the facts and circumstances, would violate the Commission's prohibitions against fraudulent, deceptive or manipulative practices, including Sections 4b, 4s(h)(4)(A) and 6(c)(1) of the Act and Regulations §§ 23.410 and 180.1.

II. Regulatory Intersections

A. Securities and Exchange Commission Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants

In addition to CEA Section 4s(h), which was added by Section 731 of the Dodd-Frank Act, Section 764 of the Dodd-Frank Act added virtually identical business conduct standards provisions in Section 15F(h) of the Securities Exchange Act of 1934 (“Exchange Act”).

Section 15F(h)

of the Exchange Act provides the SEC with rulemaking authority to impose business conduct standards on security-based swap dealers (“SBS Dealers”) and major security-based swap participants (“Major SBS Participants” and collectively “SBS Entities”) in their dealings with counterparties, including Special Entities. Furthermore, Section 712(a)(1) of the Dodd-Frank Act requires that the Commission and SEC consult with one another in promulgating certain rules including business conduct standards.

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.

15 U.S.C. 78

-10(h).

Section 712(a)(1) of the Dodd-Frank Act requires that the Commission consult with the SEC and prudential regulators in promulgating rules pursuant to Section 4s(h).

On July 18, 2011, the SEC published in the

Federal Register

proposed rules for Business Conduct Standards for SBS Entities (“SEC's proposed rules”).

The comment period for the SEC's proposed rules closed on August 29, 2011. Following publication of the SEC's proposed rules, commenters requested that the Commission work with the SEC to harmonize the rules for swap dealers, major swap participants, and SBS Entities.

SEC proposed rules, Business Conduct Standards for Security-Based Swap Dealers & Major Security-Based Swap Participants, 76 FR 42396, Jul. 18, 2011.

See, e.g.,

FIA/ISDA/SIFMA Sept. 14 Letter, at

passim;

CFA/AFR Aug. 29 Letter, at

passim.

Commission staff worked closely with SEC staff in the development of the Commission's proposed rules,

the SEC's proposed rules, and these final rules. Additionally, the Commission and SEC staffs held thirteen joint external consultations on business conduct standards with interested parties following the publication of the SEC's proposed rules.

The Commission's objective was to establish consistent requirements for CFTC and SEC registrants to the extent practicable given the differences in existing regulatory regimes and approaches. At this time, the SEC's business conduct standards rules for SBS Entities remain at the proposal stage; however, the Commission believes it has appropriately harmonized its final rules with the SEC's proposed rules, to the extent practicable, and will continue to work with the SEC as it approaches finalization of the SEC's proposed rules.

See

proposing release, 75 FR at 80640 (Commission staff and SEC staff jointly held numerous external consultations with stakeholders prior to publication of the proposed rules in the

Federal Register

A list of Commission staff consultations in connection with this final rulemaking is posted on the Commission's Web site,

available at http://www.cftc.gov/.

B. Department of Labor ERISA Fiduciary Regulations

Special Entities defined in Section 4s(h)(2)(C) of the CEA include “any employee benefit plan, as defined in Section 3”

of the Employee Retirement Income Security Act of 1974 (“ERISA”). DOL is the federal agency responsible for administering and enforcing Title I of ERISA.

29 U.S.C. 1002.

29 U.S.C. 1001

et seq.;

History of EBSA and ERISA, available at

http://www.dol.gov/ebsa/aboutebsa/history.html.

On October 22, 2010, DOL published in the

Federal Register

proposed revisions (“DOL's proposed fiduciary rule”) to the regulatory definition of “fiduciary” under Section 3(21)(A)(ii) of ERISA.

Section 3(21)(A)(ii) states that a person is a fiduciary (“ERISA fiduciary”) to an employee benefit plan subject to Title I of ERISA (“ERISA plan”) “to the extent it renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so.”

In 1975, DOL issued a regulation that defines the circumstances under which a person renders “investment advice” to a plan within the meaning of Section 3(21)(A)(ii).

The regulation established a 5-part test that must be satisfied for a person to be treated as an ERISA fiduciary by reason of rendering investment advice.

DOL's proposed fiduciary rule would have revised the 5-part test and created a counterparty exception or “limitation” for a person acting in its capacity as a purchaser or seller.

Definition of the Term “Fiduciary,” 75 FR 65263, Oct. 22, 2010 (“DOL's proposed fiduciary rule”).

29 U.S.C. 1002(21)(A)(ii).

29 CFR 2510.3-21(c);

see also

DOL's proposed fiduciary rule, 75 FR at 65264.

See id.,

at 65264. The 5-part test states in relevant part:

For advice to constitute “investment advice,” an adviser * * * must—(1) Render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property (2) On a regular basis (3) Pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary, that (4) The advice will serve as a primary basis for investment decisions with respect to plan assets, and that (5) The advice will be individualized based on the particular needs of the plan.

DOL's proposed fiduciary rule provided that, unless the person has expressly represented that it is acting as a fiduciary, it will not be treated as one if it:

[C]an demonstrate that the recipient of the advice knows or, under the circumstances, reasonably should know, that the person is providing the advice or making the recommendation in its capacity as a purchaser or seller of a security or other property, or as an agent of, or appraiser for, such a purchaser or seller, whose interests are adverse to the interests of the plan or its participants or beneficiaries, and that the person is not undertaking to provide impartial investment advice.

DOL's proposed fiduciary rule, 29 CFR 2310.3-21(c)(2), 75 FR at 65277.

The Commission received numerous comments concerning the intersection between ERISA, DOL's proposed fiduciary rule, and existing fiduciary regulation with the business conduct standards under the CEA and the Commission's proposed rules.

Many commenters, including ERISA plan sponsors, swap dealers and institutional asset managers, stated that although many ERISA plans currently use swaps as part of their overall hedging or investment strategy, the statutory and regulatory intersections of ERISA and the CEA could prevent ERISA plans from participating in swap markets in the future.

See, e.g.,

ERIC Feb. 22 Letter, at

passim;

SIFMA/ISDA Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 8; ABC/CIEBA Feb. 22 Letter, at 2-3.

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 2-3; SIFMA/ISDA Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 8.

Commenters were primarily concerned that compliance with the business conduct standards under the CEA or the Commission's proposed rules would cause a swap dealer or major swap participant to be an ERISA fiduciary to an ERISA plan and subject to ERISA's prohibited transaction provisions.

Thus, if a swap dealer or major swap participant were to become an ERISA fiduciary to an ERISA plan, it would be prohibited from entering into a swap with that ERISA plan absent an exemption.

Commenters stated that the penalties for violating ERISA's prohibited transaction provisions are significant and would discourage swap dealers or major swap participants from dealing with ERISA plans.

Section 406(b) of ERISA (29 U.S.C. 1106(b)) states that an ERISA fiduciary with respect to an ERISA plan shall not—(1) deal with the assets of the plan in his own interest or for his own account, (2) in his individual or in any other capacity act in any transaction involving the plan on behalf of a party (or represent a party) whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries, or (3) receive any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan.

In addition to other statutory exemptions, Section 408(a) of ERISA (29 U.S.C. 1108(a)) gives DOL authority to grant administrative exemptions from prohibited transactions prescribed in Section 406 of ERISA.

See, e.g.,

AMG-SIFMA Feb. 22 Letter, at 8 (“This substantial penalty would serve as a serious disincentive for swap dealers and [major swap participants] from engaging in swap transactions with Special Entities subject to ERISA.”); SIFMA/ISDA Feb. 17 Letter, at 5-6 (“there is a serious risk that [swap dealers] will refuse to engage in swap transactions with an ERISA plan to avoid the risks of costly ERISA violations”).

Prior to proposing the business conduct standards rules, the Commission received submissions from stakeholders concerning the interaction with ERISA, DOL's proposed fiduciary rule and current regulation regarding the definition of ERISA fiduciaries.

Thus, Commission and DOL staffs consulted on issues regarding Special Entity definitions that reference ERISA and the intersection of ERISA fiduciary status with the Dodd-Frank Act business conduct provisions.

See, e.g.,

SIFMA/ISDA Oct. 22, 2010 Letter, at 8 fn. 19 (A swap dealer “should not be an advisor in circumstances where it is not a fiduciary under [DOL's proposed] standard.”).

Proposing release, 75 FR at 80640 and 80650 fn. 101.

Informed by discussions between the Commission and DOL staffs, the Commission published its proposed business conduct standards rules. Many commenters, however, expressed ongoing concern that the proposed business conduct standards rules, if adopted in final form without clarification, could have unintended consequences for swap dealers and major swap participants dealing with ERISA plans. Commenters remained concerned that compliance with the business conduct standards could cause a swap dealer or major swap participant to be an ERISA fiduciary to an ERISA plan, which would trigger the prohibited transaction provisions of ERISA.

Specifically, commenters expressed concerns that the business conduct standards could: (1) Cause a swap dealer or major swap participant to become an ERISA fiduciary under current law;

(2) require a swap dealer or major swap participant to cause a third-party advisor to fail to meet DOL's Qualified Professional Asset Manager (“QPAM”) prohibited transaction class exemption;

(3) require a swap dealer or major swap participant to perform certain activities that could make it an ERISA fiduciary under DOL's proposed fiduciary rule, such as calculating and providing a daily mark that is the mid-market value of a swap or providing a scenario analysis of a swap;

(4) require a swap dealer or major swap participant to engage in advisor-like activities such as those required under proposed § 23.401(c)—Know your counterparty, proposed § 23.434—Institutional suitability, or proposed § 23.440—Swap dealers acting as advisors to Special Entities;

or (5) cause a swap dealer to fail to satisfy the counterparty exception or “limitation”

provision in DOL's proposed fiduciary rule.

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at

passim;

ERIC Feb. 22 Letter, at

passim.

SIFMA/ISDA Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 8; ABC/CIEBA Feb. 22 Letter, at 2-3.

SIFMA/ISDA Feb. 17 Letter, at 5 fn. 13; AMG-SIFMA Feb. 22 Letter, at 6; ERIC Feb. 22 Letter, at 14;

see also

DOL Amendment to Prohibited Transaction Exemption (PTE) 84-14 for Plan Asset Transactions Determined by Independent Qualified Professional Asset Managers, 75 FR 38837, Jul. 6, 2010 (“DOL QPAM PTE 84-14”).

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 5-6; SIFMA/ISDA Feb. 17 Letter, at 32.

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 5 fn. 13; AMG-SIFMA Feb. 22 Letter, at 6; ERIC Feb. 22 Letter, at 14.

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 5-6, 19-21, 23-24, and 39; ABC/CIEBA Feb. 22 Letter, at

passim;

ERIC Feb. 22 Letter, at

passim.

Many commenters also requested that the Commission and DOL publicly coordinate the respective proposed rules to avoid swap dealers and major swap participants being deemed ERISA fiduciaries.

On April 28, 2011, DOL submitted a letter to the Chairman of the CFTC regarding its views on DOL's proposed fiduciary rule and potential intersections with the business conduct standards statutory provisions and the Commission's proposed rules.

The letter stated that DOL's proposed fiduciary rule “is not broadly intended to impose ERISA fiduciary obligations on persons who are merely counterparties to plans in arm's length commercial transactions * * * [and] is not intended to upend these expectations by imposing ERISA fiduciary norms on parties who are on the opposite side of plans in such arm's length deals.”

The letter concludes, “[in DOL's] view, with careful attention to fairly straightforward drafting issues, we can ensure that the DOL regulation and the CFTC business conduct standards are appropriately harmonized.”

Subsequently, the Commission received additional comments stating that, although supportive of DOL's statement of intent and analysis of DOL's proposed fiduciary rule, the letter did not resolve all of their concerns and was non-binding.

AFSCME Feb. 22 Letter, at 4; BlackRock Feb. 22 Letter, at 2 and 5; AMG-SIFMA Feb. 22 Letter, at 9; ERIC Feb. 22 Letter, at 2 and 4; Sen. Kerry May 18 Letter, at 1; Sen. Harkin May 3 Letter, at 1-2; Rep. Bachus Mar. 15 Letter, at 2; Rep. Smith July 25 Letter, at 1-2; Sen. Johnson Oct. 4 Letter, at 2.

DOL Apr. 28 Letter.

DOL Apr. 28 Letter, at 1.

DOL Apr. 28 Letter, at 3.

See, e.g.,

ABC/CIEBA June 3 Letter, at 3.

On September 19, 2011, DOL announced that it would re-propose its rule on the definition of fiduciary and expected the new proposed rule to be issued in early 2012.

DOL also stated that it “will continue to coordinate closely with the * * * Commission to ensure that this effort is harmonized with other ongoing rulemakings.”

The Commission has continued to coordinate with DOL to ensure that the final business conduct standards rules are appropriately harmonized with ERISA and DOL regulations.

DOL has reviewed the Commission's final business conduct standards rules for swap dealers and major swap participants and provided the Commission with the following statement:

Office of Public Affairs News Release, U.S. Dept. of Labor,

U.S. Labor Department's EBSA to re-propose rule on definition of a fiduciary

(Sept. 19, 2011).

Id.

Final § 23.440—Requirements for swap dealers acting as advisors to Special Entities and § 23.450—Requirements for swap dealers and major swap participants acting as counterparties to Special Entities address the issues raised by commenters.

See

Sections IV.B. and IV.C. of this adopting release for a discussion of final §§ 23.440 and 23.450.

The Department of Labor has reviewed these final business conduct standards and concluded that they do not require swap dealers or major swap participants to engage in activities that would make them fiduciaries under the Department of Labor's current five-part test defining fiduciary advice 29 CFR § 2510.3-21(c). In the Department's view, the CFTC's final business conduct standards neither conflict with the Department's existing regulations, nor compel swap dealers or major swap participants to engage in fiduciary conduct. Moreover, the Department states that it is fully committed to ensuring that any changes to the current ERISA fiduciary advice regulation are carefully harmonized with the final business conduct standards, as adopted by the CFTC and the SEC, so that there are no unintended consequences for swap dealers and major swap participants who comply with these business conduct standards.

