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2012-1244

  • Federal Register, Volume 77 Issue 33 (Friday, February 17, 2012)[Federal Register Volume 77, Number 33 (Friday, February 17, 2012)]

    [Rules and Regulations]

    [Pages 9734-9835]

    From the Federal Register Online via the Government Printing Office [www.gpo.gov]

    [FR Doc No: 2012-1244]

    [[Page 9733]]

    Vol. 77

    Friday,

    No. 33

    February 17, 2012

    Part II

    Commodity Futures Trading Commission

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    17 CFR Parts 4 and 23

    Business Conduct Standards for Swap Dealers and Major Swap Participants

    With Counterparties; Final Rule

    Federal Register / Vol. 77 , No. 33 / Friday, February 17, 2012 /

    Rules and Regulations

    [[Page 9734]]

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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.

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    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

    Sec. Sec. 23.400-402, 23.410, 23.430-434, 23.440, and 23.450-451 under

    Section 4s(h) of the CEA and Sec. 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 Sec. 23.400--Scope

    b. Comments and Final Sec. 23.400--Scope

    2. Section 23.401--Definitions

    a. Proposed Sec. 23.401

    b. Comments

    c. Final Sec. 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 Sec. 23.410(a)

    b. Comments

    c. Final Sec. 23.410(a) and (b)

    2. Section 23.410(c)--Confidential Treatment of Counterparty

    Information

    a. Proposed Sec. 23.410(b)

    b. Comments

    c. Final Sec. 23.410(c)

    3. Proposed Section 23.410(c)--Trading Ahead and Front Running

    Prohibited--Not Adopted as Final Rule

    a. Proposed Sec. 23.410(c)

    b. Comments

    c. Commission Determination

    C. Section 23.430--Verification of Counterparty Eligibility

    1. Proposed Sec. 23.430

    2. Comments

    3. Final Sec. 23.430

    D. Section 23.431--Disclosure of Material Risks,

    Characteristics, Material Incentives and Conflicts of Interest

    Regarding a Swap

    1. Proposed Sec. 23.431--Generally

    2. Comments--Generally

    3. Final Sec. 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 Sec. 23.432--Clearing Disclosures

    1. Proposed Sec. 23.432

    2. Comments

    3. Final Sec. 23.432

    F. Section 23.433--Communications--Fair Dealing

    1. Proposed Sec. 23.433

    2. Comments

    3. Final Sec. 23.433

    G. Section 23.434--Recommendations to Counterparties--

    Institutional Suitability

    1. Proposed Sec. 23.434

    2. Comments

    3. Final Sec. 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 Sec. 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 Sec. 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 Sec. 23.440(b)(2)--Duty to Make Reasonable

    Efforts

    3. Final Sec. 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 Sec. 23.440(c)(2)--Duty to Make Reasonable Efforts

    f. Final Sec. 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 Sec. 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 Sec. 23.450

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

    b. ERISA Plan Representatives That Are ERISA Fiduciaries

    [[Page 9735]]

    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 Sec. 23.451

    2. Comments

    3. Final Sec. 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.\1\

    Title VII of the Dodd-Frank Act amended the CEA \2\ to establish a

    comprehensive new regulatory framework for swaps.\3\ 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.

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    \1\ See Dodd-Frank Wall Street Reform and Consumer Protection

    Act, Public Law 111-203, 124 Stat. 1376 (2010).

    \2\ 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.

    \3\ 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.

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    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'').\4\ 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.\5\ 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

    Sec. 155.7, which would have required Commission registrants to comply

    with swap execution standards.\6\ Should the Commission determine to

    consider execution standards at a later date, it would re-propose such

    rules.

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    \4\ Proposed Rules for Business Conduct Standards for Swap

    Dealers and Major Swap Participants With Counterparties, 75 FR

    80638, Dec. 22, 2010 (``proposing release'').

    \5\ 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.

    \6\ Proposing release, 75 FR at 80648-49 and 80662.

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    Section 731 of the Dodd-Frank Act amends the CEA by adding Section

    4s(h).\7\ 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.\8\ 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.\9\

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

    \8\ 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.''

    \9\ 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.

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    In compliance with Sections 712(a)(1) and 752(a) \10\ of the Dodd-

    Frank Act, Commission staff consulted and coordinated with the

    Securities and Exchange Commission (``SEC''),\11\ 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.

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    \10\ 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 * * *.''

    \11\ 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.

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    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.\12\

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    \12\ 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'').

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    The Commission received more than 120 written submissions on the

    proposing release from a range of commenters.\13\ 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

    [[Page 9736]]

    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.\14\ The proposed rules included a scope

    provision,\15\ definitions,\16\ general compliance provisions,\17\

    rules that would apply to dealings with all counterparties \18\ and

    rules that would apply to dealings with Special Entities.\19\ 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.

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    \13\ 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.

    \14\ 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.

    \15\ See proposed Sec. 23.400.

    \16\ See proposed Sec. 23.401.

    \17\ See proposed Sec. 23.402.

    \18\ See proposed Sec. Sec. 23.410, 23.430, 23.431, 23.432,

    23.433, and 23.434.

    \19\ See proposed Sec. Sec. 23.440, 23.450 and 23.451.

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    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.\20\ 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.\21\ 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.

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    \20\ 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.

    \21\ 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 Sec. 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 Sec. 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

    Sec. Sec. 23.410 and 180.1.

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    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'').\22\ Section

    15F(h) \23\ 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.\24\

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    \22\ 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.

    \23\ 15 U.S.C. 78o-10(h).

    \24\ 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).

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    On July 18, 2011, the SEC published in the Federal Register

    proposed rules for Business Conduct Standards for SBS Entities (``SEC's

    proposed rules'').\25\ 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.\26\

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    \25\ SEC proposed rules, Business Conduct Standards for

    Security-Based Swap Dealers & Major Security-Based Swap

    Participants, 76 FR 42396, Jul. 18, 2011.

    \26\ See, e.g., FIA/ISDA/SIFMA Sept. 14 Letter, at passim; CFA/

    AFR Aug. 29 Letter, at passim.

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    Commission staff worked closely with SEC staff in the development

    of the Commission's proposed rules,\27\ 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.\28\ 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.

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    \27\ 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).

    \28\ 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/.

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    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'' \29\ of the

    Employee Retirement Income Security Act of 1974 (``ERISA''). DOL is the

    federal agency responsible for administering and enforcing Title I of

    ERISA.\30\

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    \29\ 29 U.S.C. 1002.

    \30\ 29 U.S.C. 1001 et seq.; History of EBSA and ERISA,

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

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    [[Page 9737]]

    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.\31\

    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.'' \32\ 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).\33\ 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.\34\ 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.\35\

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    \31\ Definition of the Term ``Fiduciary,'' 75 FR 65263, Oct. 22,

    2010 (``DOL's proposed fiduciary rule'').

    \32\ 29 U.S.C. 1002(21)(A)(ii).

    \33\ 29 CFR 2510.3-21(c); see also DOL's proposed fiduciary

    rule, 75 FR at 65264.

    \34\ 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.

    \35\ 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.

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    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.\36\ 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.\37\

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    \36\ 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.

    \37\ 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.

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    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.\38\ 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.\39\ 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.\40\

    ---------------------------------------------------------------------------

    \38\ 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.

    \39\ 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.

    \40\ 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.\41\ 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.\42\

    ---------------------------------------------------------------------------

    \41\ 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.'').

    \42\ 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.\43\ 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;

    \44\ (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; \45\ (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; \46\ (4) require a swap dealer or major swap participant to

    engage in advisor-like activities such as those required under proposed

    Sec. 23.401(c)--Know your counterparty, proposed Sec. 23.434--

    Institutional suitability, or proposed Sec. 23.440--Swap dealers

    acting as advisors to Special Entities; \47\ or (5) cause a swap dealer

    to fail to satisfy the counterparty exception or ``limitation''

    [[Page 9738]]

    provision in DOL's proposed fiduciary rule.\48\

    ---------------------------------------------------------------------------

    \43\ See, e.g., ABC/CIEBA Feb. 22 Letter, at passim; ERIC Feb.

    22 Letter, at passim.

    \44\ SIFMA/ISDA Feb. 17 Letter, at 5; AMG-SIFMA Feb. 22 Letter,

    at 8; ABC/CIEBA Feb. 22 Letter, at 2-3.

    \45\ 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'').

    \46\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 5-6; SIFMA/ISDA

    Feb. 17 Letter, at 32.

    \47\ 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.

    \48\ 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.\49\ 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.\50\ 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.'' \51\ 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.''

    \52\ 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.\53\

    ---------------------------------------------------------------------------

    \49\ 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.

    \50\ DOL Apr. 28 Letter.

    \51\ DOL Apr. 28 Letter, at 1.

    \52\ DOL Apr. 28 Letter, at 3.

    \53\ 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.\54\ DOL also stated that it ``will continue

    to coordinate closely with the * * * Commission to ensure that this

    effort is harmonized with other ongoing rulemakings.'' \55\ 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.\56\ 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:

    ---------------------------------------------------------------------------

    \54\ 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).

    \55\ Id.

    \56\ Final Sec. 23.440--Requirements for swap dealers acting as

    advisors to Special Entities and Sec. 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 Sec. Sec. 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 Sec. 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.\57\

    ---------------------------------------------------------------------------

    \57\ 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'').\58\ 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,'' \59\ that provide advice to a ``municipal

    entity'' \60\ with respect to, among other things, municipal financial

    products, which include municipal derivatives. Municipal advisors are

    required to register with the SEC \61\ and are subject to the rules of

    the Municipal Securities Rulemaking Board (``MSRB''), a self-regulatory

    organization (``SRO'').\62\ On January 6, 2011, the SEC published in

    the Federal Register proposed rules for the Registration of Municipal

    Advisors (``SEC Proposed MA Rules'').\63\

    ---------------------------------------------------------------------------

    \58\ Section 4s(h)(2)(C)(ii) of the CEA (7 U.S.C.

    6s(h)(2)(C)(ii)).

    \59\ 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. 78o-4(e)(4).

    \60\ 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. 78o-4(e)(8).

    \61\ 15 U.S.C. 78o-4(a)(1).

    \62\ 15 U.S.C. 78o-4(b)(2).

    \63\ 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 Sec. 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.\64\

    Thus, an independent representative

    [[Page 9739]]

    under Section 4s(h)(5) that advises State and municipal Special

    Entities will be subject to registration with the Commission as a

    CTA,\65\ 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.'' \66\ 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.\67\ 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.\68\

    ---------------------------------------------------------------------------

    \64\ Section 4s(h)(5) of the CEA (7 U.S.C. 6s(h)(5)).

    \65\ 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.

    \66\ 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. 78o-4(e)(4)(C).

    \67\ 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.

    \68\ 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.\69\ For example,

    some commenters asked whether a swap dealer that complies with Section

    4s(h)(4)(B) and proposed Sec. 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.\70\

    ---------------------------------------------------------------------------

    \69\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 6, 19-21, 24, and

    34-35; BDA Feb. 22 Letter, at 2.

    \70\ 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.\71\ 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 4o of the

    CEA and registration with the Commission.\72\ In addition, a CTA,

    depending on the nature of the relationship, may also owe fiduciary

    duties to its clients under applicable case law.\73\

    ---------------------------------------------------------------------------

    \71\ Proposing release, 75 FR at 80647-48.

    \72\ 7 U.S.C. 6m and 6o.

    \73\ See Commodity Trend Serv., Inc. v. 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.\74\ 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).\75\ 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.\76\

    ---------------------------------------------------------------------------

    \74\ CEF Feb. 22 Letter, at 17.

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

    \76\ 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.\77\ 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

    [[Page 9740]]

    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.\78\

    ---------------------------------------------------------------------------

    \77\ Section 1a(12) of the CEA (7 U.S.C. 1a(12)).

    \78\ 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 Sec. 4.6. Under new Sec. 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.\79\ ``Swap dealer'' is defined for purposes of the

    rule by reference to the definitions in Section 1a(49) of the CEA and

    Sec. 1.3, and would include ``associated persons'' \80\ acting on

    behalf of a swap dealer.

    ---------------------------------------------------------------------------

    \79\ While swap dealers that make recommendations will be

    excluded from the CTA definition, they must comply with other

    applicable provisions (i.e., Sec. 23.434-Suitability and Sec.

    23.440-Requirements for swap dealers acting as advisors to Special

    Entities).

    \80\ ``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.\81\ 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.\82\ 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.

    ---------------------------------------------------------------------------

    \81\ See Section III.G. of this adopting release for a

    discussion of the term ``recommendation'' in connection with the

    institutional suitability rule in Sec. 23.434.

    \82\ 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.\83\ 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: Sec. 23.400--Scope; Sec. 23.401--

    Definitions; Sec. 23.402--General provisions; Sec. 23.410--

    Prohibition on fraud, manipulation and other abusive practices; Sec.

    23.430--Verification of counterparty eligibility; Sec. 23.431--

    Disclosures of material information; Sec. 23.432--Clearing

    disclosures; Sec. 23.433--Communications-fair dealing; and Sec.

    23.434--Recommendations to counterparties-institutional suitability. A

    section-by-section description of the final rules follows.

    ---------------------------------------------------------------------------

    \83\ 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 Sec. 23.400--Scope

    Proposed Sec. 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.\84\

    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.\85\ 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.

    ---------------------------------------------------------------------------

    \84\ Proposing release, 75 FR at 80640.

    \85\ 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 Sec. 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 Sec. 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

    [[Page 9741]]

    date of the final rules.\86\ 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.\87\ 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., Sec. 23.410(a)--

    Prohibitions on fraud, Sec. 23.410(c)--Confidential treatment of

    counterparty information, and Sec. 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., Sec.

    23.430--Verification of counterparty eligibility).\88\

    ---------------------------------------------------------------------------

    \86\ SIFMA/ISDA Feb. 17 Letter, at 8.

    \87\ See CFA/AFR Aug. 29 Letter, at 11.

    \88\ 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.\89\ 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.\90\ Some believed that swap dealers

    and major swap participants should be subject to different

    regulations.\91\ Others were concerned about the extraterritorial reach

    of the Commission's Regulations.\92\ Some commentators were concerned

    that violating the rules could be a basis for a private right of action

    under the CEA.\93\ The Commission addresses these issues in the

    discussion below.

    ---------------------------------------------------------------------------

    \89\ See, e.g. SIFMA/ISDA Feb. 17 Letter, at 3 and 25-26.

    \90\ 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).

    \91\ 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.

    \92\ 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.

    \93\ 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.\94\ Two commenters

    suggested that the rules should be modified to clarify when an

    ``offer'' occurs.\95\ 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.\96\ They believe that this is necessary because, unlike

    in securities or futures, the terms of the product are not preset but

    can be negotiated.

    ---------------------------------------------------------------------------

    \94\ See, e.g., final Sec. 23.430(a)--Verification of

    counterparty eligibility (``before offering to enter into * * * a

    swap with that counterparty''); final Sec. 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 * * *'').

    \95\ See APPA/LPPC Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17

    Letter, at 35-36.

    \96\ 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.\97\ 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.'' \98\ The final fair dealing rule \99\ 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\

    ---------------------------------------------------------------------------

    \97\ See, e.g., Restatement (Second) of Contracts Sec. 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 Sec. 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.

    \98\ See Section III.G. of this adopting release for a

    discussion of Sec. 23.434--Recommendations to Counterparties--

    Institutional Suitability.

    \99\ See Section III.F.3. of this adopting release for a

    discussion of final Sec. 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

    [[Page 9742]]

    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 Sec.

    23.402(b) (know your counterparty), Section III.F.3. of this release

    at fn. 500 discussing final Sec. 23.433 (communications-fair

    dealing), and Section III.G.3. of this release at fn. 542 discussing

    final Sec. 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.

    ---------------------------------------------------------------------------

    [[Page 9743]]

    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--

    Sec. 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. v. 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 Sec. 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

    [[Page 9744]]

    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: Sec. 23.430(c)--

    Verification of counterparty eligibility, Sec. 23.431(b)--

    Disclosures of material information, Sec. 23.450(g)--Acting as

    counterparties to Special Entities, and Sec. 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 Sec. 23.430(c).

    \130\ See proposed Sec. 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\

    ---------------------------------------------------------------------------

    \133\ Swap market participants should be aware that the

    Commission's anti-evasion rule in Sec. 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 Sec. 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\

    ---------------------------------------------------------------------------

    \134\ Providing required disclosures under Sec. 23.431 through

    such mechanisms will not be considered evasion under Sec.

    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 Sec. 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

    [[Page 9745]]

    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 Sec. 23.402(a) and the anti-fraud

    provisions in Sec. 23.410.

    ---------------------------------------------------------------------------

    \143\ Real Time Public Reporting, 77 FR 1182 at 1187, Jan. 9,

    2012.

    ---------------------------------------------------------------------------

    2. Section 23.401--Definitions

    a. Proposed Sec. 23.401

    Proposed Sec. 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 Sec. 23.400-Scope, including

    how the Commission addressed these issues.

    \147\ CEF Feb. 22 Letter, at 7-8.

    \148\ Id.

    ---------------------------------------------------------------------------

    c. Final Sec. 23.401

    The Commission has determined to adopt the definitions of

    counterparty, swap dealer and major swap participant as proposed

    (renumbered as Sec. 23.401(a)--Counterparty, Sec. 23.401(b)--Major

    swap participant and Sec. 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 Sec. 23.431--Disclosures of Material Information and Sec. 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 Sec.

    23.433-Communications--fair dealing.

    3. Section 23.402--General Provisions \149\

    ---------------------------------------------------------------------------

    \149\ The Commission proposed Sec. 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 Sec. 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 Sec. 23.402(a)

    Proposed Sec. 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\

    ---------------------------------------------------------------------------

    \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 Sec. 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 Sec.

    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

    Sec. 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 Sec. 23.402(a)

    The Commission has considered the comments and has determined to

    adopt Sec. 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

    [[Page 9746]]

    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 Sec. 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 Sec. 23.402(c)

    Among the Commission's proposed business conduct rules was a ``know

    your counterparty'' requirement.\156\ Proposed Sec. 23.402(c)

    (renumbered as final Sec. 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 Sec.

    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 Sec. 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 Sec. 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 Sec.

    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\

    ---------------------------------------------------------------------------

    \161\ MetLife Feb. 22 Letter, at 4-5.

    ---------------------------------------------------------------------------

    Commenters stated that proposed Sec. 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 Sec. 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 Sec. 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 Sec. 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

    [[Page 9747]]

    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 Sec. 23.402(b)

    The Commission has determined to adopt proposed Sec. 23.402(c)

    (renumbered as Sec. 23.402(b)) with changes to reflect certain of the

    comments it received. In making this determination, the Commission

    concluded that final Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 23.402(c) are

    better addressed in connection with Sec. 23.434--Recommendations to

    counterparties--institutional suitability.\186\ Accordingly, the

    Commission is removing from final Sec. 23.402(b) the requirements in

    proposed Sec. 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 Sec. 23.434.

    ---------------------------------------------------------------------------

    The Commission believes comments opposing proposed Sec. 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 Sec. 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 Sec. 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 Sec. 23.402(b) with modification from the

    [[Page 9748]]

    proposal to account for the specific comments received and to conform,

    where appropriate, to the SEC's proposed ``know your counterparty''

    rule. Accordingly, final Sec. 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

    Sec. 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 Sec. 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 Sec. 23.402(g), must be

    sufficient so as to enable the Commission to determine compliance with

    final Sec. 23.402(b). Unlike the SEC proposed rule, the Commission has

    determined not to include the following as an essential fact in final

    Sec. 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 Sec. 23.450.

    ---------------------------------------------------------------------------

    As with other business conduct standards rules, final Sec.

    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 Sec.

    23.402(d)--Reasonable Reliance on Representations.

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

    i. Proposed Sec. 23.402(d)

    Proposed Sec. 23.402(d) (renumbered as final Sec. 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

    Sec. 23.402(d).

    iii. Final Sec. 23.402(c)

    As stated in the proposing release, proposed Sec. 23.402(d) was

    based on existing Commission Regulation Sec. 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 Sec. 23.430).

    Accordingly, the Commission is adopting proposed Sec. 23.402(d)

    (renumbered as Sec. 23.402(c)).

    ---------------------------------------------------------------------------

    \194\ 17 CFR 1.37(a)(1).

    ---------------------------------------------------------------------------

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

    i. Proposed Sec. 23.402(e)

    Proposed Sec. 23.402(e) (renumbered as final Sec. 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 Sec. 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 Sec. 23.402(e). However, many commenters addressed the

    concept in proposed Sec. 23.402(e) of reasonable reliance on

    representations in connection with the due diligence requirements under

    certain other proposed rules, such as proposed Sec. 23.430--

    Verification of Counterparty Eligibility, proposed Sec. 23.434--

    Recommendations to Counterparties--Institutional Suitability, and

    proposed Sec. 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 Sec. 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 Sec.

    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 * * *.'').

    ---------------------------------------------------------------------------

    [[Page 9749]]

    iii. Final Sec. 23.402(d)

    The Commission has considered the comments discussed above and, as

    a result, has determined to refine the language in proposed Sec.

    23.402(e) (renumbered as Sec. 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\

    ---------------------------------------------------------------------------

    \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: Sec. 23.402(b)--Know your counterparty; Sec.

    23.430--Verification of counterparty eligibility; Sec. 23.434--

    Institutional suitability; Sec. 23.440--Requirements for swap

    dealers acting as advisors to Special Entities; and Sec. 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 Sec. 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 Sec. 23.402(f)

    Proposed Sec. 23.402(f) (renumbered as final Sec. 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\

    ---------------------------------------------------------------------------

    \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 Sec. 23.402(e)

    The Commission is adopting proposed Sec. 23.402(f) (renumbered as

    Sec. 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 Sec. Sec. 3.3, 23.600, 23.602 and 23.606,

    Governing the Duties of Swap Dealers, 75 FR 71397.

    ---------------------------------------------------------------------------

    Final Sec. 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 Sec. 23.402(g)

    Proposed Sec. 23.402(g) (renumbered as final Sec. 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

    [[Page 9750]]

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

    parties.\211\

    ---------------------------------------------------------------------------

    \211\ Proposing release, 75 FR at 80642.

    ---------------------------------------------------------------------------

    ii. Comments

    The Commission received letters from several commenters regarding

    proposed Sec. 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 Sec. 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 Sec. 23.402(f)

    The Commission is adopting proposed Sec. 23.402(g) (renumbered as

    Sec. 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 Sec. 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

    [[Page 9751]]

    counterparties. Where such standardized disclosures are inadequate to

    meet the requirements of final Sec. 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 Sec. 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

    Sec. 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 Sec. 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 Sec. 23.402(h)

    Proposed Sec. 23.402(h) (renumbered as final Sec. 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

    Sec. 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 Sec. 23.402(g)

    After considering the comments, the Commission has determined to

    adopt Sec. 23.402(h) as proposed (renumbered as Sec. 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 Sec. 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 Sec. 23.410(a), which incorporated

    the statutory text in

    [[Page 9752]]

    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 Sec. Sec. 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 Sec. Sec. 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 Sec. 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 v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992) (``[S]ection

    206(4) uses the more neutral `act, practice, or course or business'

    language. This is similar to [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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 23.410(a) and (b)

    After considering the comments, the Commission decided to adopt

    Sec. 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, Sec. 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

    [[Page 9753]]

    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 Sec. 23.410(b) for swap dealers and major

    swap participants in cases alleging non-scienter violations of Sec.

