Today, the Commodity Futures Trading Commission (CFTC) published in the Federal Register final rules imposing business conduct standards (BCS) on swap dealers (SDs) and major swap participants (MSPs). See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9734 (Feb. 17, 2012). The BCS rules generally attempt to enhance protections for the swap counterparties of SDs and MSPs through due diligence, disclosure, fair dealing and anti-fraud requirements.¹

The BCS rules impose additional obligations on an SD when it recommends a swap to any end user counterparty² or interacts with a “Special Entity.” Acknowledging that MSPs, by law, are not dealers, the BCS rules do not apply most of these additional obligations to MSPs. The BCS rules define a “Special Entity” to mean: i) an employee benefit plan that is subject to Title I of the Employee Retirement Income Security Act of 1974 (ERISA) (which we call an ERISA plan Special Entity); ii) a governmental plan; iii) any other employee benefit plan that elects to be treated as a Special Entity and notifies the SD or MSP of this election before a swap is entered into; iv) an endowment; v) a Federal agency; or a vi) a State, State agency, political subdivision of a State (including a city, county and municipality), and any instrumentality, department or corporation of or established by a State or political subdivision of a State (which we call, along with any governmental plan, a Governmental Special Entity).³

The CFTC offers SDs and MSPs safe harbors from several BCS rules.  Some of these safe harbors are provided to harmonize the BCS rules with other regulatory regimes, such as Department of Labor (DOL) regulations that govern ERISA plans and SEC regulations that govern municipal advisors.⁴ The safe harbors can be satisfied largely through written representations and disclosures, which generally may be included in counterparty relationship documentation. SDs and MSPs will not be required to comply with the BCS rules until the later of: i) October 15, 2012; or ii) the date on which SDs and MSPs are required to apply for registration pursuant to CFTC Rule 3.10.

Statutory Framework

The CFTC adopted the new BCS rules to implement the Dodd-Frank Act’s business conduct requirements for SDs and MSPs. Section 4s(h) of the Commodity Exchange Act (CEA), as added by Section 731 of the Dodd-Frank Act, mandates that the CFTC adopt rules requiring each SD and MSP to: i) verify that its swap counterparties qualify as eligible contract participants;⁵ ii) make disclosures that allow its swap counterparties to assess a swap’s material risks and characteristics; iii) provide its swap counterparties with the daily mark; iv) communicate in a fair and balanced manner with counterparties; v) offer special protections to Special Entities; and vi) not engage in any fraudulent, manipulative or other abusive practices involving swaps.  Furthermore, Section 4s(h) grants the CFTC discretionary rulemaking authority to establish other business conduct standards.

Due Diligence

What information must an SD/MSP obtain from its counterparty to fulfill its general due diligence obligations?

The CFTC’s new rules include three general due diligence obligations. First, before offering to enter into or entering into a swap with a counterparty (except for a swap that is “initiated” on a designated contract market (DCM)), each SD and MSP must verify: i) that its counterparty is an eligible contract participant; and ii) whether its counterparty is a “Special Entity.” Second, each SD and MSP must obtain and retain a record of identifying information about the counterparty, any guarantor or anyone exercising control over the counterparty’s positions. Third, each SD – but no MSP – must satisfy a “know your counterparty” requirement by obtaining and retaining a record of the “essential facts” concerning each counterparty. Those “essential facts” are facts required to comply with applicable law, facts that the SD needs to implement its credit and operational risk management policies and information regarding the authority of persons acting for the counterparty.

An SD or MSP may rely on counterparty written representations to satisfy these due diligence obligations, unless the SD or MSP has information that would cause a reasonable person to question the accuracy of a representation. The due diligence obligations generally will not apply to an SD/MSP that does not know the identity of its counterparty prior to execution of the transaction.

What additional due diligence obligations does an SD have when it recommends a swap to an end user counterparty?

An SD that “recommends” a swap or a trading strategy involving a swap to an end user counterparty generally must comply with: i) a general suitability requirement to undertake reasonable diligence to understand the potential risks and rewards associated with the recommended swap or trading strategy; and ii) a counterparty-specific requirement to have a reasonable basis that the recommended swap or trading strategy is suitable for the SD’s counterparty based on information the SD obtains about the counterparty, including the counterparty’s investment profile, trading objectives and ability to absorb losses. Whether an SD’s communication (or communications) constitutes a “recommendation” depends on the particular facts and circumstances and requires analysis of the content, context and presentation of the communication(s). The CFTC offers an SD a safe harbor from the counterparty-specific suitability requirement, which may be satisfied through a combination of written representations, written disclosures and compliance in good faith with specified policies and procedures.⁶ However, there is no safe harbor from the SD’s general suitability obligation.