A copy of the statement is included as Appendix 2 of this adopting release.

After considering the comments and DOL's statement, the Commission has determined that the final business conduct standards are appropriately harmonized with ERISA and DOL regulations. The Commission understands from DOL that compliance with the business conduct standards statutory provisions and Commission rules will not, by itself, cause a swap dealer or major swap participant to be an ERISA fiduciary to an ERISA plan. Furthermore, DOL stated its intention to continue to coordinate and appropriately harmonize with Commission rules when it re-proposes its rule on the definition of fiduciary. Thus, the Commission has determined that issues and concerns raised by commenters regarding ERISA requirements have been addressed appropriately.

C. Securities and Exchange Commission Municipal Advisor Registration

The amendments to the CEA in Section 731 of the Dodd-Frank Act also direct the Commission to adopt business conduct standards rules for swap dealers and major swap participants dealing with Special Entities, which include “a State, State agency, city, county, municipality, or other political subdivision of a State” (“State and municipal Special Entities”).

In addition, Section 975 of the Dodd-Frank Act amended Section 15B of the Exchange Act to provide for new regulatory oversight of “municipal advisors,”

that provide advice to a “municipal entity”

with respect to, among other things, municipal financial products, which include municipal derivatives. Municipal advisors are required to register with the SEC

and are subject to the rules of the Municipal Securities Rulemaking Board (“MSRB”), a self-regulatory organization (“SRO”).

On January 6, 2011, the SEC published in the

Federal Register

proposed rules for the Registration of Municipal Advisors (“SEC Proposed MA Rules”).

Section 4s(h)(2)(C)(ii) of the CEA (7 U.S.C. 6s(h)(2)(C)(ii)).

The definition of “municipal advisor” means a person (who is not a municipal entity or an employee of a municipal entity) (i) that provides advice to or on behalf of a municipal entity with respect to municipal financial products (including municipal derivatives) or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues, or (ii) that undertakes a solicitation of a municipal entity. The definition includes financial advisors, third-party marketers, and swap advisors that engage in municipal advisory activities. 15 U.S.C. 78

-4(e)(4).

Section 975 of the Dodd-Frank Act amended Section 15B(e)(8) of the Exchange Act to define the term “municipal entity” as any State, political subdivision of a State, or municipal corporate instrumentality of a State, including (A) any agency, authority, or municipal corporate instrumentality; (B) any plan, program, or pool of assets sponsored or established by the State, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof, and (C) any other issuer of municipal securities. 15 U.S.C. 78

-4(e)(8).

15 U.S.C. 78

-4(a)(1).

15 U.S.C. 78

-4(b)(2).

SEC Proposed Registration of Municipal Advisors, 76 FR 824, Jan. 6, 2011 (“SEC Proposed MA Rules”).

The intersection of the business conduct standards provisions under Section 731 of the Dodd-Frank Act and the municipal advisor provisions under Section 975 raises two important issues. The first issue concerns the regulatory intersection of requirements for SEC-registered municipal advisors and Commission-registered commodity trading advisors (“CTA”) that may serve as qualified independent representatives to a Special Entity under Section 4s(h)(5) and proposed § 23.450. Section 4s(h)(5) of the CEA mandates the Commission to establish a duty for swap dealers or major swap participants that offer to or enter into a swap with a Special Entity to have a reasonable basis to believe that the Special Entity has a qualified independent representative.

Thus, an independent representative

under Section 4s(h)(5) that advises State and municipal Special Entities will be subject to registration with the Commission as a CTA,

except for those independent representatives who are employees of such entity or otherwise excluded or exempt under the CEA or Commission rules. Similarly, municipal advisors include financial advisors and swap advisors that engage in municipal advisory activities, including providing advice with respect to municipal derivatives, with municipal entities, which include all State and municipal Special Entities. Additionally, registered CTAs “who are providing advice related to swaps” are expressly excluded from the definition of “municipal advisor.”

Accordingly, a registered CTA would be subject to the Commission's regulatory requirements, but not those of the SEC or MSRB, even if such CTA registration were required solely for swap advice provided to a municipal entity.

Given these intersections, commenters requested that the Commission coordinate with the SEC to appropriately harmonize the regulatory regime for Commission-registered CTAs that advise municipalities with the regulatory regime for SEC-registered municipal advisors.

Section 4s(h)(5) of the CEA (7 U.S.C. 6s(h)(5)).

Section 1a(12) of the CEA (7 U.S.C. 1a(12)) defines “commodity trading advisor” to be any person who for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in any swap, among other CEA jurisdictional products.

The exclusion includes “any commodity trading advisor registered under the Commodity Exchange Act or persons associated with a commodity trading advisor who are providing advice related to swaps.” 15 U.S.C. 78

-4(e)(4)(C).

To the extent that a registered CTA engages in any municipal advisory activities other than advice related to swaps, registration may still be required with the SEC.

See

SEC Proposed MA Rules, 76 FR at 833;

see also

proposed rule 17 CFR 15Ba1-1(d)(2)(iii), 76 FR at 882.

See, e.g.,

SFG Feb. 22 Letter, at 2 (“[t]here is a need for a single, harmonized regulatory scheme for credentialing and registering swap advisors”); GFOA Feb. 22 Letter, at 2.

A second issue raised by commenters concerns whether compliance with the proposed business conduct standards rules would cause a swap dealer or major swap participant dealing with a State or municipal Special Entity to be deemed to be a municipal advisor.

For example, some commenters asked whether a swap dealer that complies with Section 4s(h)(4)(B) and proposed § 23.440, which requires a swap dealer that “acts as an advisor to a Special Entity” to “act in the best interests” of the Special Entity, would trigger the municipal advisor definition. These commenters opposed such an outcome and requested that the Commission and SEC coordinate and harmonize the proposed rules.

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 6, 19-21, 24, and 34-35; BDA Feb. 22 Letter, at 2.

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 24 and 34 (the Commission and SEC should adopt a unified standard for recognizing when “advice” is being given).

After considering the comments, the Commission has taken steps to ensure that the business conduct standards provisions are appropriately harmonized with the SEC and MSRB regulatory regime for municipal advisors. Commission staff has engaged in several consultations with the staffs of the SEC, MSRB, and the National Futures Association (“NFA”) regarding the regulatory regimes for municipal advisors and CTAs that provide advice to municipal entities with respect to swaps. The Commission is considering several options with respect to CTAs and municipal advisors, including proposing a CTA registration exemption for CTAs that are registered municipal advisors whose CTA activity is limited to swap advice to municipal entities. The Commission is also considering developing rules for CTAs that would be comparable to those adopted by the SEC and MSRB for municipal advisors. Such rules could be adopted by the Commission or, for CTAs that are members of NFA, by NFA. Commission staff continues to consult with SEC staff regarding municipal advisor registration requirements to address the treatment of swap dealers and major swap participants that comply with the Commission's business conducts standards rules. At this time, the rules for the registration of municipal advisors remain at the proposal stage. Therefore, the Commission believes it has appropriately harmonized these final rules and will continue to work with the SEC as it approaches finalization of the SEC's Proposed MA Rules.

D. Commodity Trading Advisor Status for Swap Dealers

The Commission noted in its proposed rules that swap dealers would likely be acting as CTAs when they make recommendations to their counterparties, and particularly recommendations that are tailored to the needs of their counterparty.

Classification as a CTA under the CEA subjects a person to various statutory and regulatory requirements including, among others, the anti-fraud provisions of Section 4

of the CEA and registration with the Commission.

In addition, a CTA, depending on the nature of the relationship, may also owe fiduciary duties to its clients under applicable case law.

Proposing release, 75 FR at 80647-48.

7 U.S.C. 6m and 6

See Commodity Trend Serv., Inc.

CFTC,

233 F.3d 981, 990 (7th Cir. 2000).

Commenters expressed concerns about the implications of swap dealers being treated as CTAs and urged the Commission to make clear that a swap dealer would not be a CTA solely by virtue of providing swap “recommendations” to counterparties. One of these commenters noted that a swap dealer operates in a principal-to-principal market and plays a different role than that of a typical CTA that provides advice to “retail” clients.

This commenter contended that a swap dealer should not be required to register as a CTA in addition to registering in its capacity as a swap dealer. A second commenter stated that by using the term “advisor” rather than “commodity trading advisor” in the relevant provisions of Section 4s(h)(4), Congress likely regarded the provisions of the CEA regulating CTAs as unrelated to those adopted under Section 4s(h)(4).

This commenter requested that the Commission specifically state that no requirement or combination of requirements under the proposed rules would cause a swap dealer, including a swap dealer that makes a recommendation to a Special Entity, to be treated as a CTA.

CEF Feb. 22 Letter, at 17.

SIFMA/ISDA Feb. 17 Letter, at 32 fn. 75.

Id.,

at 34.

A “commodity trading advisor” includes any person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in any swap.

The CEA, however, excludes from the CTA definition banks, floor brokers, and futures commission merchants (“FCMs”), among others, whose advice is “solely incidental to the conduct of their business or profession.” Section 1a(12)(B)(vii) of the CEA also grants the Commission authority to exclude “such other persons not within the intent of [the CTA definition] as the Commission may specify * * *”; however, such exclusion is limited to advice that is “solely incidental to the conduct of their business or profession.” The Commission has determined to provide a similar exclusion for swap dealers whose advice is solely incidental to their business as swap dealers. In determining that a swap dealer's recommendations to a counterparty regarding proposed swap

transactions or trading strategies should be considered “solely incidental” to the conduct of its business, the Commission considered the definition of “swap dealer.” Section 1a(49) of the CEA defines the term “swap dealer” as a person who (1) holds itself out as a dealer in swaps; (2) makes a market in swaps; (3) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (4) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.

Section 1a(12) of the CEA (7 U.S.C. 1a(12)).

Section 1a(49) of the CEA (7 U.S.C. 1a(49)).

Based on the types of activities that define a swap dealer's business, commenters' views and the statutory scheme under Section 4s(h), the Commission has determined that making swap related recommendations to counterparties is most appropriately considered “solely incidental” to the conduct of a swap dealer's business as a dealer or market maker in swaps, including customized swaps, and is not CTA business. Specifically, the Commission has determined that, when making recommendations to a counterparty with respect to an otherwise arm's length principal-to-principal swap transaction with a counterparty a swap dealer will be acting solely incidental to its business as a swap dealer as defined in the CEA and Commission rules. Thus, the Commission has determined to exercise its authority under Section 1a(12)(B)(vii) to add a new exclusion from the CTA definition applicable to swap dealers, including swap dealers that may be excluded or exempt from registration under the CEA or Commission rules, in existing § 4.6. Under new § 4.6(a)(3) a swap dealer is excluded from the definition of the term “commodity trading advisor” provided that its “advisory activities” are solely incidental to its business as a swap dealer.

“Swap dealer” is defined for purposes of the rule by reference to the definitions in Section 1a(49) of the CEA and § 1.3, and would include “associated persons”

acting on behalf of a swap dealer.

While swap dealers that make recommendations will be excluded from the CTA definition, they must comply with other applicable provisions (

i.e.,

§ 23.434-Suitability and § 23.440-Requirements for swap dealers acting as advisors to Special Entities).

“Associated person of a swap dealer or major swap participant” is a defined term in Section 1a(4) of the CEA (7 U.S.C. 1a(4)).

With respect to the scope of the “solely incidental” exclusion for swap dealers, the Commission is generally of the view that making recommendations to a counterparty would not cause a swap dealer to be a CTA.

The exclusion would cover customizing a swap for a counterparty in response to a counterparty's expressed interest or on the swap dealer's own initiative.

Also, preparing a term sheet for purposes of outlining proposed terms of a swap for negotiation or otherwise would be an activity solely incidental to a swap dealer's business.

See

Section III.G. of this adopting release for a discussion of the term “recommendation” in connection with the institutional suitability rule in § 23.434.

The “solely incidental” exclusion also would encompass providing information to a counterparty that is general transaction, financial, or market information, or swap terms in response to a request for quote.

There are advisory activities that the Commission would consider to be beyond the scope of the “solely incidental” exclusion, and depending on the facts and circumstances could cause a swap dealer to be a CTA within the statutory definition. For example, a swap dealer that has general discretion to trade the account of, or otherwise act for or on behalf of, a counterparty would be engaging in activity that is not solely incidental to the business of a swap dealer. Limited discretion related to the execution of a particular counterparty order, however, would not cause a swap dealer to be a CTA. Also, the exclusion would not apply if a swap dealer received separate compensation for, or otherwise profited primarily from, advice provided to a counterparty. Furthermore, a swap dealer that enters into an agreement with its counterparty to provide advisory services or a swap dealer that otherwise holds itself out to the public as a CTA would also not be within the “solely incidental” exclusion. These examples are not exhaustive. There may be other circumstances in which a swap dealer's activity would fall outside the available exclusion. A determination of whether activity is “solely incidental” would necessarily need to be viewed in context based on the particular facts and circumstances.

III. Final Rules for Swap Dealers and Major Swap Participants Dealing With Counterparties Generally

The final business conduct standards rules dealing with counterparty relationships are contained in subpart H of new part 23 of the Commission's Regulations.

This section of the adopting release discusses the following rules that apply to swap dealers' and, unless otherwise indicated, major swap participants' dealings with counterparties generally: § 23.400—Scope; § 23.401—Definitions; § 23.402—General provisions; § 23.410—Prohibition on fraud, manipulation and other abusive practices; § 23.430—Verification of counterparty eligibility; § 23.431—Disclosures of material information; § 23.432—Clearing disclosures; § 23.433—Communications-fair dealing; and § 23.434—Recommendations to counterparties-institutional suitability. A section-by-section description of the final rules follows.

The “solely incidental” CTA exclusion for swap dealers is promulgated in part 4 of the Commission's Regulations.