    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 Sec. 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 Sec. 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 Sec. 180.1.\260\

    ---------------------------------------------------------------------------

    \260\ In the release promulgating Commission Regulation Sec.

    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 Sec. 23.410(b)

    The Commission proposed Sec. 23.410(b) (renumbered as final Sec.

    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 any

    counterparty information that the swap dealer or major swap participant

    has agreed with the counterparty to keep confidential.\264\ The

    commenter also stated that the confidentiality rule should be

    implemented as an SRO rule and should allow sophisticated

    counterparties to opt out of heightened protections they may not want

    or need.\265\ The commenter expressed concern that the proposed rule

    would restrict swap dealers and major swap participants in properly

    servicing counterparties through discussions with the swap dealer's or

    major swap participant's affiliates.\266\ Further, the commenter

    asserted that there would be facts and circumstances that would warrant

    particular disclosures in certain contexts.\267\

    ---------------------------------------------------------------------------

    \263\ SIFMA/ISDA Feb. 17 Letter, at 11.

    \264\ Id.

    \265\ Id.

    \266\ Id., at 10-11.

    \267\ Id., at 11.

    ---------------------------------------------------------------------------

    Another commenter asserted that the confidential treatment and

    trading ahead rules should not apply to major swap participants because

    they are customers of swap dealers and should be treated as such,

    rather than as dealers or quasi-dealers.\268\ Another commenter stated

    that the Commission should avoid specifying in detail the conduct that

    would violate the rule because doing so could have unintended

    consequences of limiting its scope. This commenter stated that a broad,

    enforceable principles based approach is the best approach for

    promoting market integrity.\269\

    ---------------------------------------------------------------------------

    \268\ MetLife Feb. 22 Letter, at 4-5.

    \269\ CFA/AFR Feb. 22 Letter, at 12.

    ---------------------------------------------------------------------------

    c. Final Sec. 23.410(c)

    Upon consideration, the Commission has determined to adopt proposed

    Sec. 23.410(b) (renumbered as Sec. 23.410(c)) with several changes.

    First, the final rule has been changed to also permit swap dealers and

    major swap participants \270\ to disclose confidential information to

    an SRO designated by the Commission or as required by law. The proposed

    rule addressed disclosure only to the CFTC, Department of Justice

    (``DOJ'') and applicable prudential regulators. Second, the Commission

    has clarified that the final rule will protect confidential

    counterparty information from disclosure to third parties, as well as

    from improper use by the swap dealer

    [[Page 9754]]

    or major swap participant. It is not intended to restrict the necessary

    and appropriate use of the information by the swap dealer or major swap

    participant, but is intended to address material conflicts of interest

    that must be identified and managed to avoid trading or other

    activities on the basis of confidential counterparty information that

    would tend to be materially adverse to the interests of the

    counterparty.\271\ By promulgating final Sec. 23.410(c), the

    Commission does not intend to prohibit legitimate trading activities,

    which, depending on the facts and circumstances, would include, among

    other things, (1) bona fide risk-mitigating and hedging activities in

    connection with the swap, (2) purchases or sales of the same or similar

    types of swaps consistent with commitments of the swap dealer or major

    swap participant to provide liquidity for the swap, or (3) bona-fide

    market-making in the swap.\272\

    ---------------------------------------------------------------------------

    \270\ The Commission has determined to impose the final rule on

    both swap dealers and major swap participants, which is consistent

    with the application of Section 4s(h)(4)(A), prohibiting

    manipulative, deceptive and fraudulent practices, to both swap

    dealers and major swap participants.

    \271\ The final rule is aimed at improper disclosure of the

    counterparty's position, the transaction and the counterparty's

    intentions to enter or exit the market, which may be detrimental to

    the interests of the counterparty.

    \272\ The Commission notes by analogy that Section 621 of the

    Dodd-Frank Act, to be codified at Section 27B of the Securities Act

    (15 U.S.C. 77z-2a), provides for exceptions to the conflict of

    interest prohibitions in that section for risk-mitigating hedging

    activities in connection with an asset-backed security, purchases or

    sales made consistent with commitments to the underwriter or others

    to provide liquidity for the asset-backed security, or bona-fide

    market making in the asset-backed security. The Commission's final

    Sec. 23.410(c) provides for exceptions for disclosure and use for

    effective execution of the order, risk mitigation and hedging, and

    when authorized in writing by the counterparty.

    ---------------------------------------------------------------------------

    The final rule requires swap dealers and major swap participants to

    have written policies and procedures reasonably designed to protect

    material confidential information provided by or on behalf of a

    counterparty from disclosure and use by any person acting for or on

    behalf of the swap dealer or major swap participant. Such policies and

    procedures should be designed to identify and manage material conflicts

    of interest between a swap dealer or major swap participant and a

    counterparty through, for example, information barriers and

    restrictions on access to confidential counterparty information on a

    ``need-to-know'' basis.\273\ Information barriers can be used to

    restrict the dissemination of information within a complex organization

    and to prevent material conflicts by limiting knowledge and

    coordination of specific business activities among different units of

    the entity. Examples of information barriers include restrictions on

    information sharing, limits on types of trading and greater separation

    between various functions of the firm. Such information barriers have

    been recognized in the federal securities laws and rules as a means to

    address or mitigate potential conflicts of interest or other

    inappropriate activities within an organization.

    ---------------------------------------------------------------------------

    \273\ For example, the Commission expects that the swap dealer

    would generally have information barriers between its sales desk and

    proprietary trading desk.

    ---------------------------------------------------------------------------

    Depending on the facts and circumstances, the Commission would

    consider it to be an abuse of confidential counterparty information for

    a swap dealer or major swap participant to disclose or use such

    information for its own benefit if such use or disclosure would tend to

    be materially adverse to the interests of the counterparty.\274\ Final

    Sec. 23.410(c) does not prohibit disclosure or use that is necessary

    for the effective execution of any swap for or with the counterparty,

    to hedge or mitigate any exposure created by such swap or to comply

    with a request of the Commission, DOJ, any SRO designated by the

    Commission, or applicable prudential regulator, or is otherwise

    required by law.

    ---------------------------------------------------------------------------

    \274\ The financial industry has long-held standards relating to

    confidential treatment of counterparty information similar to those

    set forth in the final rule. While not endorsing any particular

    industry practice, the Commission notes, for example, that one

    industry group has recommended that financial institutions ``have

    internal written policies and procedures in place governing the use

    of and access to proprietary information provided to them by trading

    counterparties as a basis for credit evaluations.'' Improving

    Counterparty Risk Management Practices, Counterparty Risk Management

    Policy Group (June 1999) (``CRMPG I Report''), at 5; see also Toward

    a Greater Financial Stability: A Private Sector Perspective,

    Counterparty Risk Management Policy Group (July 2005) (``CRMPG II

    Report''), at 47 (recommending that firms evaluate operational risks

    with customized legal documents that deviate from a firm's existing

    procedures for handing confidential counterparty information). Also

    without endorsement by the Commission, one firm's code of conduct

    states that employees ``must maintain the confidentiality of the

    information with which you are entrusted, including complying with

    information barriers procedures applicable to your business. The

    only exception is when disclosure is authorized or legally mandated.

    * * * Confidential or proprietary information * * * provided by a

    third party [is provided with] the expectation that the information

    will be kept confidential and used solely for the business purpose

    for which it was conveyed.'' Goldman Sachs Code of Business Conduct

    and Ethics (amended, effective January 11, 2011).

    ---------------------------------------------------------------------------

    In response to the commenter that expressed concern that the

    proposed rule would restrict swap dealers and major swap participants

    in properly servicing counterparties through discussions with the swap

    dealer's or major swap participant's affiliates,\275\ it is not the

    intent of the rule to prohibit certain interactions needed to execute

    the swap but is to ensure that the counterparty's confidential

    information is disseminated only on a ``need to know'' basis. Further,

    in response to a commenter that stated that there may be facts or

    circumstances that would warrant particular disclosures or uses in

    certain contexts,\276\ the Commission included a provision in the rule

    that allows for use or disclosure of confidential counterparty

    information if authorized in writing by the counterparty.

    ---------------------------------------------------------------------------

    \275\ See SIFMA/ISDA Feb. 17 Letter, at 10-11.

    \276\ See id., at 11.

    ---------------------------------------------------------------------------

    The Commission decided it is appropriate to establish an explicit

    confidential treatment duty for swap dealers and major swap

    participants with respect to confidential counterparty information.

    Because swap dealers and major swap participants principally act as

    counterparties rather than as agents or brokers (unlike FCMs), in the

    absence of such an explicit duty, it could be more difficult to

    establish that disclosure or misuse of confidential counterparty

    information is fraudulent, deceptive or manipulative. Depending on the

    facts and circumstances, however, as set forth in final Sec.

    23.410(b), good faith compliance with reasonably designed policies and

    procedures will constitute an affirmative defense to a non-scienter

    violation of final Sec. 23.410(a)(2) or (3) for improper disclosure or

    abuse of counterparty information.

    The Commission considered the commenter's suggestion that

    confidential treatment of counterparty information should be left to

    negotiation between counterparties or, alternatively, be implemented as

    an SRO rule or on an opt in or opt out basis.\277\ The Commission

    determined that such alternatives would be inconsistent with Congress'

    intent that the Commission promulgate rules that raise business conduct

    standards for the protection of all counterparties.\278\ The final rule

    is in accordance with current industry practices where confidential

    treatment is routinely part of negotiations among the parties that is

    then incorporated into the counterparty relationship

    documentation.\279\

    ---------------------------------------------------------------------------

    \277\ See SIFMA/ISDA Feb. 17 Letter, at 11.

    \278\ See Section III.A.1. of this adopting release for a

    discussion of ``Discretionary Rules'' and ``Opt in or Opt out for

    Certain Classes of Counterparties.''

    \279\ See SIFMA/ISDA Feb. 17 Letter, at 11 (stating that the

    definition, treatment, use and disclosure of confidential

    information are routinely the subject of negotiation between the

    parties).

    ---------------------------------------------------------------------------

    Adopting a confidential treatment rule will ensure that all

    counterparties, irrespective of their negotiating power, will be able

    to protect their confidential

    [[Page 9755]]

    information from disclosure and abuse by swap dealers and major swap

    participants. Counterparties will continue to be free to negotiate

    additional protections based on their individual needs. By establishing

    such a duty, the Commission is not changing the ``counterparty'' nature

    of the relationship between a swap dealer or major swap participant and

    a counterparty. Nor is the Commission imposing a general fiduciary duty

    on swap dealers or major swap participants. Violation of the

    confidential treatment duty, however, depending on the facts and

    circumstances, could constitute a fraudulent, deceptive or manipulative

    practice.

    3. Proposed Sec. 23.410(c)--Trading Ahead and Front Running

    Prohibited--Not Adopted as Final Rule

    a. Proposed Sec. 23.410(c)

    The Commission proposed Sec. 23.410(c), which prohibited swap

    dealers and major swap participants from front running or trading ahead

    of counterparty swap transactions.\280\ The proposed rule was based on

    trading standards applicable to FCMs and introducing brokers that

    prohibit trading ahead of customer orders.\281\

    ---------------------------------------------------------------------------

    \280\ Proposing release, 75 FR at 80642.

    \281\ See, e.g., 17 CFR 155.3-4.

    ---------------------------------------------------------------------------

    b. Comments

    One commenter urged that the Commission not adopt the trading ahead

    and front running rule or, in the alternative, apply the rule only when

    the swap dealer or major swap participant has an executable order and

    not when a swap is still under negotiation.\282\ The commenter asserted

    that the prohibition on trading during the negotiation of a swap fails

    to appreciate the distinction between bilateral swaps and orders for

    standardized products, as bilateral swap terms must be negotiated,

    which can take weeks or months, and counterparties may negotiate with

    multiple dealers to obtain the best price.\283\ The commenter further

    asserted that enforcement of a front running ban would be untenable,

    disruptive to the market and prevent hedging activity related either to

    the pending transaction or the other liabilities of the swap dealer or

    major swap participant.\284\ The commenter urged that, if the

    Commission were to adopt the proposed rule, then it should prohibit

    only a transaction (1) that is entered into for a non-hedging purpose

    on the basis of actual knowledge of a non-public, executable order of a

    counterparty, (2) that exhibits consistent and estimable positive price

    correlation to the pending executable counterparty swap transaction,

    and (3) whose execution is substantially likely to materially affect

    the price of that pending executable swap transaction.\285\ The

    commenter asserted that, without an actual knowledge standard, the

    proposed rule would prohibit transactions by other parts of an

    organization not privy to the order.\286\ Finally, the commenter urged

    the Commission to clarify its proposed ``specific'' consent standard

    and the duration of the prohibition.\287\

    ---------------------------------------------------------------------------

    \282\ SIFMA/ISDA Feb. 17 Letter, at 13.

    \283\ Id., at 12.

    \284\ Id.

    \285\ Id., at 13.

    \286\ Id.

    \287\ Id.

    ---------------------------------------------------------------------------

    In addition, the commenter urged the Commission to clarify that the

    following trades would not be considered front running under proposed

    Sec. 23.410(c): (1) When a swap dealer or major swap participant

    enters a trade at the request of another customer; (2) when the

    specifics of a pending counterparty transaction are as yet undefined;

    (3) when a swap dealer or major swap participant trades in the ordinary

    course of hedging other transactions, assets or liabilities; (4) when

    there is not a clear price-related nexus to the pending swap

    transaction; (5) if the transaction would not affect the counterparty;

    and (6) if the transaction is an anticipatory hedge of the subject

    transaction and disclosed to the counterparty.\288\ The commenter also

    urged that the prohibition should only exist until the transaction is

    executed or cancelled, or the relevant information ceases to be

    material, non-public information, and the proposed rule should not

    require further specific consent to trade with respect to specific

    transactions at specific times.\289\

    ---------------------------------------------------------------------------

    \288\ Id., at 13-14.

    \289\ Id.

    ---------------------------------------------------------------------------

    Another commenter stated that it did not object to applying the

    front running prohibition to trades executable on a DCM and for which a

    swap dealer or major swap participant is merely an intermediary.\290\

    However, the commenter believed proprietary trading desks should be

    able to trade freely as long as they are unaware of the counterparty's

    order.\291\ Without such a limitation, the commenter asserted, swap

    dealers may have little incentive to accept swap orders that can be

    executed electronically or may refuse to accept orders for such

    transactions altogether.\292\

    ---------------------------------------------------------------------------

    \290\ CEF Feb. 22 Letter, at 10-11.

    \291\ Id.

    \292\ Id., at 11.

    ---------------------------------------------------------------------------

    Further, the commenter urged that the proposed front running

    prohibition should not apply to bilaterally negotiated and settled

    swaps. Since some swaps take months to negotiate, the commenter

    believed front running rules would severely limit a swap dealer's

    ability to be in the market.\293\ The commenter stated that front

    running should be defined in a manner more appropriate for the swaps

    markets as the present definition could be interpreted to force a swap

    dealer to stop, or severely limit, physical trading related to the

    swap.\294\ The commenter urged the Commission to eliminate the front

    running rules or to exclude swap markets with actual physical

    underlying commodities from such rules.\295\

    ---------------------------------------------------------------------------

    \293\ Id.

    \294\ Id.

    \295\ Id.

    ---------------------------------------------------------------------------

    Another commenter stated that the proposed rule is tailored to a

    securities broker-dealer model and is not suited to the commodities

    market.\296\ The commenter asserted that instruments relating to

    derivatives of an underlying physical market are not susceptible to

    insider trading or broker-dealer abuses, and that the disclosures

    required in proposed Sec. 23.410(c) would chill the open interaction

    that occurs between counterparties in a competitive swaps market.\297\

    ---------------------------------------------------------------------------

    \296\ Exelon Feb. 22 Letter, at 3.

    \297\ Id.

    ---------------------------------------------------------------------------

    Another commenter stated that prohibiting front running would have

    unintended consequences that would, along with other proposed rules,

    increase the administrative and compliance burden on swap dealers.\298\

    The combined effect of the proposed rules, the commenter asserted,

    would slow the process of swap trading and increase costs by requiring

    additional time, effort, and risks taken in trading swaps.\299\

    ---------------------------------------------------------------------------

    \298\ HOOPP Feb. 22 Letter, at 2.

    \299\ Id.

    ---------------------------------------------------------------------------

    One commenter that generally supported the proposed rule

    recommended imposing a time limit on the trading ahead prohibition for

    swaps under negotiation and believed swap dealers should be required to

    disclose the time limit to counterparties.\300\ Alternatively, the

    commenter urged that swap dealers should have reasonable grounds for

    believing the counterparty does not intend to enter into the

    transaction in the near future.\301\

    ---------------------------------------------------------------------------

    \300\ CFA/AFR Feb. 22 Letter, at 7.

    \301\ Id.

    ---------------------------------------------------------------------------

    [[Page 9756]]

    Another commenter that supported the proposed rule urged that the

    entire front running section be removed because it is duplicative of

    the rules promulgated by the Commission under Section 6(c)(1) of the

    CEA (the new general fraudulent, deceptive and manipulative practices

    provision).\302\

    ---------------------------------------------------------------------------

    \302\ CEF Feb 22 Letter, at 12; see also Prohibition on

    Manipulative and Deceptive Devices, 76 FR 41398.

    ---------------------------------------------------------------------------

    c. Commission Determination

    The Commission has considered the comments and has determined not

    to promulgate proposed Sec. 23.410(c). The fraudulent, deceptive and

    manipulative practices rule in final Sec. 23.410(a), coupled with the

    confidential treatment rule in final Sec. 23.410(c), should

    effectively protect counterparties from abuse of their material

    confidential information by swap dealers and major swap

    participants.\303\ The Commission agrees with the commenter that stated

    that, depending on the facts and circumstances, improperly trading

    ahead or front running counterparty orders would constitute fraudulent,

    deceptive or manipulative conduct under final Sec. 23.410(a) and Sec.

    180.1, among other fraudulent, deceptive and manipulative practices

    protections under the CEA and Commission Regulations.

    ---------------------------------------------------------------------------

    \303\ The Commission's other deceptive and manipulative

    practices provisions, including Sections 4b and 6(c)(1) of the CEA

    and Sec. 180.1 of the Commission's Regulations also prohibit

    trading ahead and front running.

    ---------------------------------------------------------------------------

    In response to commenters seeking clarity as to the types of

    transactions that would constitute illegal trading ahead or front

    running by a swap dealer or major swap participant, the Commission

    declines to adopt the request of certain commenters to list the trades

    or specific situations that would not be considered illegal trading

    ahead or front running in violation of the anti-fraud and confidential

    treatment rules in final Sec. 23.410(a) and final Sec. 23.410(c),

    respectively. The Commission expects swap dealers and major swap

    participants to implement policies and procedures, including

    establishing appropriate information barriers and other means to

    protect material confidential counterparty information, that would

    allow the swap dealer or major swap participant to continue to provide

    liquidity in the swap or engage in bona-fide market-making in the swap.

    The Commission states, however, that use of confidential counterparty

    information to trade ahead of or front run a counterparty's order would

    tend to be materially adverse to the interests of the counterparty,

    depending on the facts and circumstances, and would be considered an

    abuse of final Sec. Sec. 23.410(a) and (c), among other similar

    protections under the CEA and Commission Regulations.

    The Commission's decision not to adopt proposed Sec. 23.410(c) was

    informed by commenters who stated that the proposed rule would have

    unintended consequences of severely hampering the ability of swap

    dealers and major swap participants to conduct swaps business and would

    have the potential to impose additional costs on swap transactions.

    While abuse of counterparty information, including trading ahead, will

    still be prohibited under the manipulative, deceptive and fraudulent

    practices rule in final Sec. 23.410(a) and the confidential treatment

    rule in final Sec. 23.410(c), among other provisions, the approach

    adopted by the Commission should eliminate the uncertainties identified

    by commenters in the proposed trading ahead and front running rule, and

    allow legitimate trading by swap dealers and major swap participants.

    The Commission, however, will continue to monitor market conduct to

    determine whether, in the future, there is a need to address explicitly

    abuses related to trading ahead and front running of counterparty swap

    transactions.

    C. Section 23.430--Verification of Counterparty Eligibility

    1. Proposed Sec. 23.430

    The Dodd-Frank Act makes it unlawful for any person, other than an

    ECP,\304\ to enter into a swap unless it is executed on or subject to

    the rules of a DCM.\305\ Section 4s(h)(3)(A) also requires the

    Commission to establish a duty for swap dealers and major swap

    participants to verify that any counterparty meets the eligibility

    standards for an ECP. Proposed Sec. 23.430 required swap dealers and

    major swap participants to verify that a counterparty meets the

    definition of an ECP prior to offering to enter into or entering into a

    swap and to determine whether the counterparty is a Special Entity as

    defined in Section 4s(h)(2)(C) and proposed Sec. 23.401.\306\

    ---------------------------------------------------------------------------

    \304\ ``Eligible contract participant'' is a defined term in

    Section 1a(18) of the CEA. (7 U.S.C. 1a(18)).

    \305\ See Section 2(e) of the CEA. (7 U.S.C. 2(e)).

    \306\ Proposing release, 75 FR at 80643.

    ---------------------------------------------------------------------------

    The Commission contemplated that, in the absence of ``red flags,''

    and as provided in proposed Sec. 23.402(e), a swap dealer or major

    swap participant would be permitted to rely on reasonable written

    representations of a potential counterparty to establish its

    eligibility as an ECP. In addition, under proposed Sec. 23.402(g),

    such written representations could be expressed in a master agreement

    or other written agreement and, if agreed to by the parties, could be

    deemed to be renewed with each subsequent swap transaction, absent any

    facts or circumstances to the contrary. Finally, as set forth in

    proposed Sec. 23.430(c), a swap dealer or major swap participant would

    not be required to verify the ECP or Special Entity status of the

    counterparty for any swap initiated on a SEF where the swap dealer or

    major swap participant does not know the identity of the

    counterparty.\307\

    ---------------------------------------------------------------------------

    \307\ This provision was informed by the statutory language in

    Sections 2(e) and 4s(h)(7).

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received several comments regarding proposed Sec.

    23.430.\308\ Two commenters recommended that swap dealers and major

    swap participants be able to rely principally on counterparty

    representations regarding eligibility.\309\ It was asserted that only

    actual notice of countervailing facts or facts that reasonably put the

    swap dealer or major swap participant on notice should trigger a duty

    to inquire further, consistent with industry practice.\310\ One

    commenter supported sufficiently detailed representations to facilitate

    eligibility determinations and regulatory compliance audits.\311\ Other

    commenters requested that the proposed rule be amended to specifically

    allow counterparties to make eligibility representations in master

    agreements.\312\ A different commenter recommended that the Commission

    sponsor and promote standardized due diligence documentation to

    facilitate compliance, reduce costs and promote legal certainty.\313\

    Certain commenters questioned whether the verification duty was an

    ongoing duty throughout the life of the swap.\314\ Two commenters

    [[Page 9757]]

    suggested amending the rule to require an update whenever there is a

    change impacting a counterparty's eligibility or status.\315\ A

    commenter recommended additional guidance regarding red flags and the

    nature and timing of evidence necessary to establish ECP status.\316\

    Lastly, a commenter supported the proposed exemption from the

    verification duty for SEF and DCM transactions.\317\

    ---------------------------------------------------------------------------

    \308\ See SIFMA/ISDA Feb. 17 Letter, at 15-16; CFA/AFR Feb. 22

    Letter, at 8; CEF Feb. 22 Letter, at 12, 19 and 20; FHLBanks Feb. 22

    Letter, at 4-5; APGA Feb. 22 Letter, at 2-3.