Disclosures

What disclosures will SDs and MSPs be required to make to their counterparties?

Before entering into any swap with a known end user counterparty, an SD or MSP must disclose material information concerning the swap that allows the counterparty to assess the swap’s material risks and characteristics and any material incentives or conflicts of interest that the SD/MSP has in connection with the swap.  In some cases, if the swap is executed through a private bilateral negotiation, an SD (but not an MSP) must also notify any end user counterparty of its right to receive and consult on a scenario analysis.

For any swap an SD or MSP enters into with an end user counterparty, the SD or MSP must notify the end user of its right to elect to clear the swap (if the swap is not required to be cleared) and to select the derivatives clearing organization (DCO) at which the swap will be cleared. If the swap ultimately is not cleared, the SD or MSP must provide the swap’s daily mark to its end user counterparty.

In what manner are SDs and MSPs permitted to make these disclosures? 

Each SD or MSP generally may make the required disclosures using any reliable means agreed to in writing by the SD/MSP and its counterparty, including through standardized disclosures in counterparty relationship documentation.⁷ Even oral disclosures are permitted, provided that the disclosures are subsequently provided in writing.  For swaps initiated on a DCM or swap execution facility (SEF), no written agreement by the counterparty regarding the means of disclosure is necessary, but the manner of disclosure must be reliable. The SD or MSP may arrange for certain disclosures to be provided through a third party (such as a DCO or SEF), but the SD or MSP will remain fully responsible for compliance.

Outright Prohibitions

What kind of conduct do the rules prohibit?

An SD or MSP is generally prohibited from communicating in an unfair or unbalanced manner and from engaging in any fraudulent, deceptive, or manipulative act or practice involving swaps. When dealing with Special Entities, an SD or MSP is specifically prohibited from: i) employing any device, scheme or artifice to defraud any Special Entity; and ii) engaging in any transaction, practice or course of business that operates as a fraud or deceit on any Special Entity. Under the BCS rules, an SD or MSP will have an affirmative defense in some circumstances where it can establish that it did not act intentionally or recklessly in connection with the violation and complied in good faith with specified written policies and procedures.

An SD or MSP also is prohibited from disclosing material confidential counterparty information or using such information in a way that would be materially adverse to the counterparty’s interests. However, an SD or MSP can use or disclose material confidential counterparty information if: i) authorized by the counterparty in writing; ii) necessary to effectively execute a swap with the counterparty or to hedge or mitigate the SD/MSP’s exposure created by entering into a swap with the counterparty; or iii) required by law. Each SD or MSP must implement written policies and procedures to prevent improper use or disclosure by any person acting for or on behalf of the SD or MSP.

Special Entities

What additional duties will an SD/MSP have when it acts as a counterparty to a Special Entity?

With the exception of swaps on a regulated trading platform where an SD or MSP does not know the identity of its counterparty before execution of a swap, the BCS rules generally require any SD or MSP that offers to enter into or enters into a swap with a Special Entity to have a reasonable basis to believe the counterparty is represented by a qualified representative. For a Special Entity that is an ERISA plan, the representative must be an ERISA fiduciary; for any other Special Entity, the representative must be knowledgeable, independent of the SD or MSP (with detailed standards for determining independence) and meet a handful of other qualifications. Under a safe harbor available to an SD or MSP for swaps with an ERISA plan Special Entity, the SD/MSP may simply receive in writing a representation that the ERISA plan has an ERISA fiduciary and the fiduciary’s name and contact information. A separate safe harbor is available to an SD or MSP for swaps with any other Special Entity if: i) the SD/MSP receives specified written representations from the Special Entity regarding its policies and procedures for selecting its representative; and ii) the SD/MSP and the Special Entity receive specified written representations from the Special Entity’s representative concerning its independence and other qualifications.

What additional duties will an SD have when it makes tailored recommendations to a Special Entity?