A. Sections 23.400, 23.401 and 23.402—Scope, Definitions and General Provisions

1. Section 23.400—Scope

a. Proposed § 23.400—Scope

Proposed § 23.400 set forth the scope of subpart H of new part 23 of the Commission's Regulations, which stated that the rules contained in subpart H were not intended to limit or restrict the applicability of other provisions of the CEA, Commission rules and regulations, or any other applicable laws, rules and regulations.

Moreover, the proposed rule provided that subpart H would apply to swap dealers and major swap participants in connection with swap transactions, including swaps that are offered but not entered into.

Some of the proposed rules required compliance prior to entering into a swap, while others, such as the requirement to provide a daily mark, were to be in effect during the entire life of a swap.

Proposing release, 75 FR at 80640.

In the proposing release, the Commission commented that the external business conduct standards rules would be most applicable when swap dealers and major swap participants have a pre-trade relationship with their counterparty. Proposing release, 75 FR at 80641. The Commission noted that for swaps initiated on a designated contract market (“DCM”) or swap execution facility (“SEF”) where the swap dealer or major swap participant does not know the counterparty's identity prior to execution, the disclosure and due diligence obligations would not apply.

See

Section III.D.3. and fn. 338 of this adopting release for a discussion of final § 23.431-Disclosures of material information, which address the disclosure duties of swap dealers and major swap participants pursuant to Section 4s(h)(3)(B) with respect to bilateral swaps and swaps executed on a DCM or SEF.

b. Comments and Final § 23.400—Scope

The Commission received numerous comments regarding issues that relate to the general scope of the proposed business conduct standards, though not necessarily concerning the text of the proposed “scope” rule. One commenter requested that the Commission clarify that the business conduct standards rules would not apply to unexpired swaps executed prior to the effective

date of the final rules.

Another commenter asked the Commission to clarify that certain business conduct standards rules impose duties for swap dealers and major swap participants that continue after the execution of a swap.

The Commission confirms that the business conduct standards will not apply to unexpired swaps executed before the effective date of this adopting release and will apply in accordance with the implementation schedule set forth in Section V.C. of this adopting release; however, the Commission will consider a material amendment to the terms of a swap to be a new swap and subject to subpart H of part 23 of the Commission's Regulations. For swaps that are subject to the business conduct standards rules, the Commission clarifies that certain rules by their terms impose ongoing duties on the swap dealer or major swap participant (

e.g.,

§ 23.410(a)—Prohibitions on fraud, § 23.410(c)—Confidential treatment of counterparty information, and § 23.433—Communications—fair dealing); however, other rules by their terms do not impose ongoing duties on the swap dealer or major swap participant (

e.g.,

§ 23.430—Verification of counterparty eligibility).

SIFMA/ISDA Feb. 17 Letter, at 8.

See

CFA/AFR Aug. 29 Letter, at 11.

Although certain rules do not impose an ongoing duty on a swap dealer or major swap participant with respect to the swap, a swap dealer or major swap participant would still be required to comply with the duty with respect to subsequent swaps offered or entered into with a counterparty.

Another concern raised by commenters was the meaning of the word “offer” in the context of negotiating a swap transaction because certain requirements are triggered when an offer occurs. Other commenters expressed views on the Commission's decision to use the authority granted by Congress to draft discretionary rules for swap transactions instead of solely drafting rules that are explicitly mandated by statute. There were comments suggesting that the discretionary rules should be delegated to an SRO.

Commenters also suggested that the rules should not apply to certain sophisticated counterparties or that counterparties be afforded the opportunity to opt in or opt out of these rules.

Some believed that swap dealers and major swap participants should be subject to different regulations.

Others were concerned about the extraterritorial reach of the Commission's Regulations.

Some commentators were concerned that violating the rules could be a basis for a private right of action under the CEA.

The Commission addresses these issues in the discussion below.

See, e.g.

SIFMA/ISDA Feb. 17 Letter, at 3 and 25-26.

See, e.g.

SIFMA/ISDA Feb. 17 Letter, at 26; NACUBO Feb. 22 Letter, at 3-4; VRS Feb. 22 Letter, at 3-4; HOOPP Feb. 22 Letter, at 3; NFP Energy End Users, Ex Parte Communication, Jan. 19, 2011 (citing NFP Energy End Users Sept. 20, 2010 Letter, at 14-15).

See, e.g.,

AMG-SIFMA Jan. 18 Letter, at 2-3; MFA Feb. 22 Letter, at 1-4; CEF Feb. 22 Letter, at 5-6; BlackRock Apr. 12 Letter, at 1-5.

See, e.g.,

Societe Generale Feb. 18 Letter, at 8-13; Barclays Jan. 11 Letter, at 5-7; Bank of Tokyo May 6 Letter, at 5-6; Barclays Feb. 17 Letter, at

passim.

See, e.g.,

VRS Feb. 22 Letter, at 3; ABC/CIEBA Feb. 22 Letter, at 9-10; SIFMA/ISDA Feb. 17 Letter, at 4, 5-6, 10, and 34-35; FHLBanks June 3 Letter, at 6 and 8; AMG-SIFMA Feb. 22 Letter, at 4-5 and 7-8; CEF Feb. 22 Letter, at 3-4 and 9-10; Exelon Feb. 22 Letter, at 3.

i. Meaning of “Offer”

Certain of the business conduct standards duties under the rules are triggered at the time an “offer” is made.

Two commenters suggested that the rules should be modified to clarify when an “offer” occurs.

One of the commenters suggested that the Commission should define “offer” to mean when sufficient terms are offered that, if accepted, would create a binding agreement under contract law.

They believe that this is necessary because, unlike in securities or futures, the terms of the product are not preset but can be negotiated.

See, e.g.,

final § 23.430(a)—Verification of counterparty eligibility (“before offering to enter into * * * a swap with that counterparty”); final § 23.450(b)(1)—Requirements for swap dealers and major swap participants acting as counterparties to Special Entities (“Any swap dealer or major swap participant that offers to enter or enters into a swap with a Special Entity * * *”).

See

APPA/LPPC Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 35-36.

See

SIFMA/ISDA Feb. 17 Letter, at 35 fn. 84.

The Commission confirms that the term “offer,” as used in the business conduct standards rules in subpart H, has the same meaning as in contract law, such that, if accepted, the terms of the offer would form a binding contract.

The Commission notes, however, that not all of the rules are triggered when an offer is made. For example, the suitability duty is triggered when a swap dealer makes a “recommendation.”

The final fair dealing rule

will apply to all communications by a swap dealer or major swap participant in connection with a swap, including communications made prior to an offer. Other final rules (

e.g.,

the anti-fraud and confidential treatment rules) will be triggered as indicated by their terms. In addition, the Commission expects that for practical purposes swap dealers and major swap participants will comply with certain of their business conduct standards duties through counterparty relationship documentation negotiated with their counterparties well before an “offer” or a “recommendation” is made.

100

See, e.g.,

Restatement (Second) of Contracts § 24 (1981) (“An offer is the manifestation of willingness to enter into a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it.”). In addition, as stated in § 23.400, nothing in these rules is intended to limit or restrict the applicability of other applicable laws, rules and regulations, including the federal securities laws.

See

Section III.G. of this adopting release for a discussion of § 23.434—Recommendations to Counterparties—Institutional Suitability.

See

Section III.F.3. of this adopting release for a discussion of final § 23.433.

100

For example, the verification of counterparty eligibility, know your counterparty and the verification of a Special Entity's independent representative would be completed prior to any recommendation or offer. Other forms of documentation may suffice depending on the circumstances. For instance, if a counterparty requests a quote from a swap dealer with which it does not have relationship documentation, the counterparty could book the swap through its prime broker with which the swap dealer may have pre-negotiated documentation.

Swap dealers and major swap participants will be permitted to arrange with third parties, such as the counterparty's prime broker, a method of providing disclosures or verifying that a Special Entity has an independent representative to satisfy its obligations under the rules. But the swap dealer or major swap participant will remain responsible for compliance with the rules.

ii. Discretionary Rules

In the proposing release, the Commission noted that some of the requirements and duties in the proposed rules were mandated by specific provisions in the Dodd-Frank Act, while others were proposed under the Commission's discretionary authority.

101

Some commenters recommended that the final rules be limited to what is mandated by statute until the CFTC gains more familiarity with these markets as they develop.

102

Another commenter expressed a contrary view that Congress intended the Commission to use its discretionary authority because, if it did not, such authority would not have been granted.

103

A commenter suggested that the rules that are promulgated based on the Commission's discretionary authority, such as suitability and scenario analysis, should apply only to a subset of eligible contract participants (“ECPs”) that require additional

protections.

104

Another commenter suggested that if the Commission does adopt the discretionary rules, it should implement any such additional proposals as SRO rules and allow sophisticated counterparties to opt out of the heightened protections that they may not need or want.

105

101

See

proposing release, 75 FR at 80639.

102

See

BlackRock Feb. 22 Letter, at 1-2; Encana Feb. 22 Letter, at 2.

103

CFA/AFR Feb. 22 Letter, at 18.

104

CEF Feb. 22 Letter, at 4-5.

105

SIFMA/ISDA Feb. 17 Letter, at 3 and 25-26.

One commenter stated that the Commission's approach in proposing discretionary rules that used industry best practices was reasonable because the proposals have already been endorsed by the industry as workable and achievable.

106

The commenter stated that the Commission should go further, however, because the industry's standards of conduct have been so poor that the industry's own suggestions may not go far enough.

106

CFA/AFR Feb. 22 Letter, at 19.

The Commission has determined to adopt the rules proposed under the Commission's discretionary authority along with the mandatory rules, albeit with the changes and for the reasons discussed in the applicable sections of this adopting release that address each final rule. In exercising that discretion, the Commission has acted consistently with the intent of Congress as expressed in Section 4s(h)(3)(D) to establish business conduct standards that the Commission determines are appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the CEA.

107

Many of the discretionary rules adopted by the Commission are based generally on existing Commission and SRO rules for registrants and industry best practices, and extending them to swap dealers and, where appropriate, to major swap participants will promote regulatory consistency. As such, the discretionary rules reflect existing business conduct standards that are time-tested, appropriate for swap dealers and major swap participants, and are well within the Commission's broad discretionary rulemaking authority under Section 4s(h). As a result, the final rules strike an appropriate balance between protecting the public interest and providing a workable compliance framework for market participants. With regard to the comments that suggest the Commission should implement any discretionary rules as SRO rules, the Commission declines to take such an approach. The Commission has relied in the past on SROs to fulfill a number of important functions in the derivatives market, and it will continue to do so in the future. Moreover, the Commission will consider SRO guidance, where relevant and appropriate, in interpreting the Commission's final rules that are based on SRO rules.

108

If, in the future, it becomes beneficial to delegate certain functions regarding the business conduct standards to SROs, the Commission will do so at that time. Delegating all discretionary rules to the SROs now, however, is premature and not consistent with the regulatory scheme that was mandated by Congress.

109

107

See also

Sections 4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6).

108

For further discussions of SRO guidance

see

Section III.A.3.b. of this release at fn. 188 discussing final § 23.402(b) (know your counterparty), Section III.F.3. of this release at fn. 500 discussing final § 23.433 (communications-fair dealing), and Section III.G.3. of this release at fn. 542 discussing final § 23.434 (recommendations to counterparties—institutional suitability).

109

The SEC has taken a consistent approach in its proposed business conduct standards rules. For example, the SEC's “know your counterparty,” suitability and fair communications rules are based on similar requirements under the rules of the Financial Industry Regulatory Authority (“FINRA”).

See

SEC's proposed rules, 76 FR at 42414 fn. 125, 42415 fn. 128, and 42418 fn. 151.

See also

FINRA Rule 2090 (know your customer), FINRA Rule 2111 (suitability), and NASD Rule 2210 (communications with the public).

iii. Different Rules for Swap Dealers and Major Swap Participants

Some commenters recommended that there be different business conduct standards rules for swap dealers and major swap participants.

110

Another commenter stated that the rules concerning “know your counterparty,” treatment of confidential information, trading ahead and front running, the requirement to provide a daily mark, fair dealing, and the determination of counterparty suitability should not apply to major swap participants.

111

This commenter believed that major swap participants, however, should receive the benefits of those rules when acting as counterparties to swap dealers. They argued that major swap participants, regardless of their size, cannot be presumed to possess a level of market or product information equal to that of swap dealers and are less likely than swap dealers to be members of a swap execution facility (“SEF”), a designated contract market (“DCM”) or a derivatives clearing organization (“DCO”). The commenter believed that major swap participants are unlikely to have systems and personnel comparable to that of a swap dealer to allow them to model and value complex instruments.

112

As a result, they argued that major swap participants, when dealing with swap dealers, should be able to: (1) Elect where to clear trades; (2) receive risk disclosure, the required scenario analyses for complex high-risk bilateral swaps, information about incentives or compensation the dealer is getting, and any new product analysis that the swap dealer does for its risk management purposes; and (3) receive the protection from the suitability provision the same as any other counterparty would receive.

110

See

AMG-SIFMA Jan. 18 Letter, at 2-3; MFA Feb. 22 Letter, at 1-4; CEF Feb. 22 Letter, at 5-6; BlackRock Apr. 12 Letter, at 1-5; BlackRock June 3 Medero and Prager Letter, at 4-5.

111

MetLife Feb. 22 Letter, at 4-5,

contra

CFA/AFR Nov. 3 Letter, at 7.

112

MetLife Feb. 22 Letter, at 4-5.

The statutory business conduct standards requirements, generally, do not distinguish between swap dealers and major swap participants. However, the Commission has considered the definitions of swap dealer and major swap participant, which are based on the nature of their swap related businesses, including marketing activities, and has determined, where appropriate, not to apply certain discretionary rules to major swap participants. The final rules for major swap participants do not include the suitability duty, pay-to-play, “know your counterparty” and scenario analysis provisions. Removing these requirements alleviates some of the regulatory burden on major swap participants without materially impacting the protections for counterparties envisioned by Congress. This is discussed further in the sections below that address these relevant rules.