    \309\ See SIFMA/ISDA Feb. 17 Letter, at 16 (recommending no

    affirmative duty to investigate representations or obtain detailed

    factual representations). Accord CEF Feb. 22 Letter, at 12, 19 and

    20.

    \310\ SIFMA/ISDA Feb. 17 Letter, at 16 fn. 35 (citing Regulation

    D (17 CFR 230.501-508) and Rule 144A (17 CFR 230.144A) transactional

    practice under the federal securities laws).

    \311\ CFA/AFR Feb. 22 Letter, at 8.

    \312\ See, e.g., NFA Aug. 25, 2010 Letter, at 2; SIFMA/ISDA Feb.

    17 Letter, at 16; APGA Feb. 22 Letter, at 2-3.

    \313\ FHLBanks Feb. 22 Letter, at 4.

    \314\ SIFMA/ISDA Feb. 17 Letter, at 16. In addition, the

    commenter questioned whether the loss of ECP status would limit the

    counterparty's ability to terminate, modify or novate the swap.

    \315\ CFA/AFR Feb. 22 Letter, at 8; SIFMA/ISDA Feb. 17 Letter,

    at 16 (asserting that swap dealers and major swap participants

    should be able to rely on eligibility representations deemed to be

    made at the inception of each swap transaction and covenant to

    notify if ECP status ceases).

    \316\ CFA/AFR Feb. 22 Letter, at 8.

    \317\ CEF Feb. 22 Letter, at 12.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.430

    After considering the comments, the Commission has determined to

    adopt the rule with three changes. First, the Commission is adding a

    new Sec. 23.430(c), Special Entity election, which will require a swap

    dealer or major swap participant to determine whether a counterparty is

    eligible to elect to be a Special Entity and notify such counterparty

    as provided for in the Special Entity definition in final Sec.

    23.401(c)(6).\318\ Second, the Commission has added a new safe harbor,

    Sec. 23.430(d), to clarify that a swap dealer or major swap

    participant may rely on written representations of counterparties to

    meet the requirements in the rule. Third, the Commission is clarifying

    that the exemption from verification applies to all transactions on a

    DCM and to anonymous transactions on a SEF.

    ---------------------------------------------------------------------------

    \318\ This addition is related to the Commission's

    determinations regarding the final Special Entity definition

    relating to certain Special Entities defined in Section 3 of ERISA.

    See Section IV.A. of this adopting release.

    ---------------------------------------------------------------------------

    In addition, the Commission is providing the following guidance in

    response to the comments it received. A swap dealer or major swap

    participant must determine ECP and Special Entity status before

    offering to enter into or entering into a swap.\319\ Counterparties

    will be able to make representations about their status at the outset

    of a transaction or in counterparty relationship documentation and

    update that representation if there is a change in status.\320\ Parties

    will not be required to terminate a swap based solely on a change in

    the counterparty's ECP status during the term of the swap.

    ---------------------------------------------------------------------------

    \319\ OTC derivatives industry best practice advises

    professional intermediaries, prior to entering into any transaction,

    to evaluate the counterparty's legal capacity, transactional

    authority and credit. See DPG Framework, at Section V.III.B.

    \320\ The Commission expects swap dealers and major swap

    participants to have policies and procedures in place that require

    the review of counterparty relationship documentation to ensure that

    representations and disclosures under subpart H of part 23 remain

    accurate. Such review should be part of its annual compliance review

    in accordance with subpart J of part 23. See proposed Sec. Sec.

    23.600 and 23.602, Governing Duties of Swap Dealers, 75 FR 71397.

    ---------------------------------------------------------------------------

    In addition, swap dealers and major swap participants may rely on

    the written representations of counterparties in the absence of red

    flags. With respect to the level of detail required in the

    representation, a swap dealer or major swap participant will be deemed

    to have a ``reasonable basis'' to rely on a representation that a

    counterparty is eligible under the rule if the counterparty identifies

    the paragraph of the ECP definition plus, in the case of a Special

    Entity, the paragraph of the Special Entity definition that applies to

    it, and the swap dealer or major swap participant does not have a

    reason to believe the representation is inaccurate. In the absence of

    counterparty representations, the swap dealer or major swap participant

    will have to engage in sufficient due diligence to have a reasonable

    basis to believe that the counterparty meets the eligibility standards

    for an ECP and whether it is a Special Entity.

    Further, the Commission is not adopting standardized due diligence

    documentation at this time. The rule is principles based and allows the

    parties flexibility in developing efficient means to address the

    requirements of the rule. By providing non-exclusive guidance as to the

    types of representations that will meet the ``reasonable basis''

    standard, the Commission believes that the parties will be able to

    comply with the rule without incurring undue cost. Lastly, the

    Commission is confirming that, with respect to transactions initiated

    on a SEF, the verification exemption is only applicable to anonymous

    transactions consistent with Section 4s(h)(7). The proposed exemption

    from the verification duty did not mention DCM transactions, unlike

    Section 4s(h)(7) of the CEA, because Section 2(e) of the CEA does not

    limit participation in DCM swap transactions to ECPs. However, for the

    sake of clarity, the Commission has added language to final Sec.

    23.430 that confirms that swap dealers and major swap participants do

    not have to verify ECP status for DCM transactions, whether anonymous

    or otherwise.

    D. Section 23.431--Disclosure of Material Risks, Characteristics,

    Material Incentives and Conflicts of Interest Regarding a Swap

    Proposed Sec. 23.431 is a multipart rule that tracks Section

    4s(h)(3)(B) of the CEA. Based on the structure of and comments relating

    to proposed Sec. 23.431, the following discussion is divided into six

    sections: Proposed Sec. 23.431--generally; material risk disclosure;

    scenario analysis; material characteristics; material incentives and

    conflicts of interest; and daily mark. Each of the six sections

    includes a summary of the proposed subsections of Sec. 23.431, public

    comments, and a description of the final rule and Commission guidance.

    1. Proposed Sec. 23.431--Generally

    Section 4s(h)(3)(B) of the CEA requires swap dealers and major swap

    participants to disclose to their counterparties material information

    about the risks, characteristics, incentives and conflicts of interest

    regarding the swap. The requirements do not apply if both

    counterparties are any of the following: Swap dealer; major swap

    participant; or SBS Entities. Proposed Sec. 23.431 implemented the

    statutory disclosure requirements and provided specificity with respect

    to certain types of material information that must be disclosed under

    the rule. The Commission stated that information is material if there

    is a substantial likelihood that a reasonable counterparty would

    consider it important in making a swap-related decision.\321\ The Dodd-

    Frank Act does not address the timing and form of the required

    disclosures. To satisfy its disclosure obligation, swap dealers and

    major swap participants would be required to make such disclosures at a

    time prior to entering into the swap and in a manner that was

    reasonably sufficient to allow the counterparty to assess the

    disclosures.\322\ Swap dealers and major swap participants would have

    flexibility to make these disclosures using reliable means agreed to by

    the counterparties, as provided in proposed Sec. 23.402(f).\323\ The

    proposed rules allowed standardized disclosure of

    [[Page 9758]]

    some required information, where appropriate, if the information is

    applicable to multiple swaps of a particular type or class.\324\ The

    Commission noted, however, that most bespoke transactions would require

    some combination of standardized and particularized disclosures.\325\

    ---------------------------------------------------------------------------

    \321\ Proposing release, 75 FR at 80643; cf. CFTC v. R.J.

    Fitzgerald & Co., 310 F.3d 1321, 1328-29 (11th Cir. 2002) (``A

    representation or omission is `material' if a reasonable investor

    would consider it important in deciding whether to make an

    investment.) (citing Affiliated Ute Citizens of Utah v. United

    States, 406 U.S. 128, 153-54 (1972)).

    \322\ Proposing release, 75 FR at 80643.

    \323\ Additionally, under proposed Sec. 23.402(h), swap dealers

    and major swap participants were required to maintain a record of

    their compliance with the proposed rules.

    \324\ Cf. SIFMA/ISDA Oct. 22, 2010 Letter, at 12 (recommending

    the use of standard disclosure templates that could be adopted on an

    industry-wide basis, with disclosure requirements satisfied by a

    registrant on a relationship (rather than a transaction-by-

    transaction) basis in cases where prior disclosures apply to and

    adequately address the relevant transaction).

    \325\ Proposing release, 75 FR at 80643.

    ---------------------------------------------------------------------------

    2. Comments--Generally

    Commenters had a variety of general concerns with the disclosure

    rules including: (1) The proposed rules should be tailored to the

    institutional swaps market, not retail futures or securities markets;

    \326\ (2) the proposed rules should not apply when a counterparty is a

    certain size and level of sophistication; \327\ (3) counterparties

    should be able to opt in to or opt out of the proposed rules; \328\ (4)

    the proposed rules alter the relationship between counterparties and

    swap dealers or major swap participants; \329\ (5) the Commission

    should coordinate with the SEC and DOL to ensure that the proposed

    rules do not trigger ERISA fiduciary status or municipal advisor

    status; \330\ (6) only mandatory statutory rules should be promulgated

    at this time and discretionary rules (e.g., scenario analysis) should

    be delayed; \331\ (7) the statute does not require the same rules for

    both swap dealers and major swap participants; different, less

    burdensome rules consistent with the statute should be drawn for major

    swap participants; \332\ (8) uncertainty regarding compliance with

    principles based disclosure rules; \333\ and (9) the costs outweigh the

    benefits of the proposed rule.\334\

    ---------------------------------------------------------------------------

    \326\ See SIFMA/ISDA Feb. 17 Letter, at 3-4 and 18; COPE Feb. 22

    Letter, at 3-5; VRS Feb. 22 Letter, at 3-4; Exelon Feb. 22 Letter,

    at 2-4; CEF Feb. 22 Letter, at 2-4; NY City Bar Feb. 22 Letter, at

    2.

    \327\ See VRS Feb. 22 Letter, at 1 and 4; NACUBO Feb. 22 Letter,

    at 3-4; HOOPP Feb. 22 Letter, at 3; CEF Feb. 22 Letter, at 4-5.

    \328\ See VRS Feb. 22 Letter, at 4; NACUBO Feb. 22 Letter, at 3-

    4; ABC/CIEBA Feb. 22 Letter, at 13.

    \329\ See BlackRock Feb. 22 Letter, at 2; CEF Feb. 22 Letter, at

    3-4 and 8.

    \330\ See Rep. Bachus Mar 15 Letter, at 1-3; SIFMA/ISDA Feb. 17

    Letter, at 9; BlackRock Feb. 22 Letter, at 2 and 6; ABC/CIEBA Feb.

    22 Letter, at 2-3; ERIC Feb. 22 Letter, at 2-3; AFSCME Feb. 22

    Letter, at 4-5; AMG-SIFMA Feb. 22 Letter, at 8-9.

    \331\ See BlackRock Feb. 22 Letter, at 2; SIFMA/ISDA Feb. 17

    Letter, at 3; CEF Feb. 22 Letter, at 8.

    \332\ See MFA Feb. 22 Letter, at 1-3; BlackRock Feb. 22 Letter,

    at 2; MetLife Feb. 22 Letter, at 1 and 4-5; CEF Feb. 22 Letter, at

    5-6.

    \333\ See, e.g., FHLBanks Feb. 22 Letter, at 3-4; FHLBanks June

    3 Letter, at 8-9; NY City Bar Feb. 22 Letter, at 2; SIFMA/ISDA Feb.

    17 Letter, at 4 and 16-18. Contra CFA/AFR Feb. 22 Letter, at 18.

    \334\ See BlackRock Feb. 22 Letter, at 6-7; VRS Feb. 22 Letter,

    at 3-4; MFA Feb. 22 Letter, at 5-6; HOOPP Feb. 22 Letter, at 2-3;

    ABC/CIEBA Feb. 22 Letter, at 13; COPE Feb. 22 Letter, at 2-4; COPE

    June 3 Letter, at 5-6; Exelon Feb. 22 Letter, at 2-3; ETA June 3

    Letter, at 20-21; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22

    Letter, at 2.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.431--Generally

    Regarding the comment that the proposed rule should be tailored to

    the institutional swaps market, not retail futures or securities

    market, as indicated in the proposing release, the disclosure rules

    follow the statute and are informed by industry practices and best

    practice recommendations. The Commission reviewed OTC derivatives

    industry reports, as well as futures and securities regulations and

    related SRO business conduct rules, prior to drafting the rule.\335\ In

    particular, reports by the Derivatives Policy Group (``DPG'') and

    Counterparty Risk Management Policy Group (``CRMPG'') included industry

    best practice recommendations regarding product disclosures.\336\ These

    OTC derivatives industry reports confirmed that the industry is

    familiar with product disclosure. In addition, a commenter reported

    that:

    ---------------------------------------------------------------------------

    \335\ Proposing release, 75 FR at 80639.

    \336\ See DPG Framework, supra fn. 178; CRMPG I Report, supra

    fn. 274; CRMPG II Report, supra fn. 274; CRMPG III Report, supra fn.

    228.

    Swap dealers also generally distribute to their end-user

    counterparties at the outset of a new swap relationship standardized

    documentation setting forth the material characteristics, risks and

    conflicts of interest with respect to the swaps to be entered into

    with such end-user counterparty under an ISDA Master Agreement or

    other master documentation.\337\

    ---------------------------------------------------------------------------

    \337\ See FHLBanks Feb. 22 Letter, at 2.

    Moreover, the plain language of Section 4s(h)(3)(B) requires disclosure

    of the material risks, characteristics, incentives and conflicts of

    interest relating to the swap. Based on the statutory language,

    industry practice and industry best practice recommendations, the

    Commission believes that the final rule is tailored appropriately to

    the swaps market.

    With respect to whether the disclosure duties should apply when a

    counterparty is a certain size and level of sophistication, and whether

    counterparties should be able to opt in to or opt out of the

    protections of the disclosure rule, the Commission notes that Section

    4s(h)(3)(B) only limits the disclosure duty when a swap transaction is

    between swap dealers, major swap participants, and/or SBS Entities. The

    only exception in Section 4s(h)(3)(B) allows counterparties to obtain

    the daily mark for cleared swaps upon request.\338\ Given that the

    statute provides such limited opt in/opt out for disclosures, the final

    rule is consistent with the plain language of the statute by not

    allowing counterparties to opt in to or opt out of the disclosure rule

    other than as provided by the statute.\339\

    ---------------------------------------------------------------------------

    \338\ The Commission also has clarified that the Sec. 23.431

    disclosure obligations do not apply to transactions that are

    initiated on a SEF or DCM where the swap dealer or major swap

    participant does not know the identity of the counterparty to the

    transaction. See final Sec. 23.431(c) (previously numbered as

    proposed Sec. 23.431(b)). See also Section 4s(h)(7) of the CEA with

    respect to the Special Entity provisions.

    \339\ See Section III.A.1. of this adopting release for a

    discussion of ``Opt in or Opt out for Certain Classes of

    Counterparties.''

    ---------------------------------------------------------------------------

    Commenters claimed that the proposed disclosure rule alters the

    relationship between counterparties and swap dealers or major swap

    participants from arm's length dealings to advisory relationships.\340\

    The Commission disagrees and confirms that the business conduct

    standards rules alone do not cause a swap dealer or major swap

    participant to assume advisory responsibilities or become a

    fiduciary.\341\ The final rule tracks the statute and includes

    explanatory language regarding the timing and content of the statutory,

    principles based disclosure duty, and was informed by industry

    practices \342\ and industry best practice recommendations.\343\ The

    statute and

    [[Page 9759]]

    the disclosure rules are intended to level the information playing

    field by requiring swap dealers and major swap participants to provide

    sufficient information about a swap to enable counterparties to make

    their own informed decisions about the appropriateness of entering into

    the swap. The additional language in the rule, including ``at a

    reasonably sufficient time prior to entering into a swap'' and

    ``information reasonably designed to allow a counterparty to assess,''

    along with the material risks and characteristics standards in the

    rule, is intended to provide guidance to swap dealers and major swap

    participants in complying with the rule. This guidance will assist swap

    dealers and major swap participants in designing reasonable policies

    and procedures to comply with the requirements of the statute and the

    final rule.

    ---------------------------------------------------------------------------

    \340\ Several commenters urged the Commission to coordinate with

    the SEC and DOL to ensure that the final rule does not trigger ERISA

    fiduciary or municipal advisor status. The Commission confirms that

    it continues to coordinate with both agencies on these issues. See

    Section II of this adopting release for a discussion of ``Regulatory

    Intersections.'' See also Section III.A.1. of this adopting release

    for a discussion of ``Discretionary Rules'' and ``Different Rules

    for Swap Dealers and Major Swap Participants.'' Regarding the

    relative costs and benefits of the disclosure rules, see Section

    VI.C.4. of this adopting release for a discussion of Sec. 23.431.

    \341\ The Commission is amending Sec. 4.6 to exclude swap

    dealers from the CTA definition, which the Dodd-Frank Act amended to

    include swaps, when their advice is solely incidental to its

    business as a swap dealer. See Section II.D. of this adopting

    release. See also Section II.B. of this adopting release for a

    discussion of how compliance with the business conduct standards

    rules, including the disclosure duties, will be considered by DOL.

    \342\ See supra at fn. 336 and accompanying text.

    \343\ The CRMPG III Report provides the following best practice

    guidance regarding disclosure:

    [I]t is critical that participants in the markets for high-risk

    complex instruments must understand the risks that they face. An

    investor or derivative counterparty should have the information

    needed to make informed decisions. While the Policy Group has

    recommended that each participant must develop a degree of

    independence in decision-making, large integrated financial

    intermediaries have a responsibility to provide their counterparties

    with appropriate documentation and disclosures. Disclosures must

    meet the standards established by the relevant regulatory

    jurisdiction. The Policy Group believes that appropriate disclosures

    should often go beyond those minimum standards, both through

    enhancement for instruments currently requiring disclosure, and by

    establishing documentation standards for instruments that currently

    require little or none.

    CRMPG III Report, at 59.

    ---------------------------------------------------------------------------

    The Commission has promoted efficiency and reduced costs by

    allowing swap dealers and major swap participants to use standardized

    formats to make required disclosures, as appropriate, in counterparty

    relationship documentation.\344\ Depending on the facts and

    circumstances, disclosures in a standard format may be appropriate if

    the information is applicable to multiple swaps of a particular type

    and class, particularly standardized swaps. Similarly, whether standard

    form disclosures are appropriate for certain bespoke swaps will depend

    on the facts and circumstances. Factors that would be relevant are the

    complexity of the transaction, including, but not limited to, the

    degree and nature of any leverage,\345\ the potential for periods of

    significantly reduced liquidity, and the lack of price

    transparency.\346\ This approach is consistent with OTC derivatives

    industry best practice recommendations for high-risk, complex financial

    instruments.\347\ Given the evolutionary nature of swaps, and

    especially bespoke swaps, swap dealers and major swap participants will

    be required to have and implement reasonably designed policies and

    procedures concerning when and how to make particularized disclosures

    on a transactional basis to account for changing characteristics, as

    well as different and newly identified risks, incentives and conflicts

    of interest. The statute is unequivocal regarding the duty to provide

    disclosures of the material risks, characteristics, incentives and

    conflicts of interest for each swap.

    ---------------------------------------------------------------------------

    \344\ See Section III.A.3.f. of this adopting release for a

    discussion of proposed Sec. 23.402(g)--Disclosures in a standard

    format (renumbered as final Sec. 23.402(f)).

    \345\ This characteristic is particularly relevant when the swap

    includes an embedded option that increases leverage. Such features

    can significantly increase counterparty risk exposure in ways that

    are not transparent. See also fn. 227.

    \346\ CRMPG III Report, at 56; see also text at fn. 228.

    \347\ CRMPG III Report, at 56.

    ---------------------------------------------------------------------------

    Regarding commenters' recommendations to delay discretionary rules

    and urging different rules for major swap participants, the Commission

    has addressed those issues above.\348\ In response to commenters

    concerns about compliance with principles based disclosure duties, the

    Commission will, in the absence of fraud, consider good faith

    compliance with policies and procedures reasonably designed to comply

    with the disclosure rules as a mitigating factor when exercising its

    prosecutorial discretion for violation of the disclosure rule.

    ---------------------------------------------------------------------------

    \348\ See Section III.A.1.b.ii. and iii. of this adopting

    release for a discussion of ``Discretionary Rules'' and ``Different

    Rules for Swap Dealers and Major Swap Participants.''

    ---------------------------------------------------------------------------

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

    i. Proposed Sec. 23.431(a)(1)

    The proposed rule tracked the statutory obligations under Section

    4s(h)(3)(B)(i) and required the swap dealer or major swap participant

    to disclose information to enable a counterparty to assess the material

    risks of a particular swap. The Commission anticipated that swap

    dealers and major swap participants typically would rely on a

    combination of standardized disclosures and more particularized

    disclosures to satisfy this requirement. The proposed rule identified

    certain types of risks that are associated with swaps generally,

    including market,\349\ credit,\350\ operational,\351\ and liquidity

    risks.\352\ Required risk disclosure included sufficient information to

    enable a counterparty to assess its potential exposure during the term

    of the swap and at expiration or upon early termination. The Commission

    noted that, consistent with industry ``best practices,'' information

    regarding specific material risks had to identify the material factors

    that influence the day-to-day changes in valuation, as well as the

    factors or events that might lead to significant losses.\353\ As

    described in the proposing release, disclosures under the proposed rule

    should consider the effect of future economic factors and other

    material events that could cause the swap to experience such losses.

    Disclosures also should identify, to the extent possible, the

    sensitivities of the swap to those factors and conditions, as well as

    the approximate magnitude of the gains or losses the swap will likely

    experience. The Commission noted that swap dealers and major swap

    participants also should consider the unique risks associated with

    particular types of swaps, asset classes and trading venues, and tailor

    their disclosures accordingly.

    ---------------------------------------------------------------------------

    \349\ Market risk refers to the risk to a counterparty's

    financial condition resulting from adverse movements in the level or

    volatility of market prices.

    \350\ Credit risk refers to the risk that a party to a swap will

    fail to perform on an obligation under the swap.

    \351\ Operational risk refers to the risk that deficiencies in

    information systems or internal controls, including human error,

    will result in unexpected loss.

    \352\ Liquidity risk is the risk that a counterparty may not be

    able to, or cannot easily, unwind or offset a particular position at

    or near the previous market price because of inadequate market

    depth, unique trade terms or remaining party characteristics or

    because of disruptions in the marketplace.

