By Hyun K. Kim
Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) adds Section 4s(h) to the Commodity Exchange Act (the “CEA”), which imposes business conduct standards for swap dealers (“SDs”) and major swap participants (“MSPs”) dealing with counterparties generally and with “Special Entities” specifically. The Commodity Futures Trading Commission (the “CFTC”) has adopted a final rule regarding these business conduct standards, which was published in the Federal Register on February 17, 2012. The final rule became effective on April 17, 2012 (the “Effective Date”). SDs/MSPs must comply with the final rule on the later of 180 days after the Effective Date or the date on which SDs/MSPs are required to apply for registration.
The final rule imposes the following business conduct requirements on SDs and/or MSPs dealing with certain counterparties:
- have written policies and procedures to ensure compliance with the business conduct requirements and to prevent evasion thereof;
- diligently monitor compliance;
- obtain and retain a record of the true name, address, and principal occupation or business of a counterparty whose identity is known to the SD/MSP prior to the execution of a transaction as well as the name and address of any other person guaranteeing the performance of such counterparty; and
- retain compliance records.
Prohibition on Fraud, Manipulation and Other Abusive Practices
SDs/MSPs shall not:
(i) employ any device, scheme, or artifice to defraud any Special Entity;
(ii) engage in any transaction, practice, or course of business that operates as a fraud or deceit on any Special Entity; or
(iii) engage in any fraudulent, deceptive, or manipulative act, practice or course of business.
If an SD/MSP can establish that it did not act intentionally or recklessly in connection with an alleged violation of this prohibition and that it complied in good faith with relevant written policies and procedures, that will be an affirmative defense to such alleged violation.
The final rule also prohibits an SD/MSP from disclosing any material confidential information obtained from a counterparty or use any such information for its own purposes that would tend to be materially adverse to the interests of the counterparty, unless such disclosure is authorized in writing by the counterparty or is necessary (x) for the effective execution of any swap, (y) to hedge or mitigate any exposure created by such swap, or (z) to comply with a request of the CFTC, the Department of Justice, or an applicable prudential regulator, or is otherwise required by law.
Duties of SDs/MSPs to Counterparties
- Verification – Duty to verify that the counterparty meets the eligibility standards for an eligible contract participant and whether the counterparty is a Special Entity.
- Disclosure – Duty to disclose:
- Material risks and characteristics of the swap:
- Material incentives or conflicts of interest on the part of the SD/MSP, including the price and the mid-market value of the swap and any compensation or other incentive from any source other than the counterparty that the SD/MSP may receive in connection with the swap;
- For cleared swaps, the right of the counterparty that is not an SD/MSP (the “non-SD/MSP counterparty”) to receive, upon request, the daily mark of the transaction from the appropriate derivatives clearing organization (“DCO”);
- For uncleared swaps, the daily mark (which shall be the mid-market value) of the transaction.
- For swaps subject to mandatory clearing – Duty to notify the non-SD/MSP counterparty of its sole right to select the DCO at which the swap will be cleared;
- For swaps notsubject to mandatory clearing – Duty to notify the non-SD/MSP counterparty of its right to choose to clear the swap if the swap is clearable as well as to select the DCO at which the swap will be cleared.
- Fair Dealing & Good Faith Communication – Duty to communicate with the counterparty in a fair and balanced manner based on principles of fair dealing and good faith.
Duties of SDs to Counterparties
- Know Your Counterparty – Duty to implement policies and procedures to obtain and retain a record of the essential facts concerning each counterparty (e.g., facts required to comply with applicable laws, regulations and rules; facts required to implement the SD’s credit and operational risk management policies in connection with transactions entered into with such counterparty; and information regarding the authority of any person acting for such counterparty) whose identity is known to the SD prior to the execution of a transaction.
- Disclosure – Duty to provide a scenario analysis to a non-SD/MSP counterparty prior to entering into a swap that is not available for trading on a DCM or SEF.
- Institutional Suitability
- Duty to undertake reasonable diligence to understand the potential risks and rewards associated with a recommended swap or trading strategy based on information concerning the counterparty’s investment profile, trading objectives, and ability to absorb potential losses associated with the recommendation;
- This duty is fulfilled if: (1) the SD reasonably determines that the counterparty or its agent with decision-making authority is capable of evaluating, independently, the risks related to the recommendations; (2) the counterparty or its agent represents in writing that it is exercising independent judgment in evaluating the recommendations; (3) the SD discloses in writing that it is acting as a counterparty and not evaluating the suitability of its recommendation for the counterparty; and (4) if dealing with a Special Entity, the SD complies with the requirements for SDs who “act as an advisor to a Special Entity” (see below “Duties of SDs Acting as Advisors to Special Entities”).
Duties of SDs Acting as Advisors to Special Entities
Under the final rule, an SD “acts as an advisor to a Special Entity” when it recommends a swap or swap trading strategy tailored to the particular needs or characteristics of the Special Entity. An SD acting as an advisor to a Special Entity has the following duties:
- Duty to make a reasonable determination that the recommended swap or trading strategy is in the best interests of the Special Entity;
- Duty to make reasonable efforts to obtain information necessary to make such determination, including:
- the financial status and future funding needs of the Special Entity;
- the tax status of the Special Entity;
- the hedging, investment, financing, or other objectives of the Special Entity;
- the experience of the Special Entity with respect to entering into swaps generally and into swaps of the type and complexity being recommended;
- whether the Special Entity has the financial capability to withstand changes in market conditions; and
- such other information as is relevant to the particular facts and circumstances of the Special Entity, market conditions and the type of a swap being recommended.