With respect to one commenter's request that major swap participants be the beneficiaries of the business conduct standards rules,

113

Congress appears to have made a contrary determination as indicated, for example, in Section 4s(h)(3), which explicitly relieves swap dealers from the duty to provide disclosures to major swap participants. Following this approach in the statute, the Commission has determined not to require that swap dealers provide major swap participants with the same protections afforded to other counterparties. Nor is the Commission requiring swap dealers to allow major swap participants to opt in to receive certain protections, such as a daily mark, suitability or scenario analysis, that are afforded to counterparties generally. That would impose a burden on swap dealers that is not contemplated by the statutory scheme. Of course, major swap participants are free to negotiate with swap dealers for such protections on a contractual basis.

113

Id.

iv. Opt In or Opt Out for Certain Classes of Counterparties

Some commenters suggested that the Commission should (1) provide an exemption from the external business conduct standards for swap dealers when they transact with certain sophisticated investors, which might include certain Special Entities, or (2) narrowly tailor the external business conduct standards to make them elective for the counterparty.

114

These commenters suggested that the Commission should set the threshold for parties that decide to opt out to include “qualified institutional buyers” as defined in Rule 144A

115

under the Securities Act of 1933 (“Securities Act”)

116

and corporations having assets under management of $100 million or more.

114

See

VRS Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 26; NACUBO Feb. 22 Letter, at 3-4.

115

17 CFR 230.144A.

116

15 U.S.C. 77a

et seq.

All references to the Securities Act are to the Securities Act, as amended by the Dodd-Frank Act.

Another commenter suggested that the Special Entity provisions should not be applicable to certain not-for-profit electricity and natural gas providers because of their sophistication in dealing with swaps concerning such commodities.

117

One commenter believed that the business conduct standards rules should not apply to sophisticated Special Entities,

118

and another commenter suggested that they should not apply to non-ERISA pension plans.

119

According to these commenters, many of the protections in place for Special Entities will slow down the process for entering into swaps and make it more difficult for Special Entities to do business. Two other commenters believed that the rules will increase the price of swaps without any material benefit.

120

One of them suggested that the Commission instead should (1) provide an exemption from the external business conduct standards rules for swap dealers when transacting with certain sophisticated investors, which would include certain government plans such as the commenter, or (2) narrowly tailor the rules to make them elective for the counterparty.

121

117

See

NFP Energy End Users, Ex Parte Communication, Jan. 19, 2011 (citing NFP Energy End Users Sept. 20, 2010 Letter, at 14-15).

118

VRS Feb. 22 Letter, at 3 (business conduct standards rules should not apply to sophisticated Special Entities).

119

HOOPP Feb. 22 Letter, at 3 (business conduct standards rules should not apply to sophisticated non-ERISA plans such as HOOPP).

120

VRS Feb. 22 Letter, at 3-4; EEI June 3 Letter, at 6.

121

VRS Feb. 22 Letter, at 3-4.

That is not the approach that Congress took in Section 4s(h) of the CEA. With a few exceptions not relevant here, the statute does not distinguish among counterparties or types of transactions.

122

Nevertheless, as discussed below in connection with the relevant rules, the Commission has determined to permit means of compliance with the final rules that should promote efficiency and reduce costs and, where appropriate, allow the parties to take into account the sophistication of the counterparty.

123

The final rules grant swap dealers and major swap participants, with approval of their counterparties, discretion in selecting a reliable, cost-effective means for providing required information, including using Web sites with password protection.

124

Additionally, the Commission adopted approaches for swap dealers and major swap participants dealing with Special Entities to streamline the process for complying with the Special Entity provisions without undermining the intent of Congress in enacting those provisions.

122

Section 4s(h) distinguishes among counterparties in the Special Entity provisions (Sections 4s(h)(4) and (5)), and among swaps transactions where the counterparty to the swap dealer or major swap participant is a swap dealer, major swap participant, or SBS Entity (Section 4s(h)(3)).

123

For example, swap dealers will be able to rely on counterparty representations with respect to sophistication, among other things, to tailor their compliance with the suitability rule—§ 23.434. To promote efficiency and lower costs, the rules allow swap dealers and major swap participants to incorporate, as appropriate, material information covered by the disclosure requirements in counterparty relationship documentation or other standardized formats to avoid having to make repetitious disclosures on a transaction-by-transaction basis.

124

Section 23.402(e)—Manner of disclosure. The Commission notes, however, that the disclosure rules are principles based and set standards for required disclosures. The standards apply to each swap covered by the rules. Therefore, whether any particular disclosure or format (

e.g.,

custom tailored or standardized in counterparty relationship documentation) meets the standard in connection with any particular swap will depend on the facts and circumstances. Swap dealers and major swap participants will be responsible for complying with the disclosure standards for each swap.

In addition, an opt in or opt out regime for counterparties could create incentives for swap dealers and major swap participants that would be inconsistent with congressional intent in enacting the business conduct standards. Rather than raising standards, pressure from swap dealers or major swap participants could discourage counterparties from electing to receive such protections and could effectively force counterparties to waive their rights or be shut out of many swaps transactions.

125

Moreover, the Commission generally frowns on attempts to get customers to waive protections under its rules.

126

As a result, the Commission declines to adopt such an opt in or opt out regime.

125

One commenter suggested that the Commission should impose a minimum comprehension requirement on counterparties.

See

Copping Jan. 12 Submission. The Commission declines to do so as it is beyond the scope of the business conduct standards rules, which govern swap dealer and major swap participant behavior and not counterparties. Moreover, Congress determined to limit swaps trading, except on a DCM, to ECPs, implicitly finding ECPs to be qualified to engage in such transactions. Nevertheless, the final rules follow the statutory scheme, which establishes a robust disclosure regime and Special Entity protections, among others. The Commission has determined to use its discretionary rulemaking authority to provide for suitability and scenario analysis, in particular. Taken together, the final rules materially enhance the ability of counterparties to assess the merits of entering into any particular swap transaction and reduce information asymmetries between swap dealers and major swap participants and their counterparties.

126

See, e.g.,

First American Discount Corp.

CFTC,

222 F. 3d 1008, 1016-17 (D.C. Cir. 2000) (the Commission contended that permitting introducing brokers to waive the required guarantee agreement with its FCM would undermine the protections provided by Commission Regulation § 1.10(j) (17 CFR 1.10(j))).

v. SEF Transactions

Some commenters stated that certain business conduct standards rules should not apply to SEF transactions where the swap dealer or major swap participant learns the identity of the counterparty only immediately prior to the execution of the swap such as in a request for quote (“RFQ”) system.

127

Another commenter opined that Section 4s(h)(7) is intended to exclude certain transactions from all of the requirements of the Commission's business conduct standards rules.

128

The commenter stated that, because the Commission only mentions the exemption with respect to verification of counterparty eligibility

129

and the requirements for swap dealers acting as counterparties to Special Entities,

130

the exclusion could be read as applying only to those rules. The commenter believed that the proper reading of Section 4s(h)(7) requires that all transactions initiated by a Special

Entity on a SEF or DCM are excluded from the business conduct standards rules, not merely those that are initiated by a Special Entity where the identity of the counterparty is not known.

131

The commenter believed the two prongs are intended to be disjunctive and carve out from the business conduct standards rules (1) any transaction a Special Entity enters into on a SEF or DCM, or (2) all SEF or DCM transactions where the swap dealer or major swap participant does not know the identity of the counterparty.

132

127

See

SIFMA/ISDA Feb. 17 Letter, at 7 (asserting that the Commission should clarify that the following proposed exceptions would be available to a swap dealer or major swap participant in an RFQ system where the counterparty's identity is known only immediately prior to the execution of the swap: § 23.430(c)—Verification of counterparty eligibility, § 23.431(b)—Disclosures of material information, § 23.450(g)—Acting as counterparties to Special Entities, and § 23.451(b)(2)(iii)—Pay-to-play prohibitions); State Street Feb. 22 Letter, at 2-3; SWIB Feb. 22 Letter, at 2.

128

ABC/CIEBA June 3 Letter, at 6-7.

129

See

proposed § 23.430(c).

130

See

proposed § 23.450(g).

131

ABC/CIEBA June 3 Letter, at 6-7.

132

Id.

Based on the statutory language, the Commission's view is that Section 4s(h)(7) creates an exclusion that applies when two conditions are met: (1) When a transaction is initiated by a Special Entity on a DCM or SEF; and (2) the swap dealer or major swap participant does not know the identity of the counterparty to the transaction. Consistent with Section 4s(h)(7), the Commission has determined that certain of the business conduct standards rules will apply only where the swap dealer or major swap participant knows the identity of the counterparty prior to execution. These are the provisions for “know your counterparty,” true name and owner, verification of eligibility, disclosures, suitability, and the Special Entity rules.

133

Swap market participants should be aware that the Commission's anti-evasion rule in § 23.402(a) requires swap dealers or major swap participants to have policies and procedures to prevent them from evading or facilitating an evasion of any provision of the Act or Commission Regulation. The Commission expects such policies and procedures to preclude routing pre-arranged trades through a SEF or DCM for the purpose of avoiding compliance with the business conduct standards rules. For example, where a swap dealer or major swap participant has a relationship with a counterparty and has discussed a transaction prior to “anonymous” execution on a SEF, the Commission will consider whether the transaction was structured to avoid compliance with the business conduct standards rules in determining whether to bring an action for failure to have or comply with written policies and procedures to prevent evasion under § 23.402(a).

For uncleared swaps executed on a SEF, swap dealers and major swap participants have ongoing duties to counterparties the same as they would in uncleared non-SEF transactions. For example, the duties to provide a daily mark, engage in fair dealing, and maintain confidentiality of counterparty information will continue to apply.

For swaps where the identity of the counterparty is known just prior to execution on a SEF, the Commission has determined that the business conduct standards rules, including the disclosure duties, will apply. Section 4s(h)(7), which limits application of the Special Entity provisions of the business conduct standards in anonymous DCM and SEF transactions, informs the applicability of other business conduct standards that are also anonymous DCM or SEF transactions. It would be inconsistent with the statutory language and blur the line of when disclosures are required, for example, to exempt swaps from the business conduct standards duties where the identity of the counterparty is known just prior to execution on a SEF. Under the final rules, swap dealers and major swap participants will have to develop mechanisms for making disclosures in connection with such transactions on a SEF, which may include working with the SEF itself, to develop functionality to facilitate disclosures.

134

Providing required disclosures under § 23.431 through such mechanisms will not be considered evasion under § 23.402(a).

vi. Extraterritoriality

A few commenters addressed the international reach of the proposed rules. Some commenters stated that the business conduct standards rules should apply only to swaps with a U.S. customer and a U.S. based salesperson.

135

For other swaps, the commenters stated the Commission should defer to foreign regulators

136

and exercise supervision through memoranda of understanding.

137

One commenter also recommended a new registration category for foreign dealers.

138

135

See, e.g.,

Societe Generale Feb. 18 Letter, at 8-13; Barclays Jan. 11 Letter, at 5; Bank of Tokyo May 6 Letter, at 5-6; Barclays Feb. 17 Letter, at 8-9.

136

See

Bank of Tokyo May 6 Letter, at 6.

137

See

Societe Generale Feb. 18 Letter, at 8.

138

Id.

The Commission expects to address extraterritorial issues under the Dodd-Frank Act in a separate release, which will include the issues raised by these commenters concerning the application of the business conduct standards rules to foreign customers and dealers.

vii. Private Rights of Action

Several commenters voiced concerns over the potential for litigation that could arise because of the business conduct standards rules.

139

They are concerned that litigation costs will increase as a result and be passed on to counterparties. Commenters noted that the proposed rules may indirectly subject swap dealers and major swap participants to private rights of action because of the statutory language in Section 4s(h).

140

While the Commission cannot exempt swap dealers and major swap participants from private rights of action under Section 22 of the CEA, and issues related to private rights of action are beyond the scope of this rulemaking, in this adopting release and in the rule text, the Commission has provided guidance to swap dealers and major swap participants for complying with the final rules. In addition, in the absence of fraud, the Commission will consider good faith compliance with policies and procedures reasonably designed to comply with the business conduct standards rules as a mitigating factor when exercising its prosecutorial discretion for violation of the rules.

139

See

VRS Feb. 22 Letter, at 3; ABC/CIEBA Feb. 22 Letter, at 9-10; SIFMA/ISDA Feb. 17 Letter, at 4, 5-6, 10 and 34-35; FHLBanks June 3 Letter, at 6 and 8; AMG-SIFMA Feb. 22 Letter, at 4-5 and 7-8; CEF Feb. 22 Letter, at 3-4 and 9-10; Exelon Feb. 22 Letter, at 3.

140

For example, Section 22 of the CEA provides a private right of action for any violation of the CEA, and Section 4s(h)(l) states that “[e]ach registered swap dealer and major swap participant shall conform with such business conduct standards * * * as may be prescribed by the Commission by rule or regulation. * * *”

viii. Inter-Affiliate Transactions

One commenter suggested that the Commission clarify that certain of the requirements applicable to swap transactions and swap dealing activities do not apply to transactions among affiliated entities because such inter-affiliate transactions do not implicate the concerns for systemic risk and market integrity that the Dodd-Frank Act is intended to address and there is very limited potential for fraudulent conduct.

141

Another commenter suggested that, with regard to banks, the Commission should provide relief from the business conduct standards with respect to transactions among bank group members when the transaction is with a group member that is a registered swap dealer or major swap participant.

142

141

Shell June 3 Letter, at 1.

142

Bank of Tokyo May 3 Letter, at 4-5.

The Commission confirms that swap dealers and major swap participants need not comply with the subpart H external business conduct standards rules for swaps entered into with their affiliates where the transactions would not be “publicly reportable swap transactions.” Under § 43.2, recently adopted in the real time reporting rulemaking, a publicly reportable swap transaction means, among other things, any executed swap that is an arm's length transaction between two parties that results in a corresponding change in the market risk position between the two parties.