    \353\ See CRMPG III Report, at 60.

    ---------------------------------------------------------------------------

    ii. Comments

    The Commission received comments on a variety of issues related to

    proposed Sec. 23.431(a)(1). Comments included claims that disclosures

    would increase costs, delay execution, expose parties to additional

    market risk, intrude on counterparty confidential information and

    result in ever longer lists of hypothetical risks.\354\ However, one

    commenter specifically disagreed, arguing that the statute requires

    material risk disclosure and not limited utility, generalized

    disclosure.\355\ With respect to the importance of a robust risk

    disclosure duty, the commenter\356\ referenced transactions profiled in

    the report from the U.S. Senate Permanent Subcommittee on

    Investigations, Committee on Homeland Security and Governmental

    Affairs, ``Wall Street and the Financial Crisis: Anatomy of a Financial

    Collapse,'' issued April 13, 2011 (``Senate Report'').\357\

    ---------------------------------------------------------------------------

    \354\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 17.

    \355\ CFA/AFR Aug. 29 Letter, at 19.

    \356\ Id., at 2-5 and 12.

    \357\ The report concludes that transactions involving

    structured collateralized debt obligations (``CDOs'') were

    problematic because they were designed to fail and the disclosures

    omitted and/or misrepresented the material risks, characteristics,

    incentives and conflicts of interest related to these types of

    transactions.

    ---------------------------------------------------------------------------

    Another commenter stated that the proposed rule was too vague

    regarding what material risks must be disclosed, creating legal

    uncertainty, potential

    [[Page 9760]]

    hindsight enforcement, and private rights of action.\358\ The commenter

    claimed that, without guidance, swap dealers and major swap

    participants may over disclose risks and/or limit the number of their

    swap counterparties.\359\ Certain commenters recommended that the

    Commission clarify that the ``material risks'' of a swap are limited to

    the economic terms of the product and not risks associated with the

    underlying asset.\360\

    ---------------------------------------------------------------------------

    \358\ FHLBanks June 3 Letter, at 8-9.

    \359\ Id.

    \360\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 17 (e.g., a

    particular event in the Middle East that could impact currency

    markets).

    ---------------------------------------------------------------------------

    Several commenters supported standardized risk disclosures.\361\

    However, others were skeptical of the value of mandatory boilerplate

    disclosures.\362\ Other commenters recommended that the Commission

    specifically require risk disclosures regarding volatility, historic

    liquidity and value at risk.\363\ One commenter recommended that, in

    lieu of proposed Sec. 23.431, the Commission limit the disclosure duty

    to a predefined scenario analysis.\364\ It was suggested, for example,

    regarding interest rate sensitivity, that the rule could mandate an

    analysis of interest rate conditions up to a certain number of standard

    deviations away from expected interest rate movements based on

    historical interest rates.\365\ It was asserted that such objective

    standards would promote marketplace and legal certainty.\366\

    ---------------------------------------------------------------------------

    \361\ See, e.g., MetLife Feb. 22 Letter, at 5; ATA Feb. 22

    Letter, at 3; APGA Feb. 22 Letter, at 3; FHLBanks Feb. 22 Letter, at

    1 and 3-4; FHLBanks June 3 Letter, at 8-9; CII Feb. 10 Letter, at 2.

    \362\ See COPE Feb. 22 Letter, at 3-4; Exelon Feb. 22 Letter, at

    2-3; BlackRock Feb. 22 Letter, at 7.

    \363\ See Better Markets Feb. 22 Letter, at 3 and 7; Barnard May

    23 Letter, at 2.

    \364\ NY City Bar Feb. 22 Letter, at 2.

    \365\ Id.

    \366\ Id.

    ---------------------------------------------------------------------------

    iii. Final Sec. 23.431(a)(1)

    After considering the comments on proposed Sec. 23.431(a)(1), the

    Commission has determined to adopt the rule as proposed. In addition,

    the Commission is confirming that the rule will be interpreted

    consistently with industry best practice regarding the disclosure of

    material risks.\367\ This guidance will assist swap dealers and major

    swap participants in designing policies and procedures to comply with

    the final rule. The final rule is tailored to give effect to the plain

    language of the statute by requiring swap dealers and major swap

    participants to provide material risk disclosure that allows a

    counterparty to assess the risks of the swap.

    ---------------------------------------------------------------------------

    \367\ As stated in the proposing release, consistent with

    industry ``best practices,'' information regarding specific material

    risks must identify the material factors that influence the day-to-

    day changes in valuation, as well as the factors or events that

    might lead to significant losses. Proposing release, 75 FR at 80644

    (citing CRMPG III Report, at 60). Appropriate disclosures should

    consider the effect of future economic factors and other material

    events that could cause the swap to experience such losses.

    Disclosures should also identify, to the extent possible, the

    sensitivities of the swap to those factors and conditions, as well

    as the approximate magnitude of the gains or losses the swap will

    likely experience. Proposing release, 75 FR at 80644. See also

    proposed 17 CFR 240.15Fh-3(b)(1), SEC's proposed rules, 76 FR at

    42454 (SEC rule regarding material risks requires disclosure,

    including, but not limited to, ``the material factors that influence

    the day-to-day changes in valuation, the factors or events that

    might lead to significant losses, the sensitivities of the security-

    based swap to those factors and conditions, and the approximate

    magnitude of the gains or losses the security-based swap will

    experience under specified circumstances''). Accordingly, the

    Commission's interpretation is consistent with the text of the SEC's

    proposed risk disclosure rule, which furthers the harmonization goal

    of the Commission and the SEC.

    ---------------------------------------------------------------------------

    Certain commenters recommended that the Commission clarify that the

    material risk disclosure requirement under Sec. 23.431(a)(1) is

    limited to disclosures about the risks associated with the economic

    terms of the product and not risks associated with the underlying

    asset.\368\ The Commission believes that for most swaps information

    about the material risks and characteristics of the swap will relate to

    the risks and characteristics of the economic terms of the swap.\369\

    For certain swaps, however, where payments or cash-flows are materially

    affected by the performance of an underlying asset for which there is

    not publicly available information (or the information is not otherwise

    accessible to the counterparty), final Sec. 23.431 would require

    disclosures about the material risks and characteristics that affect

    the value of the underlying asset to enable a counterparty to assess

    the material risks of the swap.\370\ For example, for a total return

    swap whose value is based on the performance of a broad-based index

    consisting of unique assets that it created or acquired, a swap dealer

    or major swap participant would be required to disclose information

    about the material risks and characteristics of the broad-based index,

    unless such information is accessible to the counterparty. Disclosure

    regarding an underlying asset in such circumstances is consistent with

    the duty to communicate in a fair and balanced manner based on

    principles of fair dealing and good faith as required by Section

    4s(h)(3)(C) and final Sec. 23.433. In connection with a swap based on

    the price of oil, for example, a swap dealer or major swap participant

    would not have to disclose information about the drivers of oil prices

    because such information is readily available to market

    participants.\371\

    ---------------------------------------------------------------------------

    \368\ See SIFMA/ISDA Feb. 17 Letter, at 17.

    \369\ Such economic terms would include payout structures that

    embed volatility or optionality features into the transaction,

    including, but not limited to, caps, collars, floors, knock-in or

    knock-out rights, or range accrual features. As noted above,

    disclosures concerning these features would need to provide

    sufficient information about these features to enable counterparties

    to make their own informed decisions about the appropriateness of

    entering into the swap.

    \370\ Such a requirement is not intended to create, and does not

    create, any general trading prohibition or general disclosure

    requirement concerning ``inside information'' under the CEA. This

    guidance addresses circumstances where information concerning the

    risks of the underlying asset generally are not publicly available.

    For example, where a swap dealer offered a total return swap on a

    broad-based index based on unique assets that it created or

    acquired, any potential counterparty would be unable to evaluate

    that transaction absent some form of disclosure by the swap dealer.

    This rule would require such disclosure. In contrast, where a swap

    dealer offers a swap on an underlying asset for which it has

    nonpublic information, for example, harvest information about an

    agricultural commodity or production information about an energy

    commodity, and the asset is one for which risk information is

    publicly available, the swap dealer or major swap participant would

    not be required to disclose the nonpublic information it holds.

    However, depending on the facts and circumstances, the swap dealer

    might have to disclose nonpublic information as part of its duty to

    disclose material incentives and conflicts of interest. See Section

    III.D.3.d.iii. of this release for a discussion of the duty to

    disclose material incentives and conflicts of interest. In addition,

    as part of its obligation to disclose the material economic terms of

    the swap, the swap dealer would have to provide information about

    the factors that would cause the value of the swap to change

    including any correlations with the value of the underlying asset.

    Of course, swap dealers and major swap participants also will be

    subject to the fair dealing rule and antifraud provisions with

    respect to their communications with counterparties. See Sections

    III.B. and III.F. of this release for a discussion of Sec. 23.410-

    Prohibition on Fraud, Manipulation and Other Abusive Practices, and

    Sec. 23.433-Communications-Fair Dealing, respectively. In addition,

    as stated in Sec. 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.

    \371\ With respect to the request by certain commenters that the

    Commission require material risk disclosures regarding volatility,

    historic liquidity, and value at risk, the Commission declines to

    prescribe specific parameters for compliance with the risk

    disclosure rule beyond the explanatory text of the final rule.

    Nevertheless, the Commission believes that, depending on the facts

    and circumstances, including whether the counterparty has elected to

    receive scenario analysis, disclosure of these risk factors may be

    appropriate.

    ---------------------------------------------------------------------------

    Without commenting on the Senate Report's findings, the Commission

    considered how the final disclosure rules would address transactions

    similar to those profiled in the Senate Report, as requested by

    commenters.\372\ The

    [[Page 9761]]

    final rule addresses the types of concerns raised by the Senate Report

    and by commenters by requiring the disclosure of material risks,

    characteristics, incentives and conflicts of interest, as well the duty

    to communicate in a fair and balanced manner based on principles of

    fair dealing and good faith. These duties are consistent with

    longstanding legal, regulatory and industry best practice standards,

    which are familiar to the financial services industry and the OTC

    derivatives industry.

    ---------------------------------------------------------------------------

    \372\ See, e.g., Sen. Levin Aug. 29 Letter, at passim; CFA/AFR

    Feb. 22 Letter, at 2, 10 and 12; CFA/AFR Aug. 29 Letter, at 3-8, 18

    and 20.

    ---------------------------------------------------------------------------

    The Commission declines to limit the disclosure duty to a

    predefined scenario analysis as suggested by one commenter. The

    Commission recognizes the benefits of, and encourages the use of, an

    analysis such as the one suggested by the commenter \373\ to satisfy,

    in part, the material risk disclosure requirement. In fact, the

    Commission believes that the use of historical data in tabular form to

    illustrate specific swap and/or asset prices, volatility, sensitivity,

    liquidity risks and characteristics is consistent with industry

    practice.\374\ However, the Commission has determined that such

    analyses may not satisfy all aspects of the principles based disclosure

    requirement in Section 4s(h)(3)(B) for all swaps. Accordingly, the

    Commission has determined not to adopt a predefined scenario analysis

    in lieu of proposed Sec. 23.431.

    ---------------------------------------------------------------------------

    \373\ NY City Bar Feb. 22 Letter, at 2-3.

    \374\ See CRMPG III Report, at 60.

    ---------------------------------------------------------------------------

    In response to commenters asking that the Commission develop

    standardized risk disclosures, the Commission decided not to adopt

    futures style standard form swap disclosure for the reasons discussed

    in connection with Sec. 23.402(f)-Disclosures in a standard

    format.\375\

    ---------------------------------------------------------------------------

    \375\ See Section III.A.3.f. of this adopting release for a

    discussion of final Sec. 23.402(f)-Disclosures in a standard

    format.

    ---------------------------------------------------------------------------

    b. Section 23.431(b)--Scenario Analysis

    i. Proposed Sec. 23.431(a)(1)(i)-(v)

    The Commission's scenario analysis rule in proposed Sec.

    23.431(a)(1)(i)-(v) (renumbered as Sec. 23.431(b)) required swap

    dealers and major swap participants to provide scenario analyses when

    offering to enter into a high-risk complex bilateral swap to allow the

    counterparty to assess its potential exposure in connection with the

    swap.\376\ In addition, the proposed rule allowed counterparties to

    elect to receive scenario analysis when they were offered bilateral

    swaps not available for trading on a DCM or SEF. The elective aspect of

    the rule reflected the expectation that there would be circumstances

    where scenario analysis would be helpful for certain counterparties,

    even for swaps that are not high-risk complex. Proposed Sec.

    23.431(a)(1) was modeled on the CRMPG III industry best practices

    recommendation for high-risk complex financial instruments.\377\

    ---------------------------------------------------------------------------

    \376\ Scenario analysis was proposed in addition to required

    disclosures for swaps that do not qualify as high-risk complex. Such

    required disclosures included a clear explanation of the economics

    of the instrument.

    \377\ CRMPG III Report, at 60-61.

    ---------------------------------------------------------------------------

    Like the CRMPG III industry best practices recommendation, the term

    ``high-risk complex bilateral swap'' was not defined in the proposed

    rule; rather, certain flexible characteristics were identified to

    prevent concerns about over- or under-inclusivity. The characteristics

    included: The degree and nature of leverage,\378\ the potential for

    periods of significantly reduced liquidity and the lack of price

    transparency.\379\ The proposed rule required swap dealers and major

    swap participants to establish reasonable policies and procedures to

    identify high-risk complex bilateral swaps and, in connection with such

    swaps, provide the additional risk disclosure specified in proposed

    Sec. 23.431(a)(1).

    ---------------------------------------------------------------------------

    \378\ See fn. 227 and 345 discussing risks regarding leverage.

    \379\ CRMPG III Report, at 56; see also text at fn. 228.

    ---------------------------------------------------------------------------

    Scenario analysis, as required by the proposed rule, would be an

    expression of potential losses to the fair value of the swap in market

    conditions ranging from normal to severe in terms of stress.\380\ Such

    analyses would be designed to illustrate certain potential economic

    outcomes that might occur and the effect of these outcomes on the value

    of the swap. The proposed rule required that these outcomes or

    scenarios be developed by the swap dealer or major swap participant in

    consultation with the counterparty. In addition, the proposed rule

    required that all material assumptions underlying a given scenario and

    their impact on swap valuation be disclosed.\381\ In requiring such

    disclosures, however, the Commission did not require swap dealers or

    major swap participants to disclose proprietary information about

    pricing models.

    ---------------------------------------------------------------------------

    \380\ These value changes originate from changes or shocks to

    the underlying risk factors affecting the given swap, such as

    interest rates, foreign currency exchange rates, commodity prices

    and asset volatilities.

    \381\ Material assumptions included (1) the assumptions of the

    valuation model and any parameters applied and (2) a general

    discussion of the economic state that the scenario is intended to

    illustrate.

    ---------------------------------------------------------------------------

    The Commission did not propose to define the parameters of the

    scenario analysis in order to provide flexibility to the parties in

    designing the analyses in accordance with the characteristics of the

    bespoke swap at issue and any criteria developed in consultations with

    the counterparty. Further, the proposed rule required swap dealers and

    major swap participants to consider relevant internal risk analyses,

    including any new product reviews, when designing the analyses.\382\ As

    for the format, the proposed rule required both narrative and tabular

    expressions of the analyses.

    ---------------------------------------------------------------------------

    \382\ The Commission proposed that swap dealers and major swap

    participants adopt policies and procedures regarding a new product

    policy as part of their risk management system. See proposed Sec.

    23.600(c)(3), Governing the Duties of Swap Dealers, 75 FR at 71405.

    ---------------------------------------------------------------------------

    To ensure fair and balanced communications and to avoid misleading

    counterparties, swap dealers and major swap participants also were

    required to state the limitations of the scenario analysis, including

    cautions about the predictive value of the scenario analysis, and any

    limitations on the analysis based on the assumptions used to prepare

    it. The Commission aligned the proposed rule with longstanding industry

    best practice recommendations.\383\

    ---------------------------------------------------------------------------

    \383\ See DPG Framework, at Section V.II.G.; CRMPG III Report,

    at 59-61 and Appendix A, Bullet 5; but see SIFMA/ISDA Feb. 17

    Letter, at 13-14.

    ---------------------------------------------------------------------------

    ii. Comments

    The Commission received comments on a broad range of issues

    regarding the proposed scenario analysis rule. One commenter raised a

    host of concerns, including: (1) That Section 4s(h)(3)(B) does not

    require scenario analysis; (2) codifying industry best practice will

    discourage future private sector initiatives; (3) scenario analysis is

    a broad concept encompassing many potential analyses that are not

    relevant for individual transactions and, absent a definition or

    guidance regarding the parameters of the analysis, it is possible that

    scenario analysis will be misleading; (4) scenario analysis may cause

    swap dealers and major swap participants to become ERISA fiduciaries,

    municipal advisors and/or CTAs; (5) swap dealers and major swap

    participants may have liability for failing to provide mandatory

    scenario analysis even though they have reasonable policies and

    procedures for identifying high-risk complex bilateral swaps; (6) the

    highly subjective definition of high-risk complex bilateral swap is

    problematic from a liability perspective, particularly for hindsight

    enforcement actions and private rights

    [[Page 9762]]

    of action; (7) the rule mandates delivery of scenario analysis even if

    the counterparty neither requests nor wants the analysis; and (8) the

    mandatory delivery of scenario analysis will delay execution, which

    increases risk to the counterparty.\384\

    ---------------------------------------------------------------------------

    \384\ See SIFMA/ISDA Feb. 17 Letter, at 18-21.

    ---------------------------------------------------------------------------

    Other commenters claimed that the scenario analysis rule would

    increase counterparty dependence on swap dealers and major swap

    participants thereby raising moral hazard concerns.\385\ Another

    commenter was concerned that scenario analysis, or portions thereof, is

    often proprietary, which raises confidentiality and liability

    issues.\386\ The commenter also claimed that the proposed scenario

    analysis rule is resource intensive and will increase the cost of swaps

    to counterparties.\387\

    ---------------------------------------------------------------------------

    \385\ See MFA Feb. 22 Letter, at 6; CEF Feb. 22 Letter, at 9;

    SIFMA/ISDA Feb. 17 Letter, at 19.

    \386\ CEF Feb. 22 Letter, at 9-10.

    \387\ Id.

    ---------------------------------------------------------------------------

    Certain commenters were in favor of the proposed scenario analysis

    rule. For example, a commenter said it would like to receive scenario

    analysis for the swaps covered by the proposed rule.\388\ Another

    commenter believed that scenario analysis should not be expensive in

    that swap dealers and major swap participants are expected to take the

    other side of the swap and already do the analysis, which is easily

    modified to the counterparty's purpose.\389\ Moreover, the commenter

    asserted that swap dealers and major swap participants must do the

    analysis as part of the suitability or Special Entity ``best

    interests'' analysis.\390\ Another commenter supported the proposed

    rule, but suggested allowing swap dealers and major swap participants

    to delegate responsibility for the analysis to appropriately qualified

    independent third party providers.\391\ In addition, this commenter

    recommended that the scenario analysis be provided on a portfolio

    basis.\392\ Lastly, certain commenters suggested that the proposed

    scenario analysis only be required at the request of the

    counterparty.\393\

    ---------------------------------------------------------------------------

    \388\ MetLife Feb. 22 Letter, at 5.

    \389\ CFA/AFR Feb. 22 Letter, at 9.

    \390\ Id.

    \391\ Markit Feb. 22 Letter, at 3-4; Markit June 3 Letter, at 7.

    \392\ Id.

    \393\ See COPE Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter,

    at 21; Exelon Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 10.

    ---------------------------------------------------------------------------

    iii. Final Sec. 23.431(b)

    After considering the comments, the Commission has determined to

    adopt proposed Sec. 23.431(a)(1)(i)-(v) (renumbered as Sec.

    23.431(b)) with certain modifications. The Commission revised the

    proposed rule to eliminate the requirement to provide scenario analysis

    for ``high-risk complex bilateral swaps.'' Instead, the final rule

    requires scenario analysis only when requested by the counterparty for

    any swap not ``made available for trading'' on a DCM or SEF.\394\ To

    comply with the rule, swap dealers will have to disclose to

    counterparties their right to receive scenario analysis and consult

    with counterparties regarding design. These changes eliminate both the

    mandatory element and definitional issues associated with the term

    ``high-risk complex bilateral swap.'' They also address counterparty

    concerns about execution delays and costs. In addition, major swap

    participants will not have to provide scenario analysis. Because

    modeling and providing scenario analysis is currently an industry best

    practice for dealers, the Commission is limiting the duty to swap

    dealers only.

    ---------------------------------------------------------------------------

    \394\ Under Section 2(h)(8) of the CEA, a swap that is subject

    to the clearing requirement of Section 2(h)(1) must be executed on a

    DCM or SEF unless no DCM or SEF ``makes the swap available to

    trade'' or the swap is subject to the clearing exception under

    Section 2(h)(7) (i.e., the end-user exception). See Proposed Rules,

    Swap Transaction Compliance and Implementation Schedule: Clearing

    and Trade Execution Requirements under Section 2(h) of the CEA, 76

    FR 58186, 58191, Sept. 20, 2011 (``Trade Execution Requirements'');

    see also Proposed Rules, Process for a Designated Contract Market or

    Swap Execution Facility to Make a Swap Available to Trade, 76 FR

    77728, Dec. 14, 2011 (``Process to Make a Swap Available to

    Trade''). Therefore, final Sec. 23.431(b) only requires a swap

    dealer to provide scenario analysis upon request for swaps that are

    not subject to the trade execution requirement under Section

    2(h)(8).

    ---------------------------------------------------------------------------

    Regarding parameters for scenario analysis, the Commission decided

    to retain the language in proposed Sec. 23.431(a)(1)(ii), (iv) and

    (v). The rule is principles based and allows flexibility in designing

    the analysis. As guidance, the Commission directs swap dealers to

    industry best practices for scenario analysis for high-risk complex

    financial instruments.\395\ That best practice recommends:

    ---------------------------------------------------------------------------

    \395\ See CRMPG III Report, at Appendix A, Bullet 5.

    The analysis should be done over a range of assumptions,

    including severe downside stress scenarios. Scenario analysis should

    also include an analysis of what assumptions would result in a

    significant percentage loss (e.g., 50%) of principal or notional.

    All implicit and explicit assumptions should be clearly indicated

    and calculation methodologies should be explained. Significant

    assumptions should be stress-tested with the results plainly

    disclosed.\396\

    ---------------------------------------------------------------------------

    \396\ Id.

    In addition, counterparties may request the type of information and

    scenario analyses they consider useful. Such flexibility enhances the

    benefits of scenario analysis to counterparties while limiting the

    costs of the final rule. The counterparty gets what it needs and the

    swap dealer has certainty about the type of analysis that will comply

    with the rule. As noted in the proposing release, swap dealers have

    informed Commission staff that they currently provide to counterparties

    scenario analysis upon request and without charge.\397\

    ---------------------------------------------------------------------------

    \397\ Proposing release, 75 FR at 80645.