Duties of SDs/MSPs Acting as Counterparties to Special Entities
- With respect to a Special Entity other than an ERISA plan, an SD/MSP has a duty to have a reasonable basis to believe that the Special Entity has a representative that:
- has sufficient knowledge to evaluate the transaction and risks;
- is not subject to a statutory disqualification;
- is independent of the SD/MSP;
- undertakes a duty to act in the best interests of the Special Entity;
- makes appropriate and timely disclosures to the Special Entity;
- evaluates fair pricing and the appropriateness of the swap; and
- in the case of a Special Entity that is a state, state agency, city, county, municipality, other political subdivision of a state, or governmental plan (such Special Entity, a “governmental Special Entity”), is subject to restrictions on certain political contributions imposed by the CFTC (see “Political Contributions by SDs and MSPs to Municipal Entities” below), the Securities and Exchange Commission (the “SEC”), or a self-regulatory organization subject to the jurisdiction of the CFTC or the SEC, unless the representative is an employee of the Special Entity.
- With respect to a Special Entity that is an ERISA plan, an SD/MSP has a duty to have a reasonable basis to believe that the Special Entity has an independent representative that is a fiduciary as defined in section 3 of ERISA.
- Duty to make a written record, if the SD/MSP determines that the representative does not meet the criteria above, of the basis for such determination and to submit such determination to its chief compliance officer for review to ensure that it has a substantial, unbiased basis for such determination.
- Duty to disclose, before the initiation of the swap, to the Special Entity in writing (1) the capacity in which the SD/MSP is acting in connection with the swap; and (2) if the SD/MSP engages in business with the Special Entity in more than one capacity, the material differences between such capacities.
Independence Test for a Representative of a Special Entity
A representative of a Special Entity will be deemed independent of an SD/MSP if:
- the representative was not an associated person of the SD/MSP within one year of representing the Special Entity;
- there is no principal relationship between the representative and the SD/MSP;
- the representative disclosed to the Special Entity all material conflicts of interest that could reasonably affect the representative’s judgment or decision making with respect to its duties to the Special Entity, and complies with policies and procedures designed to manage and mitigate such material conflicts of interest;
- the representative is not directly or indirectly controlled by, in control of, or under common control with the SD/MSP; and
- the SD/MSP did not refer, recommend, or introduce the representative to the Special Entity within one year of the representative representing the Special Entity.
Political Contributions by SDs to Governmental Special Entities
The final rule prohibits an SD from entering into a swap with a governmental Special Entity within two years after the SD made political contributions to officials of such governmental Special Entity. The final rule provides certain exceptions from this prohibition for very small contributions made by a “covered associate” ($350 or less to any one official per election depending on the circumstances), contributions made by a covered associate who is a natural person more than six months prior to his becoming a covered associate, or swaps initiated on a DCM or SEF if the SD/MSP does not know the identity of the counterparty prior to the execution of the swap.
 “Special Entity” means a federal agency, state, state agency, city, county, municipality and other political subdivision of a state, employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974 (“ERISA”), governmental plan, as defined in section 3 of ERISA, endowment, and employee benefit plan as defined under ERISA that is not otherwise defined as a Special Entity that elects to be a Special Entity by notifying an SD/MSP of its election prior to entering into a swap with such SD/MSP.
 This requirement will not apply with respect to a transaction initiated on a designated contract market (“DCM”) or swap execution facility (“SEF”) if the SD/MSP does not know the identity of the counterparty prior to execution of the transaction.
 This requirement will not apply with respect to a transaction initiated on a DCM or SEF and in which the SD/MSP does not know the identity of the counterparty, or with respect to counterparties that are SDs/MSPs.
 This requirement will not apply with respect to a transaction initiated on a DCM or an SEF and in which the SD/MSP does not know the identity of the counterparty, or with respect to counterparties that are SDs/MSPs.
 A SD does not “act as an advisor to a Special Entity” (i) with respect to a Special Entity that is an ERISA plan if: (x) such Special Entity represents in writing that it has a fiduciary representing the Special Entity in connection with the swap transaction, (y) the fiduciary represents in writing that it will not rely on the SD’s recommendation, and (z) the Special Entity represents in writing that the SD’s recommendation will be evaluated by a fiduciary, or (ii) with respect to any Special Entity if: (x) the SD does not express an opinion as to whether the Special Entity should enter into a recommended swap or trading strategy, (y) the Special Entity represents in writing that it will not rely on the SD’s recommendation and will rely on a qualified independent representative’s advice, and (z) the SD discloses to the Special Entity that it is not undertaking to act in the best interests of the Special Entity.
 This requirement will not apply with respect to a transaction initiated on a DCM or an SEF and one in which the SD/MSP does not know the identity of the counterparty.
 “Covered associate” means (i) any general partner, managing member, or executive officer, or other person with a similar status or function; (ii) any employee who solicits a governmental Special Entity for the SD and any person who supervises such employee; and (iii) any political action committee controlled by the SD or by any person described in (i) or (ii) above.