143

The definition of a publicly reportable swap transaction provides, by way of example, that

internal transactions to move risk between wholly-owned subsidiaries of the same parent, without having credit exposure to the other party would not require public dissemination because such swaps are not arm's-length transactions. Such transactions, however, are subject to the anti-evasion requirements of § 23.402(a) and the anti-fraud provisions in § 23.410.

143

Real Time Public Reporting, 77 FR 1182 at 1187, Jan. 9, 2012.

2. Section 23.401—Definitions

a. Proposed § 23.401

Proposed § 23.401 contained definitions for several terms that are relevant to the Commission's proposed business conduct standards rules. These include the terms “counterparty,” “major swap participant,” “Special Entity”

144

and “swap dealer.” The term counterparty was defined to include prospective counterparties. The proposed definitions of “swap dealer” and “major swap participant” incorporated by reference the proposed definitions in the Commission's entity definitions rulemaking.

145

In addition, these terms included, as appropriate under this subpart, anyone acting for or on behalf of such persons, including associated persons as defined in Section 1a(4) of the CEA.

144

See

Section IV.A. of this adopting release for a discussion of the comment letters received and the Commission's determination regarding the definition of the term “Special Entity.”

145

See

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” Major Swap Participant,” “Major Security-Based Swap Participant,” and “Eligible Contract Participant,” 75 FR 80174, Dec. 21, 2010.

b. Comments

The Commission did not receive any comments regarding the proposed definitions of swap dealer or major swap participant.

146

One commenter stated that the Commission should revise the proposed definition of counterparty to exclude swap dealers and major swap participants.

147

The commenter asserted that the Commission should revise the definition of counterparty and clarify that none of the business conduct standards rules applies where swap dealers or major swap participants transact with another swap dealer or major swap participant.

148

146

A commenter urged the Commission to refine the definition of ECP so that the discretionary rules would provide protections only for a subset of unsophisticated ECPs. Alternatively, this commenter asked the Commission to exempt swap dealers and major swap participants from compliance with the external business conduct standards when they face counterparties who are sophisticated enough to evaluate swap transactions without support from the swap dealer or major swap participant. CEF Feb. 22 Letter, at 4-5,

see also

Wells Fargo May 11 Letter, at

passim. See

Section III.A.1. of this adopting release for a discussion of § 23.400-Scope, including how the Commission addressed these issues.

147

CEF Feb. 22 Letter, at 7-8.

148

Id.

c. Final § 23.401

The Commission has determined to adopt the definitions of counterparty, swap dealer and major swap participant as proposed (renumbered as § 23.401(a)—Counterparty, § 23.401(b)—Major swap participant and § 23.401(d)—Swap dealer). The Commission declines to revise the definition of counterparty to exclude swap dealers and major swap participants. Certain rules by their terms, such as § 23.431—Disclosures of Material Information and § 23.434—Institutional Suitability, do not apply to transactions among swap dealers or major swap participants. However, the Commission has determined that it would be inappropriate and inconsistent with the statute to exclude such transactions from other rules, such as § 23.433-Communications—fair dealing.

3. Section 23.402—General Provisions

149

The Commission proposed § 23.402(b)—Diligent supervision, but has determined not to adopt it as a final rule.

See

fn. 21. As a result, the paragraphs in final § 23.402 have been renumbered as reflected in the final rules.

a. Section 23.402(a)—Policies and Procedures To Ensure Compliance and Prevent Evasion

i. Proposed § 23.402(a)

Proposed § 23.402(a) required swap dealers and major swap participants to have policies and procedures reasonably designed to ensure compliance and prevent evasion of any provision of the CEA or any Commission Regulation, and to implement and monitor compliance with such policies and procedures as part of their supervision and risk requirements under subpart J of part 23.

150

The Commission has proposed that swap dealers and major swap participants adopt policies and procedures regarding compliance with the CEA and Commission Regulations.

See, e.g.,

Governing the Duties of Swap Dealers, 75 FR 71397; Designation of a Chief Compliance Officer, Required Compliance Policies, and Annual Report of a Futures Commission Merchant, Swap Dealer, Major Swap Participant, 75 FR 70881, Nov. 19, 2010 (“CCO proposed rules”); Implementation of Conflict-of-Interest Standards by Swap Dealers and Major Swap Participants, 75 FR 71391, Nov. 23, 2010 (“Conflict-of-Interest Standards by Swap Dealers”).

ii. Comments

One commenter directly addressed proposed § 23.402(a) and asserted that the rule would require a swap dealer or major swap participant to have a policy with respect to each statutory provision or regulation that potentially applies to a swap dealer or major swap participant.

151

According to the commenter, because many regulations only apply in limited circumstances, the scope of a swap dealer or major swap participant's policies and procedures should be limited to material provisions of the CEA and Commission Regulations.

152

151

CEF Feb. 22 Letter, at 19 (Appendix A).

152

Id.

Another commenter, while not directly addressing proposed § 23.402(a), recommended that the Commission convert certain prescriptive requirements of the proposed rules and permit swap dealers and major swap participants to comply by establishing and enforcing policies and procedures.

153

Conversely, another commenter opposed an approach that would deem swap dealers or major swap participants to be in compliance with the business conduct standards for complying with policies and procedures.

154

153

SIFMA/ISDA Feb. 17 Letter, at 11 (discussing proposed § 23.410(b)—Confidential Treatment of Counterparty Information);

see also

FIA/ISDA/SIFMA Aug. 26 Letter, at 17 (discussing the SEC's proposed institutional suitability requirements and supporting the implementation of the SEC's proposed “know your counterparty” rule through policies and procedures).

154

CFA/AFR Aug. 29 Letter, at 12 (also noting, however, “it is certainly appropriate for the [SEC] to require SBS Entities to establish, maintain, document and enforce policies and procedures reasonably designed to achieve compliance with business conduct rules”).

iii. Final § 23.402(a)

The Commission has considered the comments and has determined to adopt § 23.402(a) as proposed. The Commission clarifies, however, that a swap dealer or major swap participant may consider the nature of its particular business in developing its policies and procedures and tailor such policies and procedures accordingly.

155

A swap dealer or major swap participant, however, remains responsible for complying with all applicable provisions of the CEA and Commission

Regulations, including subpart H of part 23.

155

As part of the materials submitted in an application for registration as a swap dealer or major swap participant, an applicant may submit its written policies and procedures to “demonstrate, concurrently with or subsequent to the filing of their Form 7-R with the National Futures Association, compliance with regulations adopted by the Commission pursuant to section[] * * * 4s(h) * * * of the [CEA] * * *” The Commission adopted final registration rules on the same day as these business conduct standards rules.

See also

proposed § 3.10(a)(1)(v)(A), Proposed Rules for Registration of Swap Dealers and Major Swap Participants, 75 FR 71379, Nov. 23, 2010.

A swap dealer or major swap participant will be expected to have policies and procedures reasonably designed both to ensure compliance and avoid evasion of the applicable requirements of the CEA and Commission Regulations, including subpart H of part 23. Good faith compliance with such policies and procedures will be considered by the Commission in exercising its prosecutorial discretion in connection with violations of the CEA and Commission Regulations. To be considered good faith compliance, the Commission will consider, among other things, whether the swap dealer or major swap participant made reasonable inquiry and took appropriate action where the swap dealer or major swap participant had information that would cause a reasonable person to believe that any person acting for or on behalf of the swap dealer, major swap participant or any counterparty was violating the CEA or the Commission's Regulations in connection with the swaps related business of the swap dealer or major swap participant.

b. Section 23.402(b)—Know Your Counterparty

i. Proposed § 23.402(c)

Among the Commission's proposed business conduct rules was a “know your counterparty” requirement.

156

Proposed § 23.402(c) (renumbered as final § 23.402(b)) required swap dealers and major swap participants to use reasonable due diligence to know and retain a record of the essential facts concerning each counterparty and the authority of any person acting for such counterparty, including facts necessary to: (1) Comply with applicable laws, regulations and rules; (2) effectively service the counterparty; (3) implement any special instructions from the counterparty; and (4) evaluate the previous swaps experience, financial wherewithal and flexibility, trading objectives and purposes of the counterparty.

157

156

Proposing release, 75 FR at 80641.

157

Id.,

at 80657.

The Commission stated that, among other purposes, proposed § 23.402(c) would assist swap dealers and major swap participants in avoiding violations of Section 4c(a)(7) of the CEA, which makes it “unlawful for any person to enter into a swap knowing, or acting in reckless disregard of the fact, that its counterparty will use the swap as part of a device, scheme, or artifice to defraud any third party.”

158

In proposing § 23.402(c), the Commission noted that it was guided by NFA Compliance Rule 2-30, Customer Information and Risk Disclosure, which NFA has interpreted to impose “know your customer” duties and has been a key component of NFA's customer protection regime.

159

158

Id.,

at 80641; 7 U.S.C. 6c(a)(7).

159

Proposing release, 75 FR at 80641 fn. 25 (citing NFA Interpretive Notice 9013—NFA Compliance Rule 2-30: Customer Information and Risk Disclosure (Staff, Nov. 30, 1990; revised Jul. 1, 2000)).

ii. Comments

The Commission received several comments representing a diversity of views on proposed § 23.402(c). As a general matter, some commenters believed the “know your counterparty” rule should not be adopted because it was not mandated by the Dodd-Frank Act.

160

These commenters expressed concern about a number of specific issues as well.

160

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 13-14; SIFMA/ISDA Feb. 17 Letter, at 8-9.

One commenter stated that the application of proposed § 23.402(c) and certain other proposed rules to major swap participants in connection with their trading with swap dealers and other registered market intermediaries is inappropriate because they are customers of swap dealers or registered market intermediaries and should be treated as such rather than as dealers or quasi-dealers.

161

MetLife Feb. 22 Letter, at 4-5.

Commenters stated that proposed § 23.402(c) seemed to transform swap dealers and major swap participants into “service providers,” which they contend is a departure from their actual status as counterparties.

162

In this regard, these commenters believed the Commission erred by misapplying principles of agency to arm's length, principal-to-principal relationships.

163

These commenters contend that, to the extent swap dealers and major swap participants are transacting with counterparties at arm's length, the Commission should clarify that the “know your counterparty” and corresponding recordkeeping requirements do not apply.

164

Similarly, these commenters expressed concern that requiring swap dealers and major swap participants to obtain financial information from their counterparties would be inconsistent with ordinary business practice and would place the counterparties at a severe negotiating and informational disadvantage to the swap dealer or major swap participant.

165

162

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 14; SIFMA/ISDA Feb. 17 Letter, at 9; HOOPP Feb. 22 Letter, at 3; BlackRock June 3 Medero and Prager Letter, at 5.

163

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 9.

164

See, e.g.,

MFA Feb. 22 Letter, at 5.

165

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 14; AMG-SIFMA Feb. 22 Letter, at 10.

Commenters opposed to proposed § 23.402(c) also took issue with the Commission's reference to NFA Compliance Rule 2-30 (Customer Information and Risk Disclosure).

166

In their view, the Commission's proposal to require a swap dealer or major swap participant to conduct an independent investigation in order to obtain information necessary to evaluate a counterparty's flexibility is unclear and a costly departure from NFA Compliance Rule 2-30 and FINRA Rule 2090 (Know Your Customer).

167

The commenters stated that the SRO rules are intended to protect retail customers and are ill-suited to a sophisticated institutional market.

168

By transforming an SRO rule into a Commission regulation, these commenters believed that the Commission's proposal exposes swap dealers and major swap participants to unnecessary and significant private litigation risk and associated costs.

169

166

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 8; MFA Feb. 22 Letter, at 3.

167

Id.

168

Id.

169

Id.

The concern regarding the proposal's potential to increase legal risk and transaction costs extended to those commenters who were generally supportive of the requirement in proposed § 23.402(c) that swap dealers and major swap participants use reasonable due diligence to know and retain a record of the essential facts concerning each counterparty.

170

As one commenter stated, “if the derivatives markets are unduly constrained on account of increased legal risk, the intended benefits of the external business conduct rules will not be realized.”

171

170

See, e.g.,

FHLBanks June 3 Letter, at 6.

171

Id.

Another commenter strongly supported proposed § 23.402(c) as an essential component of an effective business conduct standards rule regime and urged the Commission to strengthen the recordkeeping requirements associated with the proposed “know your counterparty” rule.

172

However, the commenter agreed with those generally opposed to the proposal on one point: That it may be appropriate to scale any “know your counterparty” requirements according to the nature of

the relationship between the counterparties. Accordingly, the commenter agreed that, where a truly arm's length relationship exists, for example, it may be appropriate to limit the “know your counterparty” obligation to information necessary to comply with the law.

173

172

CFA/AFR Feb. 22 Letter, at 6 and 19.

173

Compare

CFA/AFR Feb. 22 Letter, at 19,

with

SIFMA/ISDA Feb. 17 Letter, at 8-9.

In connection with the “know your counterparty” rule, commenters urged the Commission to harmonize its rules with those proposed by the SEC.

174

These commenters stated their belief that Congress sought to assure through Section 712(a) of the Dodd-Frank Act that the CFTC and SEC adopt comparable and consistent regulations.

175

These commenters also highlighted that, from a cost-benefit perspective, inconsistent or conflicting requirements would increase the costs to market participants of implementing the measures necessary to comply with the CEA.

176

174

See, e.g.,

FIA/ISDA/SIFMA Sept. 14 Letter, at 2-3.

175

Id.,

at 2.

176

Id.

iii. Final § 23.402(b)

The Commission has determined to adopt proposed § 23.402(c) (renumbered as § 23.402(b)) with changes to reflect certain of the comments it received. In making this determination, the Commission concluded that final § 23.402(b) is fully authorized by the discretionary rulemaking authority vested in the Commission by Section 4s(h). In Section 4s(h), Congress granted the Commission broad discretionary authority to promulgate business conduct requirements, as appropriate in the public interest, for the protection of investors or otherwise in furtherance of the purposes of the CEA.

177

The Commission considers the rule to be an appropriate exercise of its discretionary authority because a “know your counterparty” requirement is an integral component of, and consistent with, sound principles of legal and regulatory compliance and operational and credit risk management.