    ---------------------------------------------------------------------------

    Regarding comments that Section 4s(h)(3)(B) does not require

    scenario analysis, the Commission notes that OTC derivatives industry

    best practice dating back to 1995 discusses the provision of scenario

    analysis to illustrate the risks of particular derivative

    products.\398\ In addition, a recent OTC derivatives industry best

    practice disclosure recommendation for high-risk complex financial

    instruments calls for ``rigorous scenario analyses and stress tests

    that prominently illustrate how the instrument will perform in extreme

    scenarios, in addition to more probable scenarios.'' \399\ These

    industry reports, coupled with letters from commenters,\400\ are

    evidence of the value of scenario analysis in supplementing a

    counterparty's ability to assess the risks and characteristics of swaps

    and support the Commission's determination that requiring scenario

    analysis, as provided for in the final rule, is in the public interest.

    As discussed above in connection with final Sec. 23.400-Scope, the

    Commission has ample discretionary authority to adopt the scenario

    analysis rule.\401\

    ---------------------------------------------------------------------------

    \398\ See DPG Framework, at Section V.II.G.

    \399\ See CRMPG III Report, at 61.

    \400\ See MetLife Feb. 22 Letter, at 5; CFA/AFR Feb. 22 Letter,

    at 9; Better Markets Feb. 22 Letter, at 3 and 7; Barnard May 23

    Letter, at 2; Markit Feb. 22 Letter, at 3-4. Accord COPE Feb. 22

    Letter, at 4; CEF Feb. 22 Letter, at 10 (suggesting changing the

    rule from mandatory to elective by the counterparty).

    \401\ See Section III.A.1.ii. of this adopting release for a

    discussion of ``Discretionary Rules.''

    ---------------------------------------------------------------------------

    The Commission is not persuaded by the assertion that codifying

    industry best practice will discourage future private sector

    initiatives and enhance the potential for hindsight enforcement actions

    and private rights of action.\402\ By adopting industry best practice

    recommendations, it can be argued that the Commission is encouraging

    industry efforts to try to shape regulatory solutions to industry

    problems. The Commission also is not persuaded that adopting industry

    best practice recommendations will cause hindsight enforcement actions

    and private suits

    [[Page 9763]]

    filed against swap dealers. The Commission notes that litigation risk

    is not new to swap dealers. Numerous private and enforcement actions

    involving derivatives have been filed based on theories that existed

    prior to the enactment of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    \402\ SIFMA/ISDA Feb. 17 Letter, at 18.

    ---------------------------------------------------------------------------

    With regard to the claim that scenario analysis needs a definition

    and parameters to avoid potentially misleading counterparties, the

    Commission notes that the final rule, unlike the proposed rule, will

    require scenario analysis only as requested by the counterparty.\403\

    The final rule also will require consultation with the counterparty and

    disclosure of the material assumptions and calculation methodologies.

    These aspects of the rule, coupled with the other disclosure and fair

    dealing duties, should ameliorate the potential for misleading the

    counterparty. In addition, the Commission has determined to adopt the

    CRMPG III Report description of scenario analysis, which provides an

    appropriate, principles based standard for swap dealers under the final

    rule.\404\ This principles based standard should provide sufficient

    guidance to swap dealers to achieve consistency regarding the minimum

    parameters of scenario analyses. As indicated in the final rule,

    counterparties may request additional information and analyses.

    ---------------------------------------------------------------------------

    \403\ The final rule does not distinguish between high risk

    complex swaps and other swaps. This and other changes in the final

    rule address commenters' concerns about the meaning of ``high-risk

    complex swap'' and resulting potential liability issues.

    \404\ See CRMPG III Report, at Appendix A, Bullet 5.

    ---------------------------------------------------------------------------

    The Commission is not persuaded by claims that the scenario

    analysis rule would increase counterparty dependence on swap dealers

    thereby raising moral hazard concerns. As discussed above, the scenario

    analysis rule has been revised to eliminate the mandatory provision in

    favor of a counterparty election. In addition, the counterparty

    election covers swaps that are not ``made available for trading'' on a

    DCM or SEF.\405\ This narrowing of the rule reduces both swap dealer

    and counterparty costs, including potential delays in execution. Only

    counterparties that want and request the scenario analysis will receive

    it. This approach is consistent with industry practice, which was

    confirmed during meetings with swap dealers, that upon request of

    counterparties scenario analysis is provided and without any additional

    charge.\406\ Therefore, the rule should not significantly change the

    existing practice by unduly increasing counterparty dependence on swap

    dealers or creating moral hazard concerns.

    ---------------------------------------------------------------------------

    \405\ See discussion of Section 2(h)(8) and swaps ``made

    available for trading'' on a DCM or SEF at fn. 394.

    \406\ Proposing release, 75 FR at 80645.

    ---------------------------------------------------------------------------

    With respect to claims that scenario analysis, or portions thereof,

    are often proprietary, which may raise confidentiality and liability

    issues,\407\ the Commission notes that the final rule does not require

    the disclosure of ``confidential, proprietary information about any

    model it may use to prepare the scenario analysis.'' However, the rule

    does require the disclosure of all material assumptions and an

    explanation of the calculation methodologies. The Commission does not

    consider scenario analysis and its material assumptions and calculation

    methodologies to be confidential, proprietary information. This

    conclusion is based on several industry reports that confirm that

    scenario analysis and its material assumptions and calculation

    methodologies are best practice disclosure.\408\ Regarding commenter's

    concerns relating to liability for the scenario analysis, the

    Commission believes that forward-looking statements should not unduly

    expose swap dealers to liability where the scenario analysis is

    performed consistent with the rule, in consultation with the

    counterparty and subject to appropriate warnings about the assumptions

    and limitations underlying the scenario analysis. Such warnings also

    would be consistent with Sec. 23.433--Communications--fair

    dealing.\409\

    ---------------------------------------------------------------------------

    \407\ See CEF Feb. 22 Letter, at 9-10.

    \408\ See DPG Framework, at Section V.II.G.; CRMPG III Report,

    at A2.

    \409\ See Section III.F. of this adopting release for a

    discussion of Sec. 23.433--Communications--fair dealing.

    ---------------------------------------------------------------------------

    The elective approach in the final rule ameliorates concerns that

    the proposed scenario analysis rule is resource intensive and will

    increase the cost of swaps to counterparties. This approach was

    supported by commenters and should be less burdensome.\410\ In

    addition, the final rule provides for counterparty consultation in the

    design of a requested scenario analysis. Where the counterparty does

    not specify the assumptions, the swap dealer will have discretion to

    design a scenario analysis consistent with the principles established

    in the rule. This approach should assist the swap dealer in limiting

    the costs associated with complying with the final scenario analysis

    rule. The Commission notes that swap dealers are already preparing some

    form of scenario analysis of the swap for their own purposes, including

    new product review, daily product pricing, margin analysis and risk

    management.

    ---------------------------------------------------------------------------

    \410\ See, e.g., Exelon Feb. 22 Letter, at 4; COPE Feb. 22

    Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 21.

    ---------------------------------------------------------------------------

    The Commission agrees with the commenter that suggested that swap

    dealers be able to use appropriately qualified independent third party

    providers to perform the scenario analysis.\411\ However, swap dealers

    will remain responsible for ensuring compliance with the rule. With

    respect to the suggestion that the rule require that scenario analysis

    be provided on a portfolio basis,\412\ the Commission notes that the

    final rule is guided by the statute, which requires disclosure of

    information about the risks of ``the swap.'' As a result, the

    Commission has determined that it is appropriate to require swap

    dealers to provide scenario analysis, upon request, with respect to a

    particular swap. However, nothing in the rule precludes swap dealers

    from agreeing to provide scenario analysis on a portfolio basis, upon

    request. The Commission expects some counterparties may request

    scenario analysis based on a portfolio while others, for a variety of

    reasons, including confidentiality of portfolio positions, may not

    request that analysis. Lastly, the Commission addressed the commenters'

    concern that scenario analysis may cause swap dealers to become ERISA

    fiduciaries, municipal advisors and/or CTAs elsewhere in this adopting

    release.\413\

    ---------------------------------------------------------------------------

    \411\ See Markit Feb. 22 Letter, at 2-4; Markit June 3 Letter,

    at 7.

    \412\ Id.

    \413\ See Section II of this adopting release for a discussion

    of ``Regulatory Intersections,'' including DOL ERISA Fiduciary, SEC

    Municipal Advisor and CTA status issues.

    ---------------------------------------------------------------------------

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

    i. Proposed Sec. 23.431(a)(2)

    Proposed Sec. 23.431(a)(2) required swap dealers and major swap

    participants to disclose the material characteristics of the swap,

    including the material economic terms of the swap, the material terms

    relating to the operation of the swap and the material rights and

    obligations of the parties during the term of the swap. Under the

    proposed rule, the material characteristics included the material terms

    of the swap that would be included in any ``confirmation'' of a swap

    sent by the swap dealer or major swap participant to the counterparty

    upon execution.\414\

    ---------------------------------------------------------------------------

    \414\ Proposing release, 75 FR at 80645.

    ---------------------------------------------------------------------------

    [[Page 9764]]

    ii. Comments

    Commenters raised objections to language in the proposing release

    concerning delivery of a summary of the material characteristics of the

    swap to be provided by swap dealers and major swap participants to

    counterparties prior to entering into a swap.\415\ One commenter

    claimed it would be both unnecessary given the ECP status of the

    counterparty and potentially confusing due to differences between a

    pre-execution summary and the post-execution transaction

    documentation.\416\

    ---------------------------------------------------------------------------

    \415\ See Exelon Feb. 22 Letter, at 3; SIFMA/ISDA Feb. 17

    Letter, at 21-22.

    \416\ SIFMA/ISDA Feb. 17 Letter, at 21-22.

    ---------------------------------------------------------------------------

    Commenters that support the disclosure rule recommended that the

    rule be interpreted to require for bespoke swaps that disclosures

    separately detail standardized components of the swap and price of each

    component, including embedded credit for forgone collateral.\417\ In

    addition, a commenter recommended that the disclosure obligation

    include the features of the swap that could disadvantage the

    counterparty.\418\

    ---------------------------------------------------------------------------

    \417\ See CFA/AFR Feb. 22 Letter, at 10; Better Markets Feb. 22

    Letter, at 4-6; Better Markets June 3 Letter, at 13; CFA/AFR Nov. 3

    Letter, at 6.

    \418\ CFA/AFR Feb. 22 Letter, at 11 (for example, situations

    where the proposed swap has basis risk and/or an interest rate

    mismatch).

    ---------------------------------------------------------------------------

    iii. Final Sec. 23.431(a)(2)

    After considering the comments, the Commission has determined to

    adopt Sec. 23.431(a)(2) as proposed. To address questions about the

    manner and substance of disclosure that must be provided prior to

    entering into a swap, and the nature of transaction documentation that

    will be required post execution, the Commission provides the following

    guidance. As noted above, for a counterparty to assess the merits of

    entering into a swap, it will need information about the material risks

    and characteristics of the swap at a reasonably sufficient time prior

    to entering into the swap. The disclosure rules grant discretion to

    swap dealers and major swap participants, consistent with the rules on

    manner of disclosure, disclosures in a standard format and record

    retention, to adopt a reliable means of disclosure agreed to by a

    counterparty.\419\

    ---------------------------------------------------------------------------

    \419\ See Sections III.A.3.e., f. and g. of this adopting

    release for a discussion of final Sec. 23.402(e)--Manner of

    disclosure, final Sec. 23.402(f)--Disclosures in a standard format,

    and final Sec. 23.402(g)--Record retention, respectively. While the

    rules allow disclosures by any reliable means agreed to by the

    counterparty, pursuant to Sec. 23.402(f) written disclosures are

    the preferred method to avoid confusion and counterparty disputes.

    Written disclosures enhance the ability to monitor compliance and

    facilitate compliance with the record retention requirements in

    Sec. 23.402(g).

    ---------------------------------------------------------------------------

    Disclosures made prior to entering into a swap should not be

    confused with transaction documentation. The final internal business

    conduct standards rules in subpart J of part 23 will apply to

    transaction documentation.\420\ The final external business conduct

    standards rules in subpart H of part 23 establish requirements to make

    disclosures about the material characteristics, among other

    information, of the swap. The two sets of rules will work together. To

    the extent that the final internal business conduct standards rules

    require that swap dealers and major swap participants provide to

    counterparties pre-execution information about the characteristics of a

    swap, such information should be considered by swap dealers and major

    swap participants in determining what, if any, additional information

    must be provided to counterparties pre-execution to comply with the

    material characteristics disclosure duty in Sec. 23.431(a)(2).

    ---------------------------------------------------------------------------

    \420\ See, e.g., Confirmation, Portfolio Reconciliation, and

    Portfolio Compression Requirements for Swap Dealers and Major Swap

    Participants, 75 FR 81519, Dec. 28, 2010.

    ---------------------------------------------------------------------------

    One commenter requested that the Commission clarify that the

    disclosure requirement is satisfied when a counterparty has or is

    provided a copy of each item of documentation that governs the terms of

    its swap with the swap dealer or major swap participant.\421\ The

    Commission declines to make such a determination because whether the

    material characteristics disclosure requirement is met in any

    particular case will be a facts and circumstances determination, based

    on the standards set forth in the rule. This will be particularly true

    when certain features including, but not limited to, caps, collars,

    floors, knock-ins, knock-outs, range accrual features, embedded

    optionality or embedded volatility increase the complexity of the swap.

    The disclosure rule, coupled with Sec. 23.433--Communications--Fair

    Dealing,\422\ requires the swap dealer or major swap participant to

    provide a sound factual basis for the counterparty to assess how these

    features and others would impact the value of the swap under various

    market conditions during the life of the swap.\423\

    ---------------------------------------------------------------------------

    \421\ SIFMA/ISDA Feb. 17 Letter, at 21-22.

    \422\ See Section III.F. of this adopting release for a

    discussion of Sec. 23.433--Communications--fair dealing.

    \423\ Because Sec. 23.431(a)(2) creates a flexible disclosure

    regime, the Commission declines, at this time, to interpret Sec.

    23.431(a)(2) as requiring, with respect to bespoke swaps, a separate

    detailing of all standardized components of the swap and the pricing

    of each component, including embedded credit, for forgone

    collateral, especially where the swap dealer has not made a

    recommendation to the counterparty. However, nothing in the final

    rule would preclude the parties from negotiating disclosures of this

    type. See Section III.D.3.d. of this adopting release for a

    discussion of disclosures in connection with a swap dealer's

    recommendation.

    ---------------------------------------------------------------------------

    Swap dealers and major swap participants will be permitted to

    include certain disclosures about material characteristics (other than

    information normally contained in a term sheet, such as price and

    dates) in counterparty relationship documentation, where appropriate,

    consistent with final Sec. 23.402(f)--Disclosures in a standard

    format.

    Commenters sought guidance on whether the material characteristics

    disclosure duty requires a swap dealer or major swap participant to

    determine and then disclose how the terms of a particular swap relate

    to the circumstances of a particular counterparty.\424\ The Commission

    believes that, for most swaps, information about the material

    characteristics of the swap will relate to the economic terms of the

    swap rather than the circumstances of the particular counterparty.

    However, if a swap dealer or major swap participant has contractually

    undertaken to do so, or a swap dealer has made a ``recommendation,''

    which triggers a suitability duty or is acting as an advisor to a

    Special Entity, the swap dealer or major swap participant will be

    required to act consistently with the relevant duty, including

    exercising reasonable due diligence and making appropriate disclosures.

    Of course, in all circumstances, swap dealers and major swap

    participants are required to communicate in a fair and balanced manner

    based on principles of fair dealing and good faith in accordance with

    final Sec. 23.433. Additionally, for a Special Entity, the swap dealer

    or major swap participant will have to have a reasonable basis to

    believe that the qualified independent representative will act in the

    Special Entity's best interests and evaluate the appropriateness of

    each swap based on the needs and characteristics of the Special Entity

    before the Special Entity enters into the swap with a swap dealer or

    major swap participant.\425\

    ---------------------------------------------------------------------------

    \424\ See CFA/AFR Feb. 22 Letter, at 11.

    \425\ See Section IV.C. of this adopting release for a

    discussion of Sec. 23.450--Requirements for swap dealers and major

    swap participants acting as counterparties to Special Entities.

    ---------------------------------------------------------------------------

    [[Page 9765]]

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

    i. Proposed Sec. 23.431(a)(3)

    Proposed Sec. 23.431(a)(3) tracked the statutory language under

    Section 4s(h)(3)(B)(ii) and required a swap dealer or major swap

    participant to disclose to any counterparty the material incentives and

    conflicts of interest that the swap dealer or major swap participant

    may have in connection with a particular swap. The Commission also

    proposed that swap dealers and major swap participants be required to

    include with the price of the swap, the mid-market value of the swap as

    defined in proposed Sec. 23.431(c)(2). In addition, swap dealers and

    major swap participants were required to disclose any compensation or

    benefit that they receive from any third party in connection with the

    swap. The Commission also stated in the proposing release that, in

    connection with any recommended swap, swap dealers and major swap

    participants were expected to disclose whether their compensation

    related to the recommended swap would be greater than for another

    instrument with similar economic terms offered by the swap dealer or

    major swap participant.\426\ With respect to conflicts of interest, the

    Commission stated that it expected such disclosure would include the

    inherent conflicts in a counterparty relationship, particularly when

    the swap dealer or major swap participant recommends the transaction.

    The Commission also indicated it expected that a swap dealer or major

    swap participant that engages in business with the counterparty in more

    than one capacity should consider whether acting in multiple capacities

    creates material incentives or conflicts of interest that require

    disclosure.\427\

    ---------------------------------------------------------------------------

    \426\ Proposing release, 75 FR at 80645.

    \427\ This may exist, for example, when the swap dealer or major

    swap participant acts both as an underwriter in a bond offering and

    as counterparty to the swaps used to hedge such financing. In these

    circumstances, the swap dealer's or major swap participant's duties

    to the counterparty would vary depending on the capacities in which

    it is operating and should be disclosed. With respect to swaps

    entered into with Special Entities, swap dealers and major swap

    participants are required to disclose the capacity in which they are

    acting and, if they engage in multiple capacities, disclose the

    difference in such capacities in accordance with Section 4s(h)(5) of

    the CEA and proposed Sec. 23.450(f) (renumbered and adopted as

    final Sec. 23.450(g)).

    ---------------------------------------------------------------------------

    ii. Comments

    The Commission received comments addressing a variety of issues.

    Several commenters generally supported the disclosure requirement.\428\

    One commenter stated that it wanted to receive information about

    incentives or compensation that the swap dealer was receiving.\429\ Two

    other commenters said they did not object to swap dealers being

    required to disclose conflicts of interest because such disclosures

    would seem to be embedded in the concept of fair dealing.\430\ Another

    commenter recommended allowing the use of standardized disclosures to

    satisfy conflicts of interest and compensation matters but supported

    specific disclosure on a transaction-by-transaction basis for any

    compensation received by the swap dealer or major swap participant in

    connection with a particular swap.\431\

    ---------------------------------------------------------------------------

    \428\ See, e.g., MetLife Feb. 22 Letter, at 5; COPE Feb. 22

    Letter, at 4; Exelon Feb. 22 Letter, at 4.

    \429\ MetLife Feb. 22 Letter, at 5.

    \430\ COPE Feb. 22 Letter, at 4; Exelon Feb. 22 Letter, at 3-4.

    \431\ CEF Feb. 22 Letter, at 13.

    ---------------------------------------------------------------------------

    A commenter approved of the proposed rule and the guidance in the

    proposing release requiring swap dealers and major swap participants to

    disclose whether their compensation for a recommended swap would be

    greater than for another instrument with similar economic terms offered

    by the swap dealer or major swap participant.\432\ However, a different

    commenter objected to, and requested withdrawal of, that same statement

    asserting that swap dealers and major swap participants should not be

    obligated to identify and evaluate comparable instruments on behalf of

    the counterparty as such a comparative analysis would be an advisory

    service that is the responsibility of the counterparty and its

    advisors.\433\

    ---------------------------------------------------------------------------

    \432\ CFA/AFR Feb. 22 Letter, at 11.

    \433\ SIFMA/ISDA Feb. 17 Letter, at 23.

    ---------------------------------------------------------------------------

    Another commenter urged full disclosure to counterparties of the

    incentives to swap dealers and major swap participants for use of

    various market infrastructures (swap data repositories (``SDRs''),

    DCOs, DCMs, and SEFs).\434\ Similarly, the commenter recommended

    prohibiting fee rebates, discounts, and revenue and profit sharing,

    which it asserts are substantively the same as preferential access to

    market infrastructures. The commenter maintained that such practices

    simply transfer costs to less influential participants who must follow

    the lead of large liquidity providers.\435\

    ---------------------------------------------------------------------------

    \434\ See Better Markets June 3 Letter, at 6-7.

    \435\ Id.

    ---------------------------------------------------------------------------

    In addition, certain commenters that supported the rule also would

    like the Commission to require separate pricing of each ``amalgamated''

    standardized component of a customized swap and a comparison of the

    risks and costs of the customized swap with comparable standardized,

    listed swaps.\436\ The commenters identified, for example, embedded

    credit for forgone collateral as an amalgamated component that should

    be priced separately. These commenters also urged the Commission to

    clarify that the material incentives and conflicts of interest

    disclosure obligation applies not only to specific alternative

    instruments but also to alternative strategies.\437\

    ---------------------------------------------------------------------------

    \436\ See Better Markets June 3 Letter, at 13-17; CFA/AFR Feb.

    22 Letter, at 11-12; CFA/AFR Nov. 3 Letter, at 6.

    \437\ Id.

    ---------------------------------------------------------------------------

    In addition, a commenter recommended that the Commission issue

    guidance that the following situations are not conflicts of interest

    that warrant disclosure because counterparties are aware of or expect

    these common business practices: (1) Simply taking the opposite side of

    a swap; (2) swap dealers, major swap participants or affiliates

    entering into other swaps that take an opposite view from that of the

    counterparty for reasons unrelated to the swap with the counterparty;

    and (3) swap dealers and major swap participants having a physical

    business that would benefit from a price movement that would be adverse

    to the counterparty's economic position under the swap.\438\ This same

    commenter also requested that the final rules formally recognize that

    no disclosure obligation exists with respect to knowledge regarding a

    swap's reference commodity (specifically, swaps referencing energy

    commodities), the physical markets in which it trades, or any

    particular entity's positions or business in such commodity.\439\

    ---------------------------------------------------------------------------

    \438\ CEF Feb. 22 Letter, at 13.

    \439\ Id.

    ---------------------------------------------------------------------------

    iii. Final Sec. 23.431(a)(3)

    After considering the comments, the Commission has determined to

    adopt the proposed rule with the following revision. In proposed Sec.

    23.431(a)(3)(i), when disclosing the price of a swap, swap dealers and

    major swap participants would have to disclose the ``mid-market value''

    of the swap. In the final rule, the Commission decided to change the

    term ``mid-market value'' to ``mid-market mark'' \440\ to more

    accurately describe the requirement and mitigate concerns that the duty

    would constitute valuation, appraisal or advisory services or impose a

    fiduciary status on swap dealers and major swap

    [[Page 9766]]

    participants.\441\ The Commission notes that information about the

    spread between the quote and mid-market mark is relevant to disclosures

    regarding material incentives and provides the counterparty with

    pricing information that facilitates negotiations and balances

    historical information asymmetry regarding swap pricing.