The BCS rules generally provide that an SD that recommends a swap or trading strategy involving a swap to a Special Entity that is tailored to the Special Entity’s particular needs or characteristics is acting as an “advisor” to the Special Entity; an SD that acts as a Special Entity’s advisor must reasonably determine that each recommended swap or trading strategy is in the Special Entity’s best interests based on certain information that the SD must collect about the Special Entity. The CFTC provides SDs with two safe harbors from this rule. The first safe harbor is for swaps with an ERISA plan Special Entity. Under this safe harbor, an SD must receive written representations from the ERISA plan that: i) an ERISA fiduciary is responsible for representing the ERISA plan in connection with the swap transaction; and ii) either a) the ERISA plan will comply in good faith with written policies and procedures reasonably designed to ensure that any recommendation the ERISA plan receives from the SD materially affecting a swap transaction is evaluated by a fiduciary before the transaction occurs or b) any recommendation the ERISA plan receives from the SD materially affecting a swap transaction will be evaluated by a fiduciary before that transaction occurs. The SD also must receive a written representation from the ERISA fiduciary that it will not rely on the SD’s recommendations.

The second safe harbor for an SD is available for a swap with any Special Entity and is satisfied if: i) the SD “does not express an opinion” as to whether the Special Entity should enter into a recommended swap or trading strategy involving a swap that is tailored to the Special Entity’s particular needs or characteristics; ii) the SD discloses to the Special Entity that the SD is not undertaking to act in the Special Entity’s best interests; and iii) the SD receives written representations from the Special Entity that it (a) will rely on advice from a qualified independent representative and (b) will not rely on the SD’s recommendations.

Restrictions on Political Contributions

Do the BCS rules impose restrictions on political contributions?

The BCS rules include “pay-to-play” restrictions on an SD’s ability to make political contributions to a counterparty or prospective counterparty that is a Governmental Special Entity. The rules also require an SD or MSP to have a reasonable basis to believe that the representative of a Governmental Special Entity is subject to certain “pay-to-play” restrictions. For details on the “play-to-play” rules, see the January 20, 2012, Skadden client alert entitled “CFTC Releases Text of Final Pay-to-Play Rule on Municipal Swap Business.”

Appendix – Dodd-Frank Title VII Final Rules and Interpretive Orders the CFTC May Consider in 2012

1. First Quarter 2012

• Client Clearing Documentation, Clearing Member Risk Management, Straight Through Processing
• Commodity Options
• DCM Core Principles
• End User Exception
• Entity Definitions
• Internal Business Conduct (Duties, Recordkeeping, Chief Compliance Officers)
• Product Definitions
• Reporting of Historical Swaps
• External Business Conduct (CFTC adopted on January 11, 2012)
• Segregation for Cleared Swaps (CFTC adopted on January 11, 2012)
• Registration of Swap Dealers and Major Swap Participants (CFTC adopted on January 11, 2012)

2. April 2012 and Beyond

• Block Rule
• Capital and Margin Requirements
• Conforming Rules
• Disruptive Trade Practices
• Extraterritoriality
• Governance and Conflict of Interest
• Implementation (clearing and trade execution)
• Internal Business Conduct (documentation)
• Process for Making a Swap Available to Trade (SEFs and DCMs)
• SEF Core Principles
• Segregation for Uncleared Swaps

_______________________

1 The Securities and Exchange Commission (SEC) has proposed, but not yet adopted, business conduct standard rules. See “Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants,” 76 Fed. Reg. 42396 (July 18, 2011).

2 When using the term “end user,” we refer to a person that is not an SD, MSP, security-based swap dealer or major security-based swap participant.

3 In response to concerns that commodity pools and hedge funds that accept investments from ERISA plan Special Entities could themselves be considered Special Entities, the CFTC states that the definition of Special Entity does not include collective investment vehicles that have Special Entity participants, except for master trusts that hold assets of two or more ERISA plans that are sponsored by a single employer or by a group of employers under common control.

4 The DOL confirmed, in a letter to the CFTC, that the BCS rules do not require SDs and MSPs to engage in any conduct that would make them fiduciaries with respect to ERISA plan counterparties under current regulations defining investment advice, and that any future changes to these regulations will be carefully harmonized with the BCS rules in order to avoid any unintended consequences under ERISA for SDs and MSPs. See Letter from Phyllis C. Borzi, Assistant Secretary, Employee Benefits Security Administration, DOL, to the CFTC (Jan. 17, 2012).

5 See CEA § 1(a)(18).

6 The CFTC also created an exclusion from the commodity trading advisor definition for an SD whose recommendations or advice is solely incidental to its business as an SD.

7 Where standardized disclosures are inadequate to satisfy disclosure obligations, SDs and MSPs will have to make particularized disclosures in a timely manner that are sufficient to allow the counterparty to assess the material characteristics and risks of the swap.

Download PDF Version