178

Many of the entities that will be subject to this requirement should already have in place, as a matter of normal business practices, “know your counterparty” policies and procedures by way of their membership in an SRO

179

or, for banks, compliance with standards set forth by their prudential regulators.

180

Given this fact, the Commission believes the additional costs of complying with this requirement, if any, will be minimal.

177

Section 4s(h)(3)(D);

see also

Sections 4s(h)(1)(D), 4s(h)(5)(B) and 4s(h)(6).

178

See

Derivatives Policy Group, “Framework for Voluntary Oversight,” at Section V.III.B. (Mar. 1995) (“DPG Framework”).

179

See, e.g.,

NFA Compliance Rule 2-30;

see also

FINRA Rule 2090.

180

See also

Trading & Capital-Markets Activities Manual, sections 2050.3, 2050.4, 2060.3, 2060.4, 3030.1, and 3030.3 (Bd. of Gov. Fed. Reserve Sys. Jan. 2009).

Final § 23.402(b) seeks to harmonize the Commission's approach with the SEC's proposed rules.

181

As one commenter noted, the SEC's “know your counterparty” proposal benefited from the comments the Commission received on proposed § 23.402(c).

182

This same commenter highlighted the congressional mandate in Section 712(a) of the Dodd-Frank Act that the Commission and the SEC consult for the purposes of assuring regulatory consistency and comparability, to the extent possible. The Commission believes that the “know your counterparty” rule is an area where the Commission and the SEC can achieve consistency. At the same time, there will be some variation to account for the comments received on the Commission's proposal and the fact that the Commission regulates different products, participants, and markets.

181

SEC's proposed rules, 76 FR at 42414.

182

See

FIA/ISDA/SIFMA Aug. 26 Letter, at 3.

The Commission agrees with comments calling for the exclusion of major swap participants from the “know your counterparty” requirements. In most cases, major swap participants will themselves be counterparties to or customers of swap dealers. By definition, their business will not be dealing in or making a market in swaps.

183

Accordingly, the Commission is deleting major swap participants from final § 23.402(b).

183

The definition of “major swap participant” states that the term “means any person who is not a swap dealer.” Section 1a(33) of the CEA (7 U.S.C. 1a(33)).

With respect to the requirement in proposed § 23.402(c) that the swap dealer evaluate the previous swap experience, financial wherewithal and flexibility, trading objectives and purposes of the counterparty, commenters expressed several objections. Rather than fostering counterparty protections, commenters asserted, this requirement could actually place counterparties at a negotiating and information disadvantage relative to swap dealers.

184

Further, commenters claimed that such protections are unnecessary when swap dealers and counterparties are dealing in arm's length transactions and are more appropriate when swap dealers make recommendations to counterparties.

185

184

See, e.g.,

ABC/CIEBA Feb. 22 Letter, at 14.

185

See, e.g.,

MFA Feb. 22 Letter, at 4.

In light of the foregoing comments, the Commission believes that certain of the protections provided for in proposed § 23.402(c) are better addressed in connection with § 23.434—Recommendations to counterparties—institutional suitability.

186

Accordingly, the Commission is removing from final § 23.402(b) the requirements in proposed § 23.402(c) to “effectively service the counterparty” and “implement any special instructions from the counterparty.” Through these changes, the Commission clarifies that the final “know your counterparty” rule does not, by itself, create an “advisor” status or impose a fiduciary duty on a swap dealer.

186

See

Section III.G. of this adopting release for a discussion of § 23.434.

The Commission believes comments opposing proposed § 23.402(c) on the basis that it transforms NFA Compliance Rule 2-30 (Customer Information and Risk Disclosure) from an SRO rule to a Commission regulation are misplaced. The Commission was guided by NFA Compliance Rule 2-30 as a model for the proposal, with modification where appropriate to achieve the Commission's policy objectives, including assisting swap dealers to avoid violations of Section 4c(a)(7) of the CEA.

187

The Commission believes that NFA Compliance Rule 2-30 and the precedent developed under it will serve as useful guidance to the Commission and the public in the application of the final rule.

188

However, as stated above, final § 23.402(b), which essentially codifies sound business practices,

189

is an important component of the Commission's overall business conduct standards framework. The Commission views NFA's and the Commission's “know your counterparty” requirements as complementary.

187

Section 4c(a)(7) of the CEA makes it “unlawful for any person to enter into a swap knowing, or acting in reckless disregard of the fact, that its counterparty will use the swap as part of a device, scheme or artifice to defraud any third party.”

See also

discussion at fn. 158.

188

See, e.g.,

NFA Interpretive Notice 9004—NFA Compliance Rule 2-30: Customer Information and Risk Disclosure (Board of Directors, effective June 1, 1986; revised January 3, 2011).

189

See

DPG Framework, at Section V.III.B.

Given the changes from the proposal to final § 23.402(b), the Commission believes it has ameliorated much of the burden commenters attributed to compliance risk associated with the “know your counterparty” requirements. Based on the foregoing, the Commission is promulgating final § 23.402(b) with modification from the

proposal to account for the specific comments received and to conform, where appropriate, to the SEC's proposed “know your counterparty” rule. Accordingly, final § 23.402(b) requires that each swap dealer shall implement policies and procedures reasonably designed to obtain and retain a record of the essential facts concerning each counterparty whose identity is known to the swap dealer that are necessary for conducting business with such counterparty.

190

For purposes of final § 23.402(b), the essential facts concerning a counterparty are: (1) Facts required to comply with applicable laws, regulations and rules; (2) facts required to implement the swap dealer's credit and operational risk management policies in connection with transactions entered into with such counterparty; and (3) information regarding the authority of any person acting for such counterparty.

190

Final § 23.402(b) will not apply to swaps that are executed on a SEF or DCM where the swap dealer does not know the identity of the counterparty to the transaction.

In adopting this final rule, the Commission makes clear that recordkeeping, in accordance with final § 23.402(g), must be sufficient so as to enable the Commission to determine compliance with final § 23.402(b). Unlike the SEC proposed rule, the Commission has determined not to include the following as an essential fact in final § 23.402(b): “If the counterparty is a Special Entity, such background information regarding the independent representative as the swap dealer reasonably deems appropriate.”

191

This requirement is specifically addressed in Section 4s(h)(5) of the CEA as well as in the final rules that address the independent representative requirement.

192

191

SEC's proposed rules, 76 FR at 42414.

192

See

Section IV.C.3. of this adopting release for a discussion of final § 23.450.

As with other business conduct standards rules, final § 23.402(b) does not allow counterparties to opt out. However, swap dealers will be able to reduce the costs of compliance by receiving written representations from their counterparties at the outset of the relationship rather than on a transaction-by-transaction basis, where appropriate, and in accordance with the requirements of final § 23.402(d)—Reasonable Reliance on Representations.

c. Section 23.402(c)—True Name and Owner

i. Proposed § 23.402(d)

Proposed § 23.402(d) (renumbered as final § 23.402(c)) required swap dealers and major swap participants to keep records that show the true name, address, and principal occupation or business of each counterparty, as well as the name and address of any other person guaranteeing the performance of such counterparty and any person exercising any control with respect to the positions of such counterparty.

193

This rule was proposed under the Commission's discretionary rulemaking authority in Section 4s(h).

193

Proposing release, 75 FR at 80641.

ii. Comments

The Commission did not receive any comments regarding proposed § 23.402(d).

iii. Final § 23.402(c)

As stated in the proposing release, proposed § 23.402(d) was based on existing Commission Regulation § 1.37(a)(1),

194

which applies to FCMs, introducing brokers, and members of a DCM. The Commission has determined that it is in the public interest to hold swap dealers and major swap participants to this same standard. Further, the Commission has determined that the recordkeeping requirements under this rule will assist swap dealers and major swap participants in meeting their other duties pursuant to the business conduct standards in subpart H of part 23 (

e.g.,

the “verification of counterparty eligibility” requirement of final § 23.430). Accordingly, the Commission is adopting proposed § 23.402(d) (renumbered as § 23.402(c)).

194

17 CFR 1.37(a)(1).

d. Section 23.402(d)—Reasonable Reliance on Representations

i. Proposed § 23.402(e)

Proposed § 23.402(e) (renumbered as final § 23.402(d)) stated that swap dealers and major swap participants that seek to rely on counterparty representations to satisfy any of the business conduct standards rules must have a reasonable basis to believe that the representations are reliable under the circumstances.

195

In other words, proposed § 23.402(e) would have allowed swap dealers and major swap participants, as appropriate, to reasonably rely, absent red flags, on representations of counterparties to meet due diligence obligations. The counterparty's representations must have included information that was sufficiently detailed for the swap dealer or major swap participant to form a reasonable conclusion that the relevant requirement was satisfied.

195

Proposing release, 75 FR at 80641.

ii. Comments

The Commission did not receive comments directly addressing proposed § 23.402(e). However, many commenters addressed the concept in proposed § 23.402(e) of reasonable reliance on representations in connection with the due diligence requirements under certain other proposed rules, such as proposed § 23.430—Verification of Counterparty Eligibility, proposed § 23.434—Recommendations to Counterparties—Institutional Suitability, and proposed § 23.450(d)—Requirements for Swap Dealers and Major Swap Participants Acting as Counterparties to Special Entities.

196

Commenters were particularly concerned with the language in these proposed rules that the representations be reliable “taking into consideration the facts and circumstances of a particular relationship, assessed in the context of a particular transaction” and that the representations be “sufficiently detailed.”

197

According to some commenters, the proposed rules that permitted reliance on representations, including proposed § 23.402(e), would require transaction-by-transaction diligence that would delay execution and increase costs for swap dealers, major swap participants and their counterparties.

198

Several commenters also asserted that a swap dealer or major swap participant should not have an affirmative duty to investigate the counterparty's representations.

199

196

See, e.g.,

ABA/ABC Feb. 22 Letter, at 2-3; ABC/CIEBA Feb. 22 Letter, at

passim;

AMG-SIFMA Feb. 22 Letter, at 9-11; APGA Feb. 22 Letter, at 2-3 and 6-7; APPA/LPPC Feb. 22 Letter, at 4; BlackRock Feb. 22 Letter, at 3; CalPERS Oct. 4 Letter, at 1; CEF Feb. 22 Letter, at 12, 16, 19-20, and 23; CFA/AFR Feb. 22 Letter, at 6, 8 and 13; Comm. Cap. Mkts. May 3 Letter, at 2; Davis & Harman Mar. 25 Letter, at 5-6; FHLBanks Feb. 22 Letter, at 4-5; Ropes & Gray Feb. 22 Letter, at 3-4; SIFMA/ISDA Feb. 17 Letter, at 12, 15-16, 27, 27 fn. 59, 35-36 and 36 fn. 85; SWIB Feb. 22 Letter, at 4-5; VRS Feb. 22 Letter, at 5.

See also

NFA Aug. 25, 2010 Letter, at 2.

197

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 36; proposing release, 75 FR at 80660.

198

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA Feb. 22 Letter, at 9-10; BlackRock Feb. 22 Letter, at 3;

see also

SIFMA/ISDA Feb. 17 Letter, at 15-16 (discussing proposed § 23.430, Verification of Counterparty Eligibility, “an SD/MSP must conduct affirmative diligence in order to determine whether it is reasonable to rely on provided representations. Such an approach effectively makes the relevant representation(s) superfluous.”).

199

See, e.g.,

SIFMA/ISDA Feb. 17 Letter, at 15-16 (“[swap dealers] should be permitted to * * * rely[] on a written representation by the counterparty * * * absent actual notice of countervailing facts (or facts that reasonably should have put the [swap dealer or major swap participant] on notice), which would trigger a

consequent duty to inquire further”); ABC/CIEBA Feb. 22 Letter, at 10-11 fn. 3 (asserting the Commission should adopt a standard used under Rule 144A of the federal securities laws, which would not impose a duty to inquire further “unless circumstances existed giving reason to question the veracity of a certification”); AMG-SIFMA Feb. 22 Letter, at 10-11 (“A swap dealer or [major swap participant] should be able to rely on an investment adviser's representation unless the swap dealer or [major swap participant] has information to the contrary.”); Comm. Cap. Mkts. May 3 Letter, at 2 (“The dealer should be required to probe beyond that representation only if it has reason to believe that the Special Entity's representations with respect to its independent representative are inaccurate.”); BlackRock Feb. 22 Letter, at 3 (“The CFTC should specifically permit the [swap dealer] to rely, absent notice of facts that would require further inquiry * * *.”).

iii. Final § 23.402(d)

The Commission has considered the comments discussed above and, as a result, has determined to refine the language in proposed § 23.402(e) (renumbered as § 23.402(d)). The revised language permits a swap dealer or major swap participant to rely on the written representations of a counterparty to satisfy its due diligence requirements under subpart H of part 23. The Commission has determined, however, that a swap dealer or major swap participant cannot rely on a representation if the swap dealer or major swap participant has information that would cause a reasonable person to question the accuracy of the representation. In other words, a swap dealer or major swap participant cannot ignore red flags when relying on representations to satisfy its due diligence obligations.

The nature and specificity of the representations required under subpart H of part 23 vary depending on the specific rule. Therefore, the Commission has separately described in the discussion of the relevant provisions the content and level of detail a particular representation must have to satisfy the due diligence obligation of a particular rule.

200

See

Sections III.A.3.b., III.C., III.G., IV.B., and IV.C. in this adopting release for a discussion of the following final rules, respectively: § 23.402(b)—Know your counterparty; § 23.430—Verification of counterparty eligibility; § 23.434—Institutional suitability; § 23.440—Requirements for swap dealers acting as advisors to Special Entities; and § 23.450—Requirements for swap dealers and major swap participants acting as counterparties to Special Entities.

The Commission reaffirms that, if agreed to by the counterparty, counterparty representations may be contained in counterparty relationship documentation and may be deemed renewed with each subsequent offer or transaction. However, a swap dealer or major swap participant may only rely on representations in the counterparty relationship documentation if the counterparty agrees to timely update any material changes to the representations.