    ---------------------------------------------------------------------------

    \440\ Further, the Commission confirms that ``mid-market mark''

    can be determined through mark-to-model calculations when a liquid

    market does not exist.

    \441\ The Commission has made the same change in proposed Sec.

    23.431(c)--Daily Mark (renumbered as Sec. 23.431(d)).

    ---------------------------------------------------------------------------

    In addition, the Commission is clarifying certain guidance provided

    in the proposing release regarding recommended swaps.\442\ The

    proposing release indicated that, in connection with the duty to

    disclose material incentives and conflicts of interest, swap dealers

    and major swap participants would be expected to disclose whether their

    compensation relating to a recommended swap would be greater than for

    another instrument with ``similar economic terms'' offered by the swap

    dealer or major swap participant.\443\ In response to commenter

    concerns that such disclosure would constitute advice,\444\ the

    Commission has determined to limit the guidance to instances where more

    than one swap and/or strategy is recommended to accomplish a particular

    financial objective.\445\ Generally, these multi-product presentations

    include a comparison of swaps or strategies. In addition, the

    Commission understands that counterparties often ask dealers for

    alternatives to a particular swap, which may lead to a comparison.

    Considering this common industry practice, which facilitates sales, the

    comparison should include the relative compensation related to the

    different alternatives. This information is material to the swap

    dealer's or major swap participant's incentives underlying the

    recommendations and should assist the counterparty in making an

    assessment. Lastly, the Commission notes that this guidance does not

    prevent counterparties from requesting, or swap dealers and major swap

    participants from providing, comparisons of other swaps or products

    that may or may not have similar economic terms.

    ---------------------------------------------------------------------------

    \442\ Proposing release, 75 FR at 80645.

    \443\ Id.

    \444\ See SIFMA/ISDA Feb. 17 Letter, at 23.

    \445\ See also Section III.G.3. of this adopting release and

    Appendix A to subpart H of part 23 of the Commission's Regulations

    for a discussion of what constitutes a ``recommendation.''

    ---------------------------------------------------------------------------

    The Commission declines to state categorically that swap dealers

    and major swap participants will be required to separately price each

    standardized component of a customized swap, compare the risks and

    costs of customized swaps with those of standardized swaps, or disclose

    the embedded cost of credit for forgone collateral. Similarly, the

    Commission believes that facts and circumstances, including whether the

    swap dealer or major swap participant recommended the swap, will

    determine whether a swap dealer or major swap participant is required

    to disclose that it is trying to move a particular position off its

    books and that the swap is part of that strategy.\446\ Swap dealers and

    major swap participants will be required to have policies and

    procedures reasonably designed to identify material incentives and

    conflicts within the scope of Sec. 23.431(a)(3). The Commission will

    consider good faith compliance with such policies and procedures when

    exercising its prosecutorial discretion in connection with any

    violation of the rule.

    ---------------------------------------------------------------------------

    \446\ See, e.g., the Senate Report, at 518-531 ($2 billion

    Hudson CDO deal included $1.2 billion in assets from Goldman's

    balance sheet. The marketing materials did not disclose that $1.2

    billion of the assets were from Goldman's balance sheet.).

    ---------------------------------------------------------------------------

    With respect to the use of standardized disclosures to satisfy

    conflicts of interest and incentives disclosures, the Commission

    reminds swap dealers and major swap participants, as it has with

    respect to other disclosure obligations, that whether such disclosures

    will be sufficient to satisfy the disclosure rule in connection with

    any particular swap will depend on the facts and circumstances.\447\ As

    discussed elsewhere in this adopting release, the statute places the

    disclosure duty on swap dealers and major swap participants to ensure

    that all material incentives and conflicts of interest relating to the

    swap are disclosed.

    ---------------------------------------------------------------------------

    \447\ See, e.g., Section III.A.3.f. of this adopting release for

    a discussion of final Sec. 23.402(f)--Disclosures in a standard

    format.

    ---------------------------------------------------------------------------

    Concerning disclosure to counterparties of the incentives to swap

    dealers and major swap participants for use of various market

    infrastructures (DCOs, SDRs, DCMs, and SEFs), the Commission agrees

    that incentives paid to swap dealers and major swap participants by

    various market infrastructures for a swap transaction are a required

    disclosure within the statute and Sec. 23.431(a)(3).\448\ With respect

    to fee rebates, discounts, and revenue and profit sharing, the

    Commission has determined not to prohibit these payments at this time,

    but rather to require disclosure of such payments because the payments

    would constitute material incentives or conflicts of interest in

    conjunction with the swap. Such disclosure also is encompassed in the

    duty to communicate in a fair and balanced manner. Further, the failure

    to disclose this information or other material disclosures under the

    rule may be a material omission under the Commission's anti-fraud

    provisions, including final Sec. 23.410(a).

    ---------------------------------------------------------------------------

    \448\ Such payments can be considered both incentives and

    conflicts of interest within the meaning of the statute and rule

    and, either way, must be disclosed. See Section 4s(h)(3)(C) of the

    CEA and final Sec. 23.433--Communications-fair dealing.

    ---------------------------------------------------------------------------

    The Commission declines the commenters' request that the Commission

    issue guidance that certain enumerated situations are not conflicts of

    interest that warrant disclosure. The plain language of Section

    4s(h)(3)(B)(ii) of the CEA requires disclosure of all material

    conflicts of interest that a swap dealer or major swap participant has

    in connection with the swap. Without assessing the list of situations

    provided by commenters, the Commission notes that the statute does not

    limit or exempt the disclosure of certain conflicts of interest where

    counterparties may be aware of or expect certain common business

    practices.

    One commenter requested confirmation that the material incentives

    and conflicts of interest disclosure obligation does not apply to

    information known by the swap dealer or major swap participant

    regarding a swap's reference commodity, the physical markets in which

    it trades or any particular entity's positions or business in such

    commodity.\449\ Based on the statutory language in Section

    4s(h)(3)(B)(ii), the Commission cannot confirm the commenter's point.

    The statute requires swap dealers and major swap participants to

    disclose ``any material incentives or conflicts of interest that the

    swap dealer or major swap participant may have in connection with the

    swap.'' It is certainly possible, particularly in the energy context

    mentioned by the commenter, that activities of the swap dealer or major

    swap participant related to the underlying commodity could create

    material incentives or conflicts of interest ``in connection with'' the

    swap offered to a counterparty. In addition, the Commission believes

    that transactions similar to those described in the Senate Report \450\

    would warrant disclosures concerning activities related to the

    underlying commodity. Without commenting on the transactions

    themselves, the Commission notes that the Senate Report raised concerns

    [[Page 9767]]

    regarding proprietary trading and the limited transparency of

    underlying assets.\451\ Whether such disclosure is required in

    connection with any particular swap will depend on the facts and

    circumstances.\452\

    ---------------------------------------------------------------------------

    \449\ See CEF Feb. 22 Letter, at 13.

    \450\ Senate Report, at 513-636.

    \451\ See Section III.D.3.a. of this adopting release for a

    discussion of Sec. 23.431(a)(1)--Material risk disclosure.

    \452\ Such a requirement is not intended to create, and does not

    create, any general trading prohibition or general disclosure

    requirement concerning ``inside information.'' See discussion at fn.

    370; see also fn. 499.

    ---------------------------------------------------------------------------

    e. Section 23.431(d)--Daily Mark

    i. Proposed Sec. 23.431(c)

    Section 4s(h)(3)(B)(iii) directs the Commission to adopt rules that

    require: (1) For cleared swaps, upon request of the counterparty,

    receipt of the daily mark of the transaction from the appropriate DCO;

    and (2) for uncleared swaps, receipt of the daily mark of the swap

    transaction from the swap dealer or major swap participant.\453\

    ---------------------------------------------------------------------------

    \453\ The Commission noted that the term ``daily mark'' is not

    defined in the statute and that the term ``mark'' is used

    colloquially to refer to various types of valuation information. See

    proposing release, 75 FR at 80645.

    ---------------------------------------------------------------------------

    For cleared swaps, proposed Sec. 23.431(c)(1) required swap

    dealers and major swap participants to notify counterparties of their

    rights to receive, upon request, the daily mark from the appropriate

    DCO. For uncleared swaps, proposed Sec. 23.431(c)(2) and (3) required

    swap dealers and major swap participants to provide a daily mark to

    their counterparties on each business day during the term of the swap

    as of the close of business, or such other time as the parties agree in

    writing. The Commission proposed to define daily mark for uncleared

    swaps as the mid-market value of the swap, which would specifically not

    include amounts for profit, credit reserve, hedging, funding, liquidity

    or any other costs or adjustments.\454\ Based on consultations with

    stakeholders, the consensus was that mid-market value was a transparent

    measure that would assist counterparties in calculating valuations for

    their own internal risk management purposes. Further, the Commission

    proposed that swap dealers and major swap participants disclose both

    the methodology and assumptions used to prepare the daily mark, and any

    material changes to the methodology or assumptions during the term of

    the swap. The Commission noted that the daily mark for certain bespoke

    swaps may be generated using proprietary models. The proposed rule did

    not require the swap dealer or major swap participant to disclose

    proprietary information relating to its model.\455\

    ---------------------------------------------------------------------------

    \454\ Proposing release, 75 FR at 80645-46.

    \455\ Id. at 80646.

    ---------------------------------------------------------------------------

    Lastly, the Commission proposed that swap dealers and major swap

    participants provide appropriate clarifying statements relating to the

    daily mark.\456\ Such disclosures could include, as appropriate, that

    the daily mark may not necessarily be: (1) A price at which the swap

    dealer or major swap participant would agree to replace or terminate

    the swap; (2) the basis for a variation margin call; nor (3) the value

    of the swap that is marked on the books of the swap dealer or major

    swap participant.

    ---------------------------------------------------------------------------

    \456\ Id.

    ---------------------------------------------------------------------------

    ii. Comments

    One commenter favored disclosure of a daily mark.\457\ The

    commenter concurred with the Commission's definition of daily mark as

    the ``mid-market value'' of the swap.\458\ The commenter noted that

    many end-user counterparties already receive daily swap valuations at

    mid-market as determined under the definition of ``Exposure'' included

    in the 1994 ISDA Credit Support Annex and requested that the Commission

    clarify that the daily mark valuations under the rule are to be

    determined by reference to the same definition.\459\ Some commenters

    recommended that the daily mark be calculated on a portfolio basis

    rather than for each individual swap because margin calls are based on

    a net or portfolio basis.\460\ Several commenters recommended that the

    rule be revised from a mandatory daily disclosure to ``upon request''

    by the counterparty model.\461\ Others asserted that daily mark

    disclosure should be negotiable, including an opt out alternative.\462\

    ---------------------------------------------------------------------------

    \457\ FHLBanks Feb. 22 Letter, at 5.

    \458\ Id.

    \459\ Id., at 6.

    \460\ See, e.g., Exelon Feb. 22 Letter, at 4; CEF Feb. 22

    Letter, at 15.

    \461\ See, e.g., COPE Feb. 22 Letter, at 4; MFA Feb. 22 Letter,

    at 6; SIFMA/ISDA Feb. 17 Letter, at 23.

    \462\ See, e.g., ERIC Feb. 22 Letter, at 16-17; CEF Feb. 22

    Letter, at 15; MFA Feb. 22 Letter, at 6.

    ---------------------------------------------------------------------------

    One commenter recommended revising the rule to allow swap dealers

    and major swap participants to delegate responsibility for providing

    the daily mark to appropriately qualified independent third party

    providers.\463\ Another commenter stated that counterparties should not

    rely on swap dealers or major swap participants, but instead should

    seek marks from independent third parties.\464\ Several commenters

    expressed concern that requiring swap dealers and major swap

    participants to provide a daily mark may be considered appraisal

    services that trigger ERISA fiduciary status, which prohibits

    principal-to-principal swap transactions.\465\

    ---------------------------------------------------------------------------

    \463\ Markit Feb. 22 Letter, at 2-3; Markit June 3 Letter, at 7.

    \464\ MFA Feb. 22 Letter, at 6.

    \465\ See BlackRock Feb. 22 Letter, at 6; SIFMA/ISDA Feb. 17

    Letter, at 24; ABC/CIEBA Feb. 22 Letter, at 5-6; AMG-SIFMA Feb. 22

    Letter, at 7; ERIC Feb. 22 Letter, at 16-17.

    ---------------------------------------------------------------------------

    One commenter recommended revising the rule to require swap dealers

    and major swap participants, upon request of a counterparty, to provide

    the mark used for determining either party's mark-to-market margin

    obligation or entitlement under an outstanding swap because this

    approach is consistent with statutory text and the daily mark

    requirement for cleared swaps.\466\

    ---------------------------------------------------------------------------

    \466\ SIFMA/ISDA Feb. 17 Letter, at 23-24.

    ---------------------------------------------------------------------------

    A different commenter recommended deeming the daily mark obligation

    for cleared swaps satisfied if the counterparty can access the

    information directly from the DCO or its FCM.\467\ In addition, the

    commenter requested that the final rule provide that swap dealers and

    major swap participants, absent fraud, have no liability for a

    counterparty's use of the provided daily mark.\468\ Further, the

    commenter asserted that requiring disclosure of the daily mark

    methodology and assumptions encourages improper reliance by the

    counterparty on the swap dealer or major swap participant.\469\ Lastly,

    one commenter suggested that the rule require swap dealers and major

    swap participants to deliver the daily mark via communication media

    that are secure, timely and auditable.\470\

    ---------------------------------------------------------------------------

    \467\ CEF Feb. 22 Letter, at 14.

    \468\ Id., at 15.

    \469\ Id.

    \470\ Markit Feb. 22 Letter, at 2-3.

    ---------------------------------------------------------------------------

    iii. Final Sec. 23.431(d)

    After considering the comments, the Commission has determined to

    adopt Sec. 23.431(c) (renumbered as Sec. 23.431(d)) as proposed, but

    change the term ``mid-market value'' to ``mid-market mark.'' This

    change more accurately describes the requirement and mitigates concerns

    that the duty would constitute valuation, appraisal or advisory

    services or impose a fiduciary status on swap dealers and major swap

    participants.\471\

    [[Page 9768]]

    The Commission has determined to define the term daily mark as the

    ``mid-market mark'' using its discretionary authority to define terms

    under the Dodd-Frank Act.\472\ Because ``mid-market'' represents an

    objective value, it provides counterparties with a baseline to assess

    swap valuations for other purposes, including margin or terminations.

    This term has been used by many industry participants since at least

    1994.\473\

    ---------------------------------------------------------------------------

    \471\ The Commission has made the same change in final Sec.

    23.431(a)(3)--Disclosures of material information, which requires

    disclosures of material incentives and characteristics. The

    Commission repeats that, with respect to final Sec. 23.431(d), the

    Dodd-Frank Act disclosures, including the daily mark and mid-market

    mark, alone do not cause a swap dealer or major swap participant to

    be an advisor to a counterparty, including a Special Entity. The

    Commission does not consider the Dodd-Frank Act disclosures to be

    advice or a recommendation. See Section II of this adopting release

    for further discussion of the intersection of the subpart H

    requirements with DOL and SEC requirements.

    \472\ Section 721(b)(2) of the Dodd-Frank Act.

    \473\ See FHLBanks Feb. 22 Letter, at 6-7. In addition, the term

    ``mid-market value'' is used in CRMPG I Report, at 7. See also Bank

    One Corp. v. IRS, 120 T.C. 174 (U.S. Tax Court 2003). For a

    discussion of mid-market value and costs, see ISDA Research Notes,

    The Value of a New Swap, Issue 3 (2010), available at http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf.

    ---------------------------------------------------------------------------

    The Commission notes that certain comments conflict directly with

    the plain language of Section 4s(h)(3)(B)(iii)(I) and (II) of the CEA.

    For example, the suggestion that the daily mark be provided on a

    portfolio basis rather than for each swap conflicts with the plain

    language of the statute.\474\ If counterparties want additional marks

    (e.g., marks on a portfolio basis or marks used to calculate margin),

    then they are free to negotiate the receipt of such information with

    swap dealers and major swap participants.

    ---------------------------------------------------------------------------

    \474\ Section 4s(h)(3)(B)(iii) of the CEA states: ``(I) for

    cleared swaps, upon the request of the counterparty, receipt of the

    daily mark of the transaction from the appropriate derivatives

    clearing organization; and (II) for uncleared swaps, receipt of the

    daily mark of the transaction from the swap dealer or major swap

    participant.''

    ---------------------------------------------------------------------------

    With respect to the recommendation that a swap dealer or major swap

    participant be deemed to satisfy the daily mark duty for cleared swaps

    if the counterparty can access the information directly from the DCO or

    its FCM, the Commission agrees, provided that the swap dealer or major

    swap participant apprises the counterparty and the counterparty agrees

    to such substituted compliance. The Commission notes that the swap

    dealer's or major swap participant's daily mark obligation for cleared

    swaps is prompted by the request of the counterparty. As a result,

    under the statute, it is up to the counterparty to decide whether it

    wishes to receive the daily mark through access to the DCO or FCM or

    from the swap dealer or major swap participant.

    As to the request to limit the liability of swap dealers or major

    swap participants in relation to a counterparty's use of a provided

    daily mark, the Commission considers the request to be beyond the scope

    of the rulemaking.\475\ Nevertheless, the Commission notes that it will

    consider good faith compliance with policies and procedures reasonably

    designed to meet the daily mark requirements, including the calculation

    of mid-market mark under final Sec. 23.431(d), in exercising its

    prosecutorial discretion for violations of the rule.\476\

    ---------------------------------------------------------------------------

    \475\ See Section III.A.1. of this adopting release for a

    discussion of ``Private Rights of Action.''

    \476\ The Commission agrees with a commenter's suggestion that

    the rule should require swap dealers and major swap participants to

    deliver the daily mark via communication media that are secure,

    timely and auditable. Markit Feb. 22 Letter, at 3. This is

    consistent with final Sec. 23.431(d)--Daily mark, as well as final

    Sec. 23.402(e)--Manner of disclosure. See Section III.A.3.e. of

    this adopting release for a discussion of final Sec. 23.402(e).

    ---------------------------------------------------------------------------

    The Commission disagrees with the assertion that requiring

    disclosure of the daily mark methodology and assumptions will encourage

    improper reliance by the counterparty on the swap dealer or major swap

    participant. The statutory daily mark requirement is meaningless unless

    the counterparty knows the methodology and assumptions that were used

    to calculate the mark. To make its own assessment of the value of the

    swap for its own purposes, the counterparty has to have information

    from the swap dealer or major swap participant about how the mid-market

    mark was calculated. To satisfy the duty to disclose both the

    methodology and assumptions used to prepare the daily mark, swap

    dealers and major swap participants may choose to provide to

    counterparties methodologies and assumptions sufficient to

    independently validate the output from a model generating the daily

    mark, collectively referred to as the ``reference model.'' The

    Commission does not intend that disclosure of the ``reference model''

    would require swap dealers and major swap participants to disclose

    proprietary information. While the Commission does not define what

    currently constitutes proprietary information, the Commission is aware

    that, in light of the disclosure requirements relating to the

    methodology and assumptions used to prepare the daily mark, market

    participants may aid in the establishment of appropriate ``reference

    models'' and, in so doing, potentially alter the extent of undisclosed

    proprietary information in the future. With proper disclosures,

    counterparties should not be misled or unduly rely on the mid-market

    mark provided by the swap dealer or major swap participant.\477\

    Therefore, the Commission's final rule requires disclosure of the

    methodology and assumptions underlying the daily mark. The Commission's

    determination is based on the statutory disclosure provisions as well

    as the duty to communicate in a fair and balanced manner based on

    principles of fair dealing and good faith.

    ---------------------------------------------------------------------------

    \477\ Without commenting on the findings of the Senate Report,

    the Commission notes that the Senate Report included descriptions of

    certain conduct relating to marks where dealers purportedly refused

    to explain the basis and methodology for the mark. See Senate

    Report, at 509-510.

    ---------------------------------------------------------------------------

    One commenter asked the Commission to confirm that the daily mark

    received by counterparties is to be determined by reference to the same

    mid-market valuations used in connection with the definition of

    ``Exposure'' under the 1994 ISDA Credit Support Annex. The Commission

    declines to endorse any particular methodology given the principles

    based nature of the rule.

    Further, the Commission is providing guidance that the term ``mid-

    market mark'' can be determined through mark-to-model calculations when

    a liquid market does not exist. In addition, swap dealers and major

    swap participants can delegate daily mark responsibilities to third

    party vendors. However, swap dealers and major swap participants will

    remain responsible for compliance with the rule.

    E. Section Sec. 23.432--Clearing Disclosures

    1. Proposed Sec. 23.432

    The Commission's proposed rule required certain disclosures

    regarding the counterparty's right to select a DCO and to clear swaps

    that are not otherwise required to be cleared. For swaps where clearing

    is mandatory,\478\ proposed Sec. 23.432(a) required a swap dealer or

    major swap participant to notify the counterparty of its right to

    select the DCO that would clear the swap. For swaps that are not

    required to be cleared, under proposed Sec. 23.432(b), a swap dealer

    or major swap participant was required to notify a counterparty that

    the counterparty may elect to require the swap to be cleared and that

    it has the sole right to select the DCO for clearing the swap.\479\

    Neither of

    [[Page 9769]]

    these notification provisions applied where the counterparty was a

    registered swap dealer, major swap participant, security-based swap

    dealer or major security-based swap participant.\480\

    ---------------------------------------------------------------------------

    \478\ See Section 2(h) of the CEA. (7 U.S.C. 2(h)).

    \479\ With respect to these proposed disclosure requirements,

    the Commission noted that, as between the parties, the counterparty

    is entitled to choose whether and where to clear, but that no DCM or

    SEF is required to make clearing available through any DCO. In other

    words, it is up to the parties to take the swap to a DCM or SEF that

    provides for clearing through the counterparty's preferred DCO. See

    proposing release, 75 FR at 80646.

    \480\ Proposing release, 75 FR at 80646.

    ---------------------------------------------------------------------------

    2. Comments

    The comments submitted on proposed Sec. 23.432 were directed at

    issues related to the substantive rules for swaps not required to be

    cleared and, as such, were beyond the scope of this rulemaking.\481\

    The only commenters on the disclosure requirement itself stated that

    they did not object to the proposed rule.\482\

    ---------------------------------------------------------------------------

    \481\ See Barclays Jan. 11 Letter, at 8 (clearing requirement

    should not apply to foreign swap transactions); SIFMA/ISDA Feb. 17

    Letter, at 24-25; CEF Feb. 22 Letter, at 22 (the Commission should

    clarify that the election to clear a swap is meant to be exercised

    at the swap's inception); id. (supporting the proposed clearing

    disclosure rule, but recommended that the election of the

    counterparty regarding where to clear that is made at the outset of

    the transaction should be binding unless both parties agree; to do

    otherwise might require the swap dealer or major swap participant to

    transfer a swap from bilateral clearing to central clearing at an

    economically disadvantageous moment); MetLife Feb. 22 Letter, at 5

    (major swap participants should be treated like other customers of a

    swap dealer, and receive the same rights as other counterparties,

    including the right to elect where to clear trades).

    \482\ See COPE Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 22.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.432

    The Commission has determined to adopt Sec. 23.432 as proposed.

    F. Section 23.433--Communications--Fair Dealing

    1. Proposed Sec. 23.433

    The Dodd-Frank Act requires that the Commission establish a duty

    for swap dealers and major swap participants to communicate in a fair

    and balanced manner based on principles of fair dealing and good faith.

    Proposed Sec. 23.433 established a duty that, consistent with the

    statutory language, applies to all swap dealer and major swap

    participant communications with counterparties. As the Commission noted

    in the proposing release,\483\ these principles are well established in

    the futures and securities markets, particularly through SRO

    rules.\484\ The duty to communicate in a fair and balanced manner is

    one of the primary requirements of the NFA customer communications rule

    \485\ and is designed to ensure a balanced treatment of potential

    benefits and risks. In determining whether a communication with a

    counterparty is fair and balanced, the Commission stated that it

    expects a swap dealer or major swap participant to consider factors

    such as whether the communication: (1) Provides a sound basis for

    evaluating the facts with respect to any swap; \486\ (2) avoids making

    exaggerated or unwarranted claims, opinions or forecasts; \487\ and (3)

    balances any statement that refers to the potential opportunities or

    advantages presented by a swap with statements of corresponding

    risks.\488\ The Commission also stated its expectation that to deal

    fairly requires the swap dealer or major swap participant to treat

    counterparties in such a way so as not to unfairly advantage a

    counterparty or group of counterparties over another. Additionally,

    communications are subject to the anti-fraud provisions of the CEA and

    Commission Regulations, as well as any applicable SRO rules.\489\

    ---------------------------------------------------------------------------

    \483\ Proposing release, 75 FR at 80646.

    \484\ See, e.g., 17 CFR 170.5 (``A futures association must

    establish and maintain a program for * * * the adoption of rules * *

    * to promote fair dealing with the public.''); NFA Compliance Rule

    2-29--Communications with the Public and Promotional Material; NFA

    Interpretative Notice 9041--Obligations to Customers and Other

    Market Participants.

    \485\ See, e.g., NFA Compliance Rule 2-29(b)(2) and (5); see

    also NFA Interpretive Notice 9043--NFA Compliance Rule 2-29: Use of

    Past or Projected Performance; Disclosing Conflicts of Interest for

    Security Futures Products (performance must be presented in a

    balanced manner).

    \486\ See, e.g., NFA Interpretive Notice 9041, Obligations to

    Customers and Other Market Participants (``Members * * * and their

    Associates should provide a sound basis for evaluating the facts

    regarding any particular security futures product * * *.'').

    \487\ See, e.g., NFA Compliance Rule 2-29(b)(4)-(5).

    \488\ Proposing release, 75 FR at 80646.

    \489\ Id.

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received several letters from commenters regarding

    proposed Sec. 23.433. One commenter found the principles based

    approach to the rule more appropriate than a prescriptive

    approach.\490\ However, a different commenter expressed concern

    regarding the rule's lack of detail, stating that it could create

    uncertainty and risk for swap dealers and major swap participants.\491\

    That commenter recommended that the Commission consider using safe

    harbors containing objective standards as a means to satisfy the

    statutory requirements.\492\ Another commenter urged the Commission to

    clarify the communications standards by reference to currently

    prevailing standards, such as FINRA and NFA standards, subject to

    appropriate modifications to reflect standards for participation in the

    swaps market.\493\ Another commenter requested that major swap

    participants not be subject to a good faith and fair dealing rule when

    transacting with swap dealers.\494\ It asserted that major swap

    participants in this particular context are customers of swap dealers

    and should not be treated as a dealer or quasi-dealer. Others had

    little or no concern regarding the fair dealing requirement.\495\

    ---------------------------------------------------------------------------

    \490\ CFA/AFR Feb. 22 Letter, at 12. In addition, the commenter

    recognized the need for future guidance, if necessary, after

    implementation.

    \491\ NY City Bar Feb. 22 Letter, at 3.

    \492\ Id.

    \493\ FHLBanks Feb. 22 Letter, at 6.

    \494\ MetLife Feb. 22 Letter, at 4-5.

    \495\ See COPE Feb. 22 Letter, at 4. Accord, Exelon Feb. 22

    Letter, at 3-4 (agreeing that holding swap dealers and major swap

    participants to standards that require fair dealing is appropriate

    as long as these principles are properly applied to commodity swap

    market).

    ---------------------------------------------------------------------------

    3. Final Sec. 23.433

    The Commission has determined to adopt Sec. 23.433 as proposed. In

    addition, the Commission is providing the following guidance regarding

    the final fair dealing rule. As discussed above regarding Sec.

    23.431--Disclosures, the fair dealing rule works in tandem with both

    the material disclosure and anti-fraud rules to ensure that

    counterparties receive material information that is balanced and fair

    at all times.\496\ The Commission intends these rules to address the

    concerns raised by commenters \497\ regarding transactions similar to

    those profiled in the Senate Report.\498\ The Senate Report concludes

    that those transactions, which involved structured CDOs, were

    problematic because they were designed to fail and the disclosures

    omitted and/or misrepresented the material risks, characteristics,

    incentives and conflicts of interest. Under all circumstances, and

    particularly those akin to the Senate Report involving complex swaps,

    the Commission's fair dealing rule will apply and operate as an

    independent basis for enforcement proceedings.

    ---------------------------------------------------------------------------

    \496\ The fair dealing communications rule applies to all

    communications between a counterparty and a swap dealer or major

    swap participant, including the daily mark and termination. See

    Section III.D. of this adopting release for a discussion of Sec.

    23.431.

    \497\ See CFA/AFR Feb. 22 Letter, at 12; Sen. Levin Aug. 29

    Letter, at 10-11.

    \498\ Senate Report, at 376-636.

    ---------------------------------------------------------------------------

    The fair dealing rule, like the disclosure rules, is principles

    based and applies flexibly based on the facts and circumstances of a

    particular swap. For example, when addressing the risks and

    characteristics of a swap with features including, but not limited to,

    caps, collars, floors, knock-ins, knock-outs and range accrual features

    that increase its complexity, the fair dealing rule

    [[Page 9770]]

    requires the swap dealer or major swap participant to provide a sound

    basis for the counterparty to assess how those features would impact

    the value of the swap under various market conditions during the life

    of the swap. In a complex swap, where the risks and characteristics

    associated with an underlying asset are not readily discoverable by the

    counterparty upon the exercise of reasonable diligence, the swap dealer

    or major swap participant is expected, under both the disclosure rule

    and fair dealing rule, to provide a sound basis for the counterparty to

    assess the swap by providing information about the risks and

    characteristics of the underlying asset.\499\ The fair dealing rule

    also will supplement requirements to inform counterparties of material

    incentives and conflicts of interest that would tend to be adverse to

    the interests of a counterparty in connection with a swap, particularly

    in situations like those referenced in the Senate Report. In this

    regard, a swap dealer or major swap participant will have to follow

    policies and procedures reasonably designed to ensure that the content

    and context of its disclosures are fair and complete to allow the

    counterparty to protect itself and make an informed decision.

    ---------------------------------------------------------------------------

    \499\ Such a requirement is not intended to create, and does not

    create, any general trading prohibition or general disclosure

    requirement concerning ``inside information.'' See discussion at fn.

    370; see also fn. 452.

    ---------------------------------------------------------------------------

    In addition, in response to the comments it received, the

    Commission is confirming that it will look to NFA guidance when

    interpreting Sec. 23.433 and, as appropriate, will consider providing

    further guidance, if necessary, after implementation.\500\ The

    Commission concludes that the futures and securities industry

    familiarity with these precedents considerably mitigates concerns about

    legal certainty as a result of the principles based rule. Also, 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 in connection with a violation of the

    rules. Lastly, the Commission is not exempting major swap participants

    from the fair communication requirement when they transact with swap

    dealers. Such an exemption would undermine congressional intent to

    improve transparency and raise the business conduct standards

    applicable to the market.

    ---------------------------------------------------------------------------

    \500\ See, e.g., NFA Compliance Rule 2-29--Communications with

    the Public and Promotional Material; NFA Interpretative Notice

    9041--Obligations to Customers and Other Market Participants; NFA

    Interpretive Notice 9043--NFA Compliance Rule 2-29: Use of Past or

    Projected Performance; Disclosing Conflicts of Interest for Security

    Futures Products.

    ---------------------------------------------------------------------------

    G. Section 23.434--Recommendations to Counterparties--Institutional

    Suitability

    1. Proposed Sec. 23.434

    In proposed Sec. 23.434, the Commission exercised its

    discretionary authority under new Section 4s(h) by proposing an

    institutional suitability obligation for any recommendation a swap

    dealer or major swap participant makes to a counterparty in connection

    with a swap or swap trading strategy.\501\ More precisely, proposed

    Sec. 23.434 required a swap dealer or major swap participant to have a

    reasonable basis to believe that any swap or trading strategy involving

    swaps that it recommends to a counterparty is suitable for such

    counterparty.\502\ A swap dealer or major swap participant would be

    required to make this determination based on reasonable due diligence

    that would include obtaining information regarding the counterparty's

    financial situation and needs, objectives, tax status, ability to

    evaluate the recommendation, liquidity needs, risk tolerance, ability

    to absorb potential losses related to the recommended swap or trading

    strategy, and any other information known by the swap dealer or major

    swap participant.\503\

    ---------------------------------------------------------------------------

    \501\ Proposing release, 75 FR at 80647.

    \502\ The proposed rule was proposed based on suitability duties

    for banks and broker dealers dealing with institutional clients. As

    such, the proposed rule also implied a general suitability duty such

    that a swap dealer would have to have a reasonable basis to believe

    that the recommended swap or swap trading strategy is suitable for

    at least some counterparties.

    \503\ Proposing release, 75 FR at 80659.

    ---------------------------------------------------------------------------

    Proposed Sec. 23.434 provided that a swap dealer or major swap

    participant could fulfill its obligations if the following conditions

    were satisfied: (1) The swap dealer or major swap participant had a

    reasonable basis to believe that the counterparty (or a party to whom

    discretionary authority has been delegated) was capable of evaluating,

    independently, the risks related to the particular swap or trading

    strategy recommended; (2) the counterparty (or its discretionary

    advisor) affirmatively indicated that it was exercising independent

    judgment in evaluating the recommendations; and (3) the swap dealer or

    major swap participant had a reasonable basis to believe that the

    counterparty had the capacity to absorb any potential losses.\504\

    ---------------------------------------------------------------------------

    \504\ Id.

    ---------------------------------------------------------------------------

    Proposed Sec. 23.434 made clear that it would not apply: To any

    recommendations made to another swap dealer, major swap participant,

    security-based swap dealer, or major security-based swap participant;

    where a swap dealer or major swap participant provides information that

    is general transaction, financial, or market information; or to swap

    terms in response to a competitive bid request from the counterparty.

    In proposing Sec. 23.434, the Commission explained that whether a swap

    dealer or major swap participant has made a recommendation and thus

    triggered its suitability obligation would depend on the facts and

    circumstances of the particular case. A recommendation would include

    any communication by which a swap dealer or major swap participant

    provides information to a counterparty about a particular swap or

    trading strategy that is tailored to the needs or characteristics of

    the counterparty.\505\

    ---------------------------------------------------------------------------

    \505\ Id., at 80647.

    ---------------------------------------------------------------------------

    While recognizing that futures market professionals have not been

    subject to an explicit suitability obligation, the Commission stated

    that such professionals have long been required to meet a variety of

    related requirements as part of their NFA-imposed obligations.\506\

    Further, in proposing Sec. 23.434, the Commission considered that a

    suitability obligation is a common requirement for professionals in

    other markets and in other jurisdictions, including the banking and

    securities markets. Thus, to promote regulatory consistency, the

    Commission proposed to adopt a suitability obligation for swap dealers

    and major swap participants, modeled, in part, on existing obligations

    for banks and broker-dealers dealing with institutional clients.\507\

    ---------------------------------------------------------------------------

    \506\ See, e.g., NFA Compliance Rule 2-30(c) and (j); see also

    NFA Interpretive Notice 9004.

    \507\ Proposing release, 75 FR at 80647.

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received several comments representing a diversity

    of views on proposed Sec. 23.434. As a general matter, some commenters

    strongly supported the proposal as an important feature of the system

    of business conduct standards and directly responsive to the concerns

    raised by members of Congress regarding conflicts of interest,

    particularly as between investment banks and their customers.\508\ For

    example, one

    [[Page 9771]]

    commenter stated that, for both swap dealers and swap advisors, there

    should be some suitability standards in place so that those entities

    with the appropriate expertise and capabilities to engage knowledgeably

    in these transactions are able to do so, while protecting those

    entities that should not be engaged in these types of

    transactions.\509\ Other commenters, however, believed that the

    institutional suitability requirement is unnecessary and inappropriate

    for the swaps market, which is comprised of institutional market

    participants, not retail investors, and should remain an SRO rule, if

    at all.\510\

    ---------------------------------------------------------------------------

    \508\ See, e.g., CFA/AFR Feb. 22 Letter, at 12-13; Better

    Markets Feb. 22 Letter, at 4-5; CFA/AFR Nov. 3 Letter, at 6-7.

    \509\ GFOA Feb. 22 Letter, at 2.

    \510\ See, e.g., Exelon Feb. 22 Letter, at 3; HETCO Feb. 22

    Letter, at 1-4; CEF Feb. 22 Letter, at 8-9; SIFMA/ISDA Feb. 17

    Letter, at 25; contra CFA/AFR Nov. 3 Letter, at 7.

    ---------------------------------------------------------------------------

    Of specific concern to some commenters was the proposal's inclusion

    of major swap participants. These commenters stated that, regardless of

    size, major swap participants cannot be presumed to possess a level of

    market or product information equal to that of swap dealers. Further,

    they expressed concern that proposed Sec. 23.434 would force major

    swap participants into a position of trust and confidence when, in

    fact, they are transacting with their counterparties on an arm's length

    basis.\511\ These commenters urged the Commission to treat major swap

    participants like any other customer of a swap dealer.\512\

    ---------------------------------------------------------------------------

    \511\ See, e.g., MFA Feb. 22 Letter, at 2 and 4; MetLife Feb. 22

    Letter, at 4-5.

    \512\ See, e.g., MFA Feb. 22 Letter, at 3; MetLife Feb. 22

    Letter, at 4-5; contra CFA/AFR Nov. 3 Letter, at 7.

    ---------------------------------------------------------------------------

    Several commenters expressed concern with the use of the term

    ``recommendation'' in proposed Sec. 23.434.\513\ One commenter opined

    that the term is not defined and, therefore, could be overly

    broad.\514\ Another commenter was concerned that general marketing

    materials could qualify as a recommendation within the meaning of the

    proposal.\515\ That commenter requested the Commission clarify that

    such materials, as opposed to the recommendation of specific swaps to a

    customer based on the individual customer's particular circumstances

    and needs, does not trigger the requirements of proposed Sec.

    23.434.\516\ Other commenters stated that unless swaps are disclosed in

    an understandable, disaggregated form, they cannot be suitable.\517\

    Similarly, a commenter suggested the Commission strengthen or clarify

    protections against swap dealers recommending swaps that expose the

    hedger to risks that are greater than those they seek to hedge, either

    by identifying this as a violation of fraud standards or clarifying

    that it would be a violation of the suitability and best interests

    standards.\518\ In contrast, one commenter believed that the complexity

    associated with collective investment vehicles would make it

    impracticable to carry out suitability and diligence requirements under

    proposed Sec. 23.434.\519\ Similarly, another commenter stated that,

    without details of the customer's business, staff, or other risks, it

    would be difficult for the swap dealer or counterparty to make a

    suitability determination.\520\

    ---------------------------------------------------------------------------

    \513\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 26 (``The

    Commission's proposal appears to assume that every `recommendation'

    is, in essence, a recommendation to the counterparty that the

    identified transaction is a transaction that the counterparty should

    execute based on its circumstances. This is far from accurate.'').

    \514\ MFA Feb. 22 Letter, at 3.

    \515\ FHLBanks Feb. 22 Letter, at 5.

    \516\ Id.

    \517\ See, e.g., CFA/AFR Feb. 22 Letter, at 12; Better Markets

    Feb. 22 Letter, at 4-5.

    \518\ CFA/AFR Feb. 22 Letter, at 20.

    \519\ AMG-SIFMA Feb. 22 Letter, at 12.

    \520\ HOOPP Feb. 22 Letter, at 2.

    ---------------------------------------------------------------------------

    Related to the comments regarding the term ``recommendation'' was

    the more general concern that proposed Sec. 23.434 would increase

    costs to, and chill communications and transactions between, swaps

    market participants.\521\ The concern was that the proposal would cut

    the flow of information and transactional alternatives that fall short

    of advice and that non-swap dealer and non-major swap participants find

    beneficial.\522\ A related concern was that the term ``recommendation''

    would encompass ordinary interactions, and, therefore, swap dealers

    would always be subject to an explicit fiduciary duty.\523\ According

    to some commenters, imposing such a fiduciary duty on swap dealers

    would result in either a blanket prohibition on swap dealers

    transacting with ERISA plans or place such plans at a negotiating

    disadvantage with swap dealers by operation of other requirements that

    would require the plans to provide their counterparty with financial

    information to enter into a swap.\524\ Regarding costs, some commenters

    believed that a suitability determination may be challenged in

    litigation as a possible defense against enforcement of a swap by a

    swap dealer, and the costs associated with defending such litigation

    would be passed on to counterparties and would be disproportionate to

    the benefits expected from proposed Sec. 23.434.\525\

    ---------------------------------------------------------------------------

    \521\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 26-27; HOOPP Feb.

    22 Letter, at 2; Exelon Feb. 22 Letter, at 3.

    \522\ SIFMA/ISDA Feb. 17 Letter, at 27.

    \523\ Id.

    \524\ Id.; ABC/CIEBA Feb. 22 Letter, at 7.

    \525\ See, e.g., FHLBanks June 3 Letter, at 7; VRS Feb. 22

    Letter, at 3; HETCO Feb. 22 Letter, at 2; COPE Feb. 22 Letter, at 4.

    ---------------------------------------------------------------------------

    Several commenters suggested that, if the Commission were to adopt

    a suitability requirement, it could ameliorate some of the costs

    associated with such a requirement by permitting swap dealers and major

    swap participants to rely, absent notice of countervailing facts, upon

    a counterparty's written representations rather than imposing an

    independent diligence requirement.\526\ These commenters contend that

    such an approach would prevent any suitability requirement from

    triggering fiduciary or other advisory status except in circumstances

    where that status reflects the reality of the parties'

    relationship.\527\ In contrast, at least one commenter expressed

    reservation about the utility of representations because it could

    subvert the intent of the suitability standard.\528\ This commenter

    believed there was no value in permitting swap dealers and major swap

    participants to recommend swaps known to be unsuitable just because the

    customer is willing to enter into the transaction.\529\ For this and

    other reasons, the commenter urged the Commission to require a

    suitability analysis, properly documented, whenever the swap dealer or

    major swap participant is the initiator in recommending the transaction

    or whenever the swap dealer or major swap participant recommends a

    customized swap or trading strategy that involves a customized

    swap.\530\

    ---------------------------------------------------------------------------

    \526\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 27; ABC/CIEBA

    Feb. 22 Letter, at 7; but see CFA/AFR Nov. 3 Letter, at 7.

    \527\ See SIFMA/ISDA Feb. 17 Letter, at 27 fn. 59.

    \528\ CFA/AFR Feb. 22 Letter, at 13; CFA/AFR Nov. 3 Letter, at

    7.

    \529\ CFA/AFR Feb. 22 Letter, at 13.

    \530\ Id.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.434

    The Commission has determined to adopt Sec. 23.434. The final rule

    text has been changed to harmonize with the SEC's proposed rule and

    FINRA's final institutional suitability rule.\531\ Through these

    changes, the Commission achieves its proposed regulatory objectives

    while reducing the cost of compliance associated with reconciliation of

    the suitability duties imposed by the Commission, the SEC and FINRA.

    ---------------------------------------------------------------------------

    \531\ See proposed 17 CFR 240.15Fh-3(f), SEC's proposed rules,

    76 FR at 42455; FINRA Rule 2111 (Suitability), 75 FR 71479, Nov. 23,

    2010 (Order Approving Proposed Rule Change; File No. SR-FINRA-2010-

    039).

    ---------------------------------------------------------------------------

    There are two principal changes from proposed Sec. 23.434. First,

    major swap

    [[Page 9772]]

    participants are excluded from the institutional suitability

    requirement. Second, the final rule clarifies that the suitability duty

    requires a swap dealer to (1) understand the swap that it is

    recommending, and (2) make a determination that the recommended swap is

    suitable for the specific counterparty. Consistent with the

    institutional suitability requirements of the proposed rule, however,

    the swap dealer will still be able to satisfy the counterparty-specific

    suitability duty by complying with the safe harbor in Sec. 23.434(b)

    through the exchange of written representations. The Commission also

    deleted paragraph (c)(2), which excluded from the scope of the rule:

    (1) Information that is general transaction, financial, or market

    information; and (2) swap terms in response to a competitive bid

    request from the counterparty. The Commission has determined that, if a

    swap dealer were to communicate such information to a counterparty,

    without more, such communication would not be considered making a

    ``recommendation.'' As a result, such exclusion in proposed Sec.

    23.434 was unnecessary and potentially confusing to the extent that it

    could be read to contain the only types of information that would be

    outside the scope of the suitability rule. The Commission agrees with

    the commenters that stated that major swap participants are unlikely,

    in the normal course of arm's length transactions, to be making

    recommendations to counterparties and has removed major swap

    participants from the final rule. This determination is consistent with

    Section 4s(h)(4), which does not impose on major swap participants the

    same ``acts as an advisor'' to a Special Entity duty as it does on swap

    dealers.\532\

    ---------------------------------------------------------------------------

    \532\ One commenter disagreed with removing major swap

    participants from the suitability requirement. The commenter

    reasoned that, if a major swap participant makes a recommendation,

    the rule would provide protection for counterparties, but would not

    otherwise be burdensome if they do not make recommendations. See

    CFA/AFR Aug. 29 Letter, at 21-25. Notwithstanding the commenter's

    view, the Commission has determined, in light of the definition of

    major swap participant and the nature of its business, to remove

    major swap participants from the suitability requirement.

    ---------------------------------------------------------------------------

    In response to the comments it received, the Commission is

    providing additional guidance as to the meaning of the term

    ``recommendation'' in the final suitability rule and adding Appendix A

    to subpart H, which clarifies the term and provides guidance as to

    compliance with the final rule.\533\ Final Sec. 23.434 requires a swap

    dealer that makes a ``recommendation'' to a counterparty to have a

    reasonable basis for believing that the recommended swap or trading

    strategy involving swaps is suitable for the counterparty. While the

    determination of whether a swap dealer has made a recommendation that

    triggers a suitability obligation will turn on the facts and

    circumstances of the particular situation, there are certain factors

    the Commission will consider in reaching such a determination. The

    facts and circumstances determination of whether a communication is a

    ``recommendation'' requires an analysis of the content, context, and

    presentation of the particular communication or set of communications.