201

In addition, the Commission expects swap dealers and major swap participants to review the representations on a periodic basis to ensure that they remain appropriate for the intended purpose. The Commission believes that “best practice” would be at least an annual review in connection with the required annual compliance review by the chief compliance officer pursuant to proposed § 3.3.

202

201

Such an agreement to update representations contained in counterparty relationship documentation is only with respect to subsequent (

i.e.,

new) swaps offered or entered into. The requirement to update representations is in the context of the execution of the subsequent swap. The Commission does not intend to require an ongoing duty to update representations except in connection with a new transaction.

202

CCO proposed rules, 75 FR at 70887.

e. Section 23.402(e)—Manner of Disclosure

i. Proposed § 23.402(f)

Proposed § 23.402(f) (renumbered as final § 23.402(e)) provided flexibility to swap dealers and major swap participants by allowing them to provide information required by subpart H of part 23, including required disclosures, by any reliable means agreed to in writing by the counterparty.

203

Proposing release, 75 FR at 80642.

ii. Comments

One commenter suggested that the Commission establish minimum requirements defining “reliable means” within the rule.

204

In addition, the use of password protected web pages to satisfy the daily mark obligation was identified as a potential area of concern. The commenter recommended that permitted interfaces should provide counterparties with tools to initiate, track and close valuation disputes and the interfaces should be designed to prevent any unintentional or fraudulent addition, modification, or deletion of a valuation record.

205

Another commenter opposed permitting pre-transaction oral disclosures to satisfy a disclosure obligation, even where such disclosures are supplemented by post-transaction written documentation.

206

204

Markit Feb. 22 Letter, at 3.

205

Id.

206

CFA/AFR Nov. 3 Letter, at 6.

iii. Final § 23.402(e)

The Commission is adopting proposed § 23.402(f) (renumbered as § 23.402(e)) with a change to account for disclosures for certain swaps initiated on a SEF or DCM. For such swaps, no written agreement by the counterparty regarding the manner of disclosure is necessary, but the manner of disclosure must be reliable. Otherwise, for swaps executed bilaterally and not on a SEF or DCM, the rule requires counterparties to agree, in writing, to the manner of disclosure.

In addition, the Commission is clarifying in this adopting release that oral disclosures are permitted if agreed to by the counterparty and the disclosures are confirmed in writing. To avoid confusion and misunderstanding among the parties, however, written disclosures are the preferred manner of disclosure. Written disclosures also facilitate diligent supervision and auditing of compliance with the disclosure duties and record retention rule.

In response to comments received prior to the publication of the proposing release, daily marks may be provided by password protected web pages.

207

This approach is consistent with industry suggestions and reflects cost of compliance concerns.

208

Regarding the concerns raised by the commenter,

209

the Commission's internal business conduct rules in new subpart J of part 23 of the Commission's Regulations

210

require swap dealers and major swap participants to have policies and procedures in place that ensure communications, including the daily mark, are reliable and timely.

207

See

proposing release, 75 FR at 80646 fn. 62.

208

Id.

209

Markit Feb. 22 Letter, at 3.

210

See

proposed §§ 3.3, 23.600, 23.602 and 23.606, Governing the Duties of Swap Dealers, 75 FR 71397.

Final § 23.402(e) provides flexibility to swap dealers and major swap participants to take advantage of technological innovations while accommodating industry practice and counterparty preferences. The Commission anticipates that technology will be adapted to expedite and reduce the costs associated with satisfying the disclosure requirements in the Commission's business conduct standards generally.

f. Section 23.402(f)—Disclosures in a Standard Format

i. Proposed § 23.402(g)

Proposed § 23.402(g) (renumbered as final § 23.402(f)) allowed swap dealers and major swap participants to use, where appropriate, standardized formats to make certain required disclosures of material information to their counterparties and to include such standardized disclosures in a master or

other written agreement between the parties, if agreed to by the parties.

211

Proposing release, 75 FR at 80642.

ii. Comments

The Commission received letters from several commenters regarding proposed § 23.402(g).

212

Generally, the commenters endorsed the proposed rule, but raised a variety of concerns, including the scope, substance, timing, frequency and cost of the standardized disclosures. Regarding scope and substance, some commenters suggested that the Commission promote or develop standardized disclosures to ensure adequate and consistent information, which would streamline the disclosure process, foster legal certainty and reduce costs.

213

One commenter proposed, as an alternative to disclosing material information, limiting the required disclosure to the provision of robust market risk scenario analyses, defined in scope, in advance of all swaps.

214

Several commenters requested that the form of disclosure be specified by the Commission as it has done for futures trading under § 1.55.

215

One commenter suggested that DCOs prepare certain standardized disclosures for cleared swaps.

216

212

See

FHLBanks Feb. 22 Letter, at 3-4; ABC/CIEBA Feb. 22 Letter, at 13; ABC Aug. 29 Letter, at 2 and 10-11; CEF Feb. 22 Letter, at 13; BlackRock Feb. 22 Letter, at 6-7; APGA Feb. 22 Letter, at 3; ATA Feb. 22 Letter, at 3; State Street Feb. 22 Letter, at 3-4; SIFMA/ISDA Feb. 17 Letter, at 16-18; NY City Bar Feb. 22 Letter, at 2-3; CFA/AFR Feb. 22 Letter, at 8.

213

See, e.g.,

FHLBanks Feb. 22 Letter, at 3-4.

214

NY City Bar Feb. 22 Letter, at 2-3.

215

See, e.g.,

APGA Feb. 22 Letter, at 3; ATA Feb. 22 Letter, at 3; State Street Feb. 22 Letter, at 3-4; CEF Feb. 22 Letter, at 13. In addition, the NY City Bar recommended standardized disclosures similar to those currently used for listed options rather than the federal securities law model, which is directed at retail investors and not sophisticated ECPs in the swaps market. NY City Bar Feb. 22 Letter, at 2.

See also

17 CFR 1.55.

216

CEF Feb. 22 Letter, at 13.

Regarding the timing and frequency of standard form disclosures, virtually all commenters agreed that, for standardized swaps, disclosures by swap dealers and major swap participants to counterparties should be allowed on a relationship basis and not required on a transaction-by-transaction basis.

217

For non-standardized swaps, one commenter challenged the statement in the proposing release that “the Commission believes that most bespoke transactions * * * will require some combination of standardized and particularized disclosures[ ]”

218

asserting that bespoke issues can be anticipated and included in standardized disclosures as part of counterparty relationship documentation or other written agreements.

219

A different commenter commended the Commission for recognizing that standardized disclosures alone would not be adequate to elucidate the risks in customized swaps.

220

Another commenter acknowledged that there are certain instances in which standardized disclosures may not provide adequate information and requested that the Commission clarify that counterparties may require additional disclosure from swap dealers and major swap participants.

221

217

See, e.g.,

FHLBanks Feb. 22 Letter, at 3; ABC/CIEBA Feb. 22 Letter, at 13; ABC Aug. 29 Letter, at 2 and 10-11; CEF Feb. 22 Letter, at 4; BlackRock Feb. 22 Letter, at 6-7.

218

Proposing release, 75 FR at 80643.

219

SIFMA/ISDA Feb. 17 Letter, at 18.

220

CFA/AFR Feb. 22 Letter, at 8.

221

FHLBanks Feb. 22 Letter, at 4.

In addition, a commenter requested guidance regarding the required disclosures and customary non-reliance language in swap documents.

222

This commenter stated: “It is anomalous to require swap dealers and major swap participants to make certain disclosures to their end-user counterparties pursuant to the proposed rule while those swap dealers and major swap participants continue to include non-reliance agreements in swap transaction documentation providing their end-user counterparties may not rely on disclosures.”

223

The commenter requested that the Commission clarify that any non-reliance provisions contained in swap transaction documentation must exclude any disclosure mandated by the Dodd-Frank Act and the rules promulgated thereunder.

224

222

Id.

223

Id.

224

Id.

iii. Final § 23.402(f)

The Commission is adopting proposed § 23.402(g) (renumbered as § 23.402(f)) with a slight modification for clarity purposes. The language referencing “a standard format, including in a master * * * agreement * * *” was changed to “counterparty relationship documentation.”

Regarding comments related to scope and substance and the request that the Commission develop a standardized disclosure form for swaps, the Commission has determined that a § 1.55

225

type disclosure form for swaps would be inconsistent with the requirements of Section 4s(h)(3). Because the types of swaps covered by the disclosure duties will not be limited to standardized products and will include negotiated, bilateral transactions, swap dealers and major swap participants are required to develop the disclosures appropriate to the transactions that they offer to and enter into with counterparties. Unlike standardized exchange traded futures and options, swaps can be bespoke instruments with a wide range of non-standardized economic features that materially influence cash flows, which do not lend themselves to a single form, futures-style risk disclosure statement developed by the Commission.

226

225

17 CFR 1.55.

226

The Commission has proposed a swap risk disclosure statement for commodity pool operators (“CPOs”) and CTAs.

See

Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations, 76 FR 7976, Feb. 11, 2011. The proposed swap risk disclosure statement for CPOs and CTAs does not affect the swap disclosure requirements under Section 4s(h)(3)(B) or any rules promulgated pursuant to that statutory provision.

In addition, commenters suggested that the Commission provide standardized disclosure to promote legal certainty. On the contrary, such a disclosure could increase uncertainty because it would necessarily have to be general enough to cover all conceivable swaps, to such an extent that the purpose of disclosure would not be served. Congress enacted this robust disclosure regime to reduce information asymmetry and give counterparties the material information to make an informed and reasoned decision before placing assets at risk. A Commission generated standard disclosure also runs the risk of offering a roadmap for evasion, or it would require constant updates to maintain pace with innovations that are engineered and may not be covered by the standard language.

To address legal certainty concerns, the Commission is clarifying in this adopting release that, in the absence of fraud, it will consider good faith compliance with policies and procedures reasonably designed to comply with the business conduct standards rules as a mitigating factor when exercising its prosecutorial discretion for violation of the rules.

The Commission expects that swap dealers and major swap participants will develop their own standard disclosures to meet certain aspects of the disclosure requirements, where appropriate, that will be tailored to the types of swaps that they offer and will be provided to counterparties in counterparty relationship documentation or through other reliable means. Such an approach will help to minimize costs without diminishing the quality of risk disclosures provided to

counterparties. Where such standardized disclosures are inadequate to meet the requirements of final § 23.402(f), swap dealers and major swap participants will have to make particularized disclosures in a timely manner that are sufficient to allow the counterparty to assess the material risks and characteristics of the swap. In addition, swap dealers and major swap participants will need to have policies and procedures to address when and how disclosures will be provided to counterparties, including particularized disclosures in connection with complex swaps. Factors that would be relevant include, but are not limited to, the complexity of the transaction, the degree and nature of any leverage,

227

the potential for periods of significantly reduced liquidity, and the lack of price transparency.

228

This approach is consistent with over-the-counter (“OTC”) industry best practice recommendations for high-risk, complex financial instruments.

229

227

The leverage characteristic is particularly relevant when the swap includes an embedded option, including one in which the counterparty has sold an option to the dealer or the dealer retains the option to alter the terms of the swap under certain circumstances. Such features can significantly increase counterparty risk exposure in ways that are not transparent.

228

“The aforementioned characteristics are neither an exhaustive list nor should they be assumed to provide a strict definition of high-risk, complex instruments, which the Policy Group believes should be avoided. Instead, market participants should establish procedures for determining, based on the key characteristics discussed above, whether an instrument is to be considered high-risk and complex and thus require the special treatment outlined in this section.” The Counterparty Risk Management Policy Group, “Containing Systemic Risk: The Road to Reform, The Report of the CRMPG III,” at 56 (Aug. 6, 2008) (“CRMPG III Report”).

229

Id.

With respect to scenario analysis, counterparties will be able to opt in to receive scenario analysis for swaps that are not “made available for trading” on a DCM or SEF.

230

The Commission declines, however, to determine, as suggested by commenters, that standard form scenario analysis is sufficient to meet all business conduct standards disclosure requirements, which include material risks, characteristics, incentives and conflicts of interest.

231

230

See

Section III.D.3.b. of this adopting release for a discussion of final § 23.431(b);

see also

discussion of Section 2(h)(8) of the CEA and swaps “made available for trading” on a DCM or SEF at

infra

fn. 394.

231

See

NY City Bar Feb. 22 Letter, at 2-3.

Regarding the suggestion that DCOs be required to provide certain standardized disclosures (other than the daily mark) for cleared swaps, the Commission is not mandating such a rule in this rulemaking because Section 4s(h) of the CEA and subpart H of part 23 only govern swap dealers and major swap participants. Swap dealers and major swap participants will be permitted, however, to arrange with third parties, including DCOs and SEFs, to provide disclosures to a counterparty to satisfy the swap dealer's or major swap participant's obligation under § 23.431. The Commission expects that a DCO or SEF may make available certain information, such as the material economic terms of cleared swaps, similar to the contract specifications provided by DCMs today. Swap dealers and major swap participants may make arrangements so that such information from the DCO or SEF satisfies certain disclosure obligations (

e.g.,

material characteristics of the swap). Regardless, the swap dealer or major swap participant will remain responsible for compliance with § 23.431. Lastly, the Commission is providing guidance that non-reliance provisions routinely included in counterparty relationship documentation will not relieve swap dealers and major swap participants of their duty to comply in good faith with the business conduct standards requirements. It will be up to the adjudicator in a particular case to determine the extent of any liability of the swap dealer or major swap participant to a counterparty under the business conduct standards rules, depending on the facts and circumstances.

g. Section 23.402(g)—Record Retention

i. Proposed § 23.402(h)

Proposed § 23.402(h) (renumbered as final § 23.402(g)) required swap dealers and major swap participants to create and retain a written record of their compliance with the requirements of the external business conduct rules in subpart H. Such requirements would be (1) part of the overall recordkeeping obligations imposed on swap dealers and major swap participants in the CEA and subpart F of part 23 of the Commission's Regulations, (2) maintained in accordance with § 1.31

232

of the Commission's Regulations, and (3) accessible to applicable prudential regulators.

233

232

17 CFR 1.31.

233

Proposing release, 75 FR at 80642.

ii. Comments

A commenter requested clarification regarding the requirement to create a written record of compliance with the external business conduct rules. In particular, guidance was requested regarding whether master agreements, which contain certain counterparty representations, qualify as a “written record of compliance” within the rule.

234

Another commenter suggested that the Commission strengthen the recordkeeping requirements throughout to ensure that records are detailed enough to allow regulators to easily determine compliance.

235

234

CEF Feb. 22 Letter, at 19.

235

CFA/AFR Feb. 22 Letter, at 6, 7, 13, 18 and 20.

iii. Final § 23.402(g)

After considering the comments, the Commission has determined to adopt § 23.402(h) as proposed (renumbered as § 23.402(g)). In addition, the Commission confirms that counterparty relationship documentation containing standard form disclosures, other material information and counterparty representations may be part of the written record of compliance with the external business conduct rules that require certain disclosures and due diligence. Further, swap dealers and major swap participants may choose to use internet based applications to provide disclosures and daily marks.

236

Swap dealers and major swap participants are required to have policies and procedures for documenting disclosures and due diligence. Recordkeeping policies and procedures should ensure that records are sufficiently detailed to allow compliance officers and regulators to determine compliance.

236

Swap dealers and major swap participants will have to retain a record of all required information irrespective of the method used to convey such information.

B. Section 23.410—Prohibition on Fraud, Manipulation and Other Abusive Practices

1. Sections 23.410(a) and (b)

a. Proposed § 23.410(a)

Section 4s(h)(1) grants the Commission discretionary authority to promulgate rules applicable to swap dealers and major swap participants related to, among other things, fraud, manipulation and abusive practices.

237

To implement this provision, the Commission proposed several rules, including proposed § 23.410(a), which incorporated the statutory text in

Section 4s(h)(4)(A).

238

The statutory provision prohibits fraudulent, deceptive and manipulative practices by swap dealers and major swap participants.

239

While the heading of Section 4s(h)(4) reads “Special Requirements for Swap Dealers Acting as Advisors,” the plain language of the statutory text within that section includes both more general and more specific restrictions. The fraudulent, deceptive and manipulative practices provision in Section 4s(h)(4)(A), by its own terms, is not limited to the advisory context or to swap dealers.

240

237

In addition, Section 753 of the Dodd-Frank Act provided the Commission with expanded anti-manipulative and deceptive practices authority by amending Section 6(c) of the CEA. (7 U.S.C. 9). On July 14, 2011, the Commission published in the

Federal Register

final rules to implement the new anti-manipulative and deceptive practices authority. Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 FR 41398, Jul. 14, 2011 (“Prohibition on Manipulative and Deceptive Devices”) (to be codified at 17 CFR part 180).

238

The Commission also proposed §§ 23.410(b) and 23.410(c), which prohibited swap dealers and major swap participants from disclosing confidential counterparty information and trading ahead and front running counterparty orders, respectively.

See

proposing release, 75 FR at 80642.

239

In addition to the proposed antifraud rule, swap dealers and major swap participants are subject to all other applicable provisions of the CEA and Commission Regulations, including those dealing with fraud and manipulation (

e.g.,

Sections 4b, 6(c)(1) and (3), and 9(a)(2) of the CEA (7 U.S.C. 6b, 9(c)(1) and (3), and 13(a)(2)), and §§ 180.1 and 180.2 (17 CFR 180.1 and 180.2)).

240

Section 4s(h)(4)(A) states: (A) In general. It shall be unlawful for a swap dealer or major swap participant—(i) to employ any device, scheme, or artifice to defraud any Special Entity or prospective customer who is a Special Entity; (ii) to engage in any transaction, practice, or course of business that operates as a fraud or deceit on any Special Entity or prospective customer who is a Special Entity; or (iii) to engage in any act, practice, or course of business that is fraudulent, deceptive or manipulative.

Proposed § 23.410(a) followed the statutory text and applied to swap dealers and major swap participants acting in any capacity,

e.g.,

as an advisor or counterparty.

241

The first two paragraphs of the proposed rule focused on Special Entities and prohibited swap dealers and major swap participants from (1) employing any device, scheme or artifice to defraud any Special Entity, and (2) engaging in any transaction, practice or course of business that operates as a fraud or deceit on any Special Entity. The third paragraph of the proposed rule was not limited to conduct with Special Entities and prohibited swap dealers and major swap participants from engaging in any act, practice or course of business that is fraudulent, deceptive or manipulative.

242

241

Proposing release, 75 FR at 80642.

242

This language mirrored the language in Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) (15 U.S.C. 80b-1

et seq.

), which does not require scienter to prove liability.

See SEC

Steadman,

967 F.2d 636, 647 (D.C. Cir. 1992) (“[S]ection 206(4) uses the more neutral `act, practice, or course or business' language. This is similar to [Securities Act] section 17(a)(3)'s `transaction, practice, or course of business,' which `quite plainly focuses upon the effect of particular conduct * * * rather than upon the culpability of the person responsible.' Accordingly, scienter is not required under section 206(4), and the SEC did not have to prove it in order to establish the appellants' liability. * * *”) (internal citations omitted).

b. Comments

The Commission received a number of comments both supporting and opposing aspects of proposed § 23.410(a). One commenter urged that the fraud prohibition in Section 4s(h)(4) should apply only when a swap dealer is acting as an advisor to a Special Entity.

243

The commenter asserted that, while the prohibitions of Section 4s(h)(4)(A) do not themselves contain language limiting them to instances where a swap dealer is an advisor, the title “Special Requirements for Swap Dealers Acting as Advisors” should be read as limiting the scope of any rules promulgated thereunder.

244

The commenter further asserted that the lack of scienter in proposed § 23.410(a)(3) is particularly misplaced as the language of Section 4s(h)(4)(A)(iii) mirrors Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”),

245

which is in the context of an advisor relationship, and that in cases where there is not an advisor relationship, the scienter standards of Rule 10b-5

246

under the Exchange Act should prevail.

247

This commenter stated that the Commission should adopt a scienter requirement when a swap dealer or major swap participant acts merely as a counterparty to a non-Special Entity and does not act as an advisor as it would be unfair to subject swap dealers or major swap participants, not acting as advisors, to liability without a showing of bad faith.

248

The Commission also received comments urging that proposed § 23.410(a) not be adopted as it is redundant of the rules promulgated in part 180.

249

243

SIFMA/ISDA Feb. 17 Letter, at 10.

244

Id.

245

15 U.S.C. 80b-6.

246

17 CFR 240.10b-5.

247

SIFMA/ISDA Feb. 17 Letter, at 10.

248

Id.

249

See

CEF Feb. 22 Letter, at 12; Barnard May 23 Letter, at 2.

Other commenters supported proposed § 23.410(a). One commenter asserted that the rule prohibiting fraud and manipulation by swap dealers and major swap participants is appropriate as long as these principles are properly applied to swap markets.

250

Another commenter supported the proposed rule because it believed the rule was largely consistent with the recommendations contained in the July 2009 report of the Investors' Working Group,

251

and another commenter believed it would strengthen the protection of market participants, encourage investor confidence and promote integrity within the financial system.

252

One commenter asserted that the title “Special Requirements for Swap Dealers Acting as Advisors” should not limit the scope of the rule where the statutory language is broad, applying to “any device, scheme or artifice to defraud,” and that Congress intended to apply these principles to the broad range of conduct engaged in by swap dealers and major swap participants with regard to counterparties generally and Special Entities in particular.

253

This commenter believed that, under the proposed rule, it should be considered an abusive practice to recommend a swap or trading strategy that achieves the counterparty's aim in a way that includes risks to the counterparty greater than those it seeks to hedge and to recommend customized swaps where the counterparty could achieve the same result at a lower cost through standardized swaps.

254

250

Exelon Feb. 22 Letter, at 4.

251

CII Feb. 10 Letter, at 1 (citing A Report by the Investors' Working Group, An Independent Taskforce Sponsored by CFA Institute Centre for Financial Market Integrity and Council of Institutional Investors,

U.S. Financial Regulatory Reform: The Investors' Perspective

(July 2009)).

252

CFA/AFR Feb. 22 Letter, at 1.

253

Id.,

at 6-7.

254

Id.

c. Final § 23.410(a) and (b)

After considering the comments, the Commission decided to adopt § 23.410(a) as proposed. Inclusion of the rule in subpart H of part 23 of the Commission's Regulations provides swap dealers, major swap participants and counterparties with easy reference to the business conduct requirements under Section 4s(h) of the CEA without any additional cost to market participants.

With respect to the concern regarding the rule's protections for counterparties other than Special Entities, § 23.410(a) mirrors the language of the statute. In addition, the prohibition against engaging in “any act, practice, or course of business that is fraudulent, deceptive, or manipulative” has been interpreted by the courts as imposing a non-scienter standard under the Advisers Act.

255

Even if the Commission were to limit the rule to require proof of scienter and apply the rule only when a swap dealer is acting as an advisor to a Special Entity, that would not restrict a court from taking a plain meaning approach to the language in Section 4s(h)(4) in a private action under Section 22 of the CEA.

256

In addition, because comparable non-scienter fraudulent and

manipulative practices provisions will apply to SBS Entities in enforcement actions under Sections 9(j)

257

and 15F(h)(4)

258

of the Exchange Act and Sections 17(a)(2) and (3) of the Securities Act, it would be inconsistent to impose a different intent standard for swap dealers and major swap participants.

259

255

See

discussion at fn. 242.

256

7 U.S.C. 25.

257

Section 763(g) of the Dodd-Frank Act amended the Exchange Act by adding Section 9(j), which states in relevant part that “It shall be unlawful for any person * * * to effect any transaction in * * * any security-based swap, in connection with which such person * * * engages in any transaction, practice, or course of business which operates as a fraud or deceit upon any person.” Courts have interpreted “operates as a fraud” provisions under a non-scienter standard. On November 8, 2010, the SEC published proposed rule 17 CFR 240.9j-1 in the

Federal Register

to clarify that the provisions of Section 9(j) apply to fraud in connection with (1) entering into a security-based swap and (2) the exercise of any right or performance of any obligation under a security-based swap. Prohibition Against Fraud, Manipulation, and Deception in Connection With Security-Based Swaps, 75 FR 68560, Nov. 8, 2010.

258

This provision mirrors Section 4s(h)(4) of the CEA.

259

One commenter stated that that the CFTC and SEC should harmonize their regulatory structures for combating disruptive and manipulative activities. SIFMA/ISDA Feb. 17 Letter, at 10.

Finally, in response to commenters who urged that it would be unfair to subject swap dealers or major swap participants to the non-scienter provision of the rule, the Commission decided to provide an affirmative defense in final § 23.410(b) for swap dealers and major swap participants in cases alleging non-scienter violations of § 23.410(a)(2) and (3) based solely on violations of the business conduct standards rules in subpart H. The affirmative defense enables swap dealers and major swap participants to defend against such claims by establishing that they complied in good faith with written policies and procedures reasonably designed to meet the requirements of the particular rule that is the basis for the alleged § 23.410(a)(2) or (3) violation. Whether the affirmative defense is established will depend on the facts and circumstances of the case. However, by way of non-exclusive example, a swap dealer or major swap participant would be unable to establish that it acted in good faith if the evidence showed that it acted intentionally or recklessly in connection with the violation. Similarly, policies and procedures that were outdated or failed to address the scope of swap business conducted by the swap dealer or major swap participant would not be considered reasonable.

With respect to whether any particular type of conduct would be abusive within the prohibitions under final § 23.410(a) as urged by commenters, the Commission will evaluate the facts and circumstances of any particular case in light of the elements of an offense under the final rule. This is consistent with the approach that the Commission took in adopting § 180.1.

260

In the release promulgating Commission Regulation § 180.1, the Commission stated: “In response to commenters requesting that front running and similar misuse of customer information be considered a form of fraud-based manipulation under final Rule 180.1, the Commission declines to adopt any per se rule in this regard, but clarifies that final Rule 180.1 reaches all manner of fraud and manipulation within the scope of the statute it implements, CEA section 6(c)(1).” Prohibition on Manipulative and Deceptive Devices, 76 FR at 41401.

2. Section 23.410(c)—Confidential Treatment of Counterparty Information

a. Proposed § 23.410(b)

The Commission proposed § 23.410(b) (renumbered as final § 23.410(c)), which prohibited swap dealers and major swap participants from disclosing confidential counterparty information,

261

using its discretionary rulemaking authority under Section 4s(h)(1)(A).

262

The proposed rule extended existing Commission standards that protect the confidentiality of customer orders.

261

Proposing release, 75 FR at 80642.

262

Senator Lincoln noted in a colloquy that the Commission should adopt rules to ensure that swap dealers maintain the confidentiality of hedging and portfolio information provided by Special Entities, and prohibit swap dealers from using information received from a Special Entity to engage in trades that would take advantage of the Special Entity's positions or strategies. 156 Cong. Rec. S5923 (daily ed. July 15, 2010) (statement of Sen. Lincoln). In consultations with stakeholders, Commission staff learned that these concerns are shared by counterparties more generally. As a result, the Commission proposed that the business conduct rules include prohibitions on these types of activities in all transactions between swap dealers or major swap participants and their counterparties.

See

proposing release, 75 FR at 80658.

b. Comments

The Commission received comments regarding the proposed prohibition against disclosing confidential counterparty information. One commenter stated that the confidentiality of counterparty information should be left to private negotiation rather than imposed by Commission rule.

263

The commenter urged that if the Commission determines to promulgate a rule protecting the confidentiality of such information, the Commission should alternatively require swap dealers and major swap participants to establish, maintain and enforce policies and procedures reasonably designed to prevent the improper use or disclosure of a

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