    The determination of whether a ``recommendation'' has been made,

    moreover, is an objective rather than a subjective inquiry. An

    important factor in this regard is whether, given its content, context,

    and manner of presentation, a particular communication from a swap

    dealer to a counterparty reasonably would be viewed as a ``call to

    action,'' or suggestion that the counterparty enter into a swap.\534\

    An analysis of the content, context, and manner of presentation of a

    communication requires examination of the underlying substantive

    information transmitted to the counterparty and consideration of any

    other facts and circumstances, such as any accompanying explanatory

    message from the swap dealer.\535\

    ---------------------------------------------------------------------------

    \533\ Appendix A to subpart H provides guidance as to the

    meaning of the term recommendation as used in Sec. 23.434 and Sec.

    23.440(a)--Acts as an Advisor to a Special Entity. The appendix also

    provides guidance related to the safe harbors for compliance with

    each final rule.

    \534\ Cf. proposing release, 75 FR at 80647 fn. 81 (citing NASD

    Notice to Members 01-23 (April 2001) and FINRA Proposed Suitability

    Rule, 75 FR 52562, 52564-69, Aug. 26, 2010).

    \535\ For example, if a swap dealer transmitted a research

    report to a counterparty at the counterparty's request, that

    communication would not be subject to the suitability obligation;

    whereas, if the same swap dealer transmitted the very same research

    report with an accompanying message, either oral or written, that

    the counterparty should act on the report, the analysis would be

    different.

    ---------------------------------------------------------------------------

    Additionally, the more individually tailored the communication to a

    specific counterparty or a targeted group of counterparties about a

    swap, group of swaps or trading strategy involving the use of a swap,

    the greater the likelihood that the communication may be viewed as a

    ``recommendation.'' For example, a ``flip book'' or ``pitch book'' that

    sets out a customized transaction tailored to the needs or

    characteristics of a specific counterparty will likely be a

    recommendation. In contrast, general marketing materials, without more,

    are unlikely to constitute a recommendation. Further, simply complying

    with the requirements of the business conduct standards (e.g.,

    verification of ECP or Special Entity status, disclosures of material

    information, scenario analysis, disclosure of the daily mark, etc.),

    without more, would not cause a swap dealer to be deemed to have made a

    recommendation.

    This formulation of ``recommendation'' is consistent with the

    institutional suitability obligation imposed on federally regulated

    banks acting as broker-dealers and making recommendations for

    government securities to institutional customers, FINRA guidance on

    determining whether a recommendation has been made in the suitability

    context for broker-dealers recommending securities, and the SEC's

    proposed rules and the federal securities laws on suitability

    requirements.\536\ Further, DOL confirms that it does not view

    compliance with the Commission's business conduct standards rules,

    including the suitability requirement, to cause swap dealers

    transacting with ERISA plans to become fiduciaries to those plans.\537\

    The Commission also confirms that compliance with the suitability duty

    would not cause a swap dealer to owe fiduciary duties to its

    counterparty, including a Special Entity.

    ---------------------------------------------------------------------------

    \536\ See, e.g., 12 CFR 13.4 (Office of the Comptroller of the

    Currency regulation for banks recommending government securities to

    customers); FINRA Rule 2111 (Suitability), 75 FR 71479; SEC's

    proposed rules, 76 FR at 42455.

    \537\ See Section II.B. of this adopting release for a

    discussion of ``Regulatory Intersections--Department of Labor ERISA

    Fiduciary Regulations.''

    ---------------------------------------------------------------------------

    The Commission has considered commenters' statements about the

    potential costs of proposed Sec. 23.434. With respect to concerns that

    the suitability requirement could chill communications or spawn

    vexatious litigation, the Commission notes that the final rule aims to

    minimize costs by allowing swap dealers to satisfy their due diligence

    duty ``to have or obtain information about the counterparty'' including

    its investment profile, trading objectives, and ability to absorb

    potential losses by relying on the representations from such

    counterparty consistent with final Sec. 23.402(d).\538\

    [[Page 9773]]

    Furthermore, the Commission is clarifying in this adopting release and

    in Appendix A to subpart H that, final Sec. 23.434(b) establishes a

    safe harbor whereby a swap dealer will satisfy its counterparty-

    specific duty under Sec. 23.434(a)(2) through the exchange of certain

    written representations between the swap dealer and the counterparty as

    provided in Sec. 23.434(c). The Commission further clarifies the types

    of representations that would satisfy the requirements of final Sec.

    23.402(d) (Reasonable Reliance on Representations) in the context of

    the final suitability rule in Sec. 23.434.

    ---------------------------------------------------------------------------

    \538\ The Commission notes, regarding counterparty-specific

    suitability, that reasonable diligence would include, for example,

    assessing whether a recommendation would expose a hedger to risks

    that are greater than those they seek to hedge. See CFA/AFR Feb. 22

    Letter, at 20. Reasonable diligence to determine suitability of a

    bespoke swap might include, as suggested by commenters and depending

    on the facts and circumstances, consideration of hedge equivalents,

    evaluations of liquidity, or added price for embedded lines of

    credit. See Better Markets Feb. 22 Letter, at 4-7; Better Markets

    June 3 Letter, at 13. Depending on the facts and circumstances, a

    violation of the suitability duty may also violate other rules,

    including the anti-fraud and fair dealing rules.

    ---------------------------------------------------------------------------

    A swap dealer may rely on representations to obtain information

    about the counterparty when complying with the counterparty-specific

    suitability obligation in Sec. 23.434(a)(2). For example, to obtain

    information about the counterparty's ``ability to absorb potential

    losses associated with the recommended swap or trading strategy,'' the

    swap dealer could rely on the counterparty's representation that it has

    a risk management program and/or hedging policy to manage and monitor

    its ability to absorb potential losses, and that it has complied in

    good faith with its policies and procedures for diligent review of and

    compliance with its risk management program and/or hedging policy.

    Alternatively, a swap dealer could satisfy the safe harbor

    requirements in Sec. 23.434(b) to satisfy the counterparty-specific

    suitability obligation. Final Sec. 23.434(b)(1) requires the swap

    dealer to assess whether the counterparty is capable of evaluating,

    independently, the risks related to a particular swap or swap trading

    strategy. To make its assessment, the swap dealer may rely on a

    counterparty's representations as provided in Sec. 23.434(c). Final

    Sec. 23.434(c)(1) describes the types of representations a swap dealer

    may rely on with respect to any counterparty other than a Special

    Entity, and Sec. 23.434(c)(2) describes the types of representations a

    swap dealer may rely on with respect to a Special Entity. Final Sec.

    23.434(c)(1) provides that a swap dealer will satisfy Sec.

    23.434(b)(1)'s requirement with respect to a counterparty other than a

    Special Entity if it receives representations that the counterparty has

    complied in good faith with its policies and procedures that are

    reasonably designed to ensure that the persons responsible for

    evaluating the recommendation and making trading decisions on behalf of

    the counterparty are capable of doing so. Final Sec. 23.434(c)(2)

    provides that a swap dealer will satisfy Sec. 23.434(b)(1)'s

    requirement with respect to a Special Entity if it receives

    representations that satisfy the terms of Sec. 23.450(d) regarding a

    Special Entity's qualified independent representative.\539\

    ---------------------------------------------------------------------------

    \539\ See Section IV.C.3.e. at fn. 867 and accompanying text for

    a discussion of Sec. 23.450(d).

    ---------------------------------------------------------------------------

    To satisfy the safe harbor in Sec. 23.434(b), the final rule

    provides that the swap dealer and counterparty must exchange

    representations that: (1) The counterparty is capable of independently

    evaluating investment risks with regard to the recommended swap, (2)

    the counterparty is exercising independent judgment and is not relying

    on the recommendation of the swap dealer, (3) the swap dealer is acting

    as a counterparty and is not undertaking to assess the suitability of

    the swap or trading strategy involving a swap for the customer, and (4)

    in the case of a counterparty that is a Special Entity, the swap dealer

    complies with Sec. 23.440 where the recommendation would cause the

    swap dealer to act as an advisor to a Special Entity within the meaning

    of Sec. 23.440(a).\540\

    ---------------------------------------------------------------------------

    \540\ Prong (4) of the safe harbor clarifies that Sec. 23.434's

    application is broader than Sec. 23.440--Requirements for swap

    dealers acting as advisors to Special Entities. Final Sec. 23.434

    is triggered when a swap dealer recommends any swap or trading

    strategy that involves a swap to any counterparty. However, Sec.

    23.440 is limited to a swap dealer's recommendations (1) to a

    Special Entity (2) of swaps that are tailored to the particular

    needs or characteristics of the Special Entity. See Section

    IV.B.3.a. at fn. 697 and accompanying text. Thus, a swap dealer that

    recommends a swap to a Special Entity that is tailored to the

    particular needs or characteristics of the Special Entity may comply

    with its suitability obligation by satisfying the safe harbor in

    Sec. 23.434(b); however, the swap dealer must also comply with

    Sec. 23.440 in such circumstances.

    ---------------------------------------------------------------------------

    The Commission believes that this approach will lower the costs of

    compliance that would result from a requirement that a swap dealer must

    always conduct counterparty-specific due diligence while encouraging

    counterparties that choose to make representations consistent with the

    final rule to have policies and procedures to ensure that they have

    their own advisors that are able to assess recommendations and make

    appropriate determinations as to suitability. To further address

    commenters' concerns about the potential burden of compliance on swap

    dealers, the Commission clarifies that there is no duty to look behind

    such representations in the absence of ``red flags.'' In this context,

    the Commission interprets ``red flags'' to mean information known by

    the swap dealer that would cause a reasonable person to question the

    accuracy of the representation.

    Commenters requested that the Commission allow swap dealers to rely

    on representations made on a relationship basis (i.e., written

    representations in counterparty relationship documentation) rather than

    requiring a representation be made on a transaction-by-transaction

    basis. The Commission agrees and believes this approach addresses the

    needs that some market participants have to enter into recommended

    transactions in short time frames. Where such representations are made

    in counterparty relationship documentation, the documentation must

    comply with final Sec. 23.402(d) and may be deemed renewed with each

    recommendation.

    The Commission has determined not to adopt suggestions from

    commenters that it exclude certain classes of ``sophisticated''

    counterparties from the protection of final Sec. 23.434. Nevertheless,

    with respect to the counterparty-specific suitability duty, the swap

    dealer will be able to rely on appropriate representations from

    ``sophisticated'' counterparties to satisfy the duty. The Commission

    stresses that the representations relied upon by the swap dealer in all

    cases must be documented in a manner that allows the Commission to

    assess compliance with the final suitability rule.

    In all cases, to meet the requirements of final Sec. 23.434, a

    swap dealer must undertake reasonable diligence to understand the swap

    that it is recommending. In general, what constitutes reasonable

    diligence will vary depending on, among other things, the complexity

    of, and risks associated with, the swap or swap trading strategy and

    the swap dealer's familiarity with the swap or swap trading strategy.

    At a minimum, a swap dealer's reasonable diligence must provide it with

    an understanding of the potential risks and rewards associated with the

    recommended swap or swap trading strategy. A swap dealer that lacks

    this understanding would not be able to meet its obligations under

    Sec. 23.434(a)(1).

    These clarifications regarding how the Commission intends to apply

    the suitability requirement are designed to address many of commenters'

    statements, including that the Commission should ensure consistency

    with the approach proposed by the SEC and the long-standing guidance

    provided by FINRA.\541\ In so doing, the Commission states its

    intention to be

    [[Page 9774]]

    guided, but not controlled, by precedent arising under analogous SRO

    rules.\542\

    ---------------------------------------------------------------------------

    \541\ See SEC's proposed rules, 76 FR at 42415 fn. 133.

    \542\ See, e.g., NASD Notice to Members 01-23 (April 2001)

    (discussing what constitutes a ``recommendation); see also FINRA

    Rule 2111 (suitability).

    ---------------------------------------------------------------------------

    IV. Final Rules for Swap Dealers and Major Swap Participants Dealing

    With Special Entities

    Swap dealers and major swap participants are also subject to

    certain business conduct standards rules when dealing with particular

    counterparties that are defined as Special Entities. This section of

    the adopting release discusses Sec. 23.401(c)-Definition of the term

    Special Entity; Sec. 23.440-Requirements for swap dealers acting as

    advisors to Special Entities; Sec. 23.450-Requirements for swap

    dealers and major swap participants acting as counterparties to Special

    Entities; and Sec. 23.451-Political contributions by certain swap

    dealers.

    A. Definition of ``Special Entity'' Under Section 4s(h)(2)(C)

    1. Section 23.401--Proposed Definition of ``Special Entity''

    Section 4s(h)(2)(C) and proposed Sec. 23.401 defined a ``Special

    Entity'' as: (i) A Federal agency; (ii) a State, State agency, city,

    county, municipality, or other political subdivision of a State; (iii)

    any employee benefit plan, as defined in Section 3 of ERISA; (iv) any

    governmental plan, as defined in Section 3 of ERISA; or (v) any

    endowment, including an endowment that is an organization described in

    Section 501(c)(3) of the Internal Revenue Code of 1986.\543\

    ---------------------------------------------------------------------------

    \543\ Proposing release, 75 FR at 80649 and 80657.

    ---------------------------------------------------------------------------

    2. Comments

    a. State and Municipal Special Entities

    One commenter requested the Commission clarify whether the proposed

    definition was intended to include instrumentalities of a State or

    municipality or a public corporation.\544\ The commenter noted that

    proposed Sec. 23.450(b) (Requirements for a Special Entity's

    representative) and proposed Sec. 23.451 (Political contributions by

    certain swap dealers and major swap participants) referenced

    ``municipal entities,'' which included any agency, authority or

    instrumentality of a State or political subdivision of a State.\545\

    ---------------------------------------------------------------------------

    \544\ APGA Feb. 22 Letter, at 2.

    \545\ Id.; see proposed Sec. Sec. 23.450(b)(8) and

    23.451(a)(3), proposing release, 75 FR at 80660-61.

    ---------------------------------------------------------------------------

    b. Employee Benefit Plans and Governmental Plans

    Section 4s(h)(2)(C)(iii) refers to any employee benefit plan ``as

    defined in'' Section 3 of ERISA. Section 3 of ERISA, however, defines

    ``employee benefit plan'' broadly and also defines several

    subcategories of employee benefit plans that are excluded from

    regulation under Title I of ERISA, including ``governmental plans,''

    which are referenced in Section 4s(h)(2)(C)(iv).

    Some commenters requested that the final rule clarify that prong

    (iii) of the Special Entity definition only include employee benefit

    plans that are ``subject to,'' i.e., regulated under, Title I of

    ERISA.\546\ Commenters stated that the ``employee benefit plan'' prong

    should be read narrowly and only include those plans ``subject to''

    ERISA because Congress included a separate prong (iv) for

    ``governmental plans'' that are ``defined in'' Section 3 of ERISA, but

    not ``subject to'' ERISA.\547\ Commenters also asserted that the

    Commission should exclude foreign pension plans from the Special Entity

    definition\548\ and that such an exclusion would be consistent with

    congressional intent and would avoid conflicts with foreign law.\549\

    ---------------------------------------------------------------------------

    \546\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 30 fn. 70

    (asserting that other than U.S. governmental plans, the Special

    Entity definition should exclude (1) unfunded plans for highly

    compensated employees, (2) foreign pension plans, (3) church plans

    that have elected not to be subject to ERISA, and (4) Section 403(b)

    plans that accept only employee contributions).

    \547\ SIFMA/ISDA Feb. 17 Letter, at 30; CPPIB Feb. 22 Letter, at

    3; OTPP Feb. 22 Letter, at 2.

    \548\ See SIFMA/ISDA Feb. 17 Letter, at 30; ASF Feb. 22 Letter,

    at 2-3; OTPP Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22 Letter, at 13

    fn. 44; see also Societe Generale Feb. 18 Letter, at 12; Barclays

    Jan. 11 Letter, at 9 fn. 9.

    \549\ CPPIB Feb. 22 Letter, at 3-4.

    ---------------------------------------------------------------------------

    Other commenters asserted that the Commission should not limit or

    exclude any governmental plans such as retirement and deferred

    compensation plans.\550\ Another commenter stated that church plans and

    church benefit boards that are ``defined in'' Section 3 of ERISA but

    not ``subject to'' ERISA should be included within the Special Entity

    definition.\551\ The commenter also asserted that the Commission should

    avoid legal uncertainty for employee benefit plans that are ``defined

    in'' but not ``subject to'' ERISA, such as church plans and church

    benefit boards, and permitting such plans to opt in to the Special

    Entities provisions of the business conduct standards rules would be a

    preferable approach.\552\

    ---------------------------------------------------------------------------

    \550\ CFA/AFR Feb. 22 Letter, at 14-15; AFSCME Feb. 22 Letter,

    at 5.

    \551\ Church Alliance Feb. 22 Letter, at 4-5; Church Alliance

    Aug. 29 Letter, at 3-4.

    \552\ Church Alliance Oct. 4 Letter, at 2 (also asserting that a

    ``church benefit board'' is an organization described in Section

    3(33)(C)(i) of ERISA).

    ---------------------------------------------------------------------------

    c. Master Trusts

    Two commenters asserted that the Commission should clarify that the

    definition of ``Special Entity'' should encompass master trusts holding

    the assets of one or more employee benefit plans of a single

    employer.\553\ Another commenter suggested that the definition apply to

    any trust that holds the assets of employee benefit plans sponsored by

    the same employer or related employers.\554\ These commenters assert

    that employers that maintain multiple employee benefit plans often pool

    their assets into a single trust called a ``master trust'' for

    efficiency purposes.\555\ The commenters also assert that the Special

    Entity provisions of the business conduct standards rules should apply

    with respect to the master trust and not on a plan-by-plan basis, which

    would be burdensome and negate some efficiencies achieved by a master

    trust.\556\

    ---------------------------------------------------------------------------

    \553\ BlackRock Feb. 22 Letter, at 7; SIFMA/ISDA Feb. 17 Letter,

    at 30; see also Church Alliance Feb. 22 Letter, at 5 (``Church

    benefit boards may also be likened to a master trust that is

    established by several multiple-employer pension plans.'').

    \554\ ERIC Feb. 22 Letter, at 2 and 4-5 (asserting that the

    assets of an employee benefit plan subject to ERISA generally must

    be held in trust and, although the trust is a separate entity from

    the plan, the trust exists solely to hold and invest the assets of

    the plan).

    \555\ See ERIC Feb. 22 Letter, at 4-5.

    \556\ See, e.g., ERIC Feb. 22 Letter, at 5.

    ---------------------------------------------------------------------------

    d. Endowments

    Section 4s(h)(2)(C)(v) refers to ``any endowment, including an

    endowment that is an organization described in Section 501(c)(3)\557\

    of the Internal Revenue Code of 1986.'' One commenter recommended the

    Commission err on the side of inclusiveness and include charitable

    organizations as Special Entities.\558\ Other commenters recommended

    that the Commission clarify that the endowment prong of the Special

    Entity definition is limited to when an endowment itself enters into

    swaps, but does not include non-profit or charitable organizations that

    enter into swaps, even where such an organization has an

    endowment.\559\ One such commenter asserted that the

    [[Page 9775]]

    Commission should clarify that prong (v) does not include non-profit

    organizations that enter into swaps to hedge operational risks, such as

    interest rate risk in connection with a bond offering, that is

    unrelated to its endowment's investment fund.\560\ Additionally, one

    commenter stated that the Special Entity definition should not apply to

    foreign endowments or foreign entities generally.\561\

    ---------------------------------------------------------------------------

    \557\ Section 501(c)(3) of the Internal Revenue Code of 1986

    exempts from federal taxes: ``Corporations, and any community chest,

    fund, or foundation, organized and operated exclusively for

    religious, charitable, scientific, testing for public safety,

    literary, or educational purposes, or to foster national or

    international amateur sports competition * * * or for the prevention

    of cruelty to children or animals, no part of the net earnings of

    which inure to the benefit of any private shareholder or individual

    * * *.'' 26 U.S.C. 501(c)(3).

    \558\ CFA/AFR Feb. 22 Letter, at 14.

    \559\ SFG Feb. 22 Letter, at 2-3; SIFMA/ISDA Feb. 17 Letter, at

    30-31; NACUBO Feb. 22 Letter, at 1 fn. 2.

    \560\ SFG Feb. 22 Letter, at 2-3.

    \561\ Barclays Jan. 11 Letter, at 9 fn. 9.

    ---------------------------------------------------------------------------

    e. Collective Investment Vehicles: The ``Look Through'' Issue

    DOL has a look through test for entities that have ERISA plan

    investors, such as collective investment vehicles, to determine whether

    the person operating the entity will be treated as an ERISA fiduciary

    with respect to the invested plan assets.\562\ Collective investment

    vehicles, such as commodity pools and hedge funds, typically include a

    variety of investors and may include organizations that fall within the

    Special Entity definition set forth in Section 4s(h)(2)(C). Because the

    statutory definition of Special Entity uses ERISA's definition of

    ``employee benefit plan,'' commenters requested clarification of

    whether the Commission will apply a ``look through'' test like DOL's to

    collective investment vehicles for purposes of the business conduct

    standards rules.

    ---------------------------------------------------------------------------

    \562\ 29 CFR 2510.3-101. If plans subject to ERISA own 25% or

    more of the assets of a collective investment vehicle, any person

    who exercises authority or control respecting the management or

    disposition of the vehicle's underlying assets, and any person who

    provides investment advice with respect to such assets for a fee, is

    a fiduciary to the investing ERISA plans.

    ---------------------------------------------------------------------------

    The Commission also received several comments regarding collective

    investment vehicles and whether they should be included within the

    Special Entity definition.\563\ The majority of commenters who

    addressed this issue were opposed to the Commission adopting a DOL-type

    ``look through'' test for collective investment vehicles.\564\ One

    commenter asserted that investment vehicles that hold plan assets

    should not be provided relief from the business conduct standards.\565\

    Certain commenters asserted that the omission of collective investment

    vehicles from the definition of Special Entity in the text of the Dodd-

    Frank Act was determinative of congressional intent.\566\ Other

    commenters pointed out that the statute addressed only direct

    counterparty relationships and not the indirect collective investment

    vehicle situation.\567\ In addition, it was argued that, because

    collective investment vehicles include non-ERISA investors, extending

    the definition would inappropriately cover investors who do not want or

    need Special Entity protection.\568\

    ---------------------------------------------------------------------------

    \563\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13; BlackRock

    Feb. 22 Letter, at 7; ABC/CIEBA Feb. 22 Letter, at 14; ASF Feb. 22

    Letter, at 3-6; MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17

    Letter, at 29-30; AFSCME Feb. 22 Letter, at 5; Church Alliance Feb.

    22 Letter, at 4-5. See also Church Alliance Oct. 4 Letter, at 3-6

    (recommending that church benefit boards be allowed to opt in to

    Special Entity status).

    \564\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13; BlackRock

    Feb. 22 Letter, at 7; ABC/CIEBA Feb. 22 Letter, at 14; ASF Feb. 22

    Letter, at 3-6; MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17

    Letter, at 29-30.

    \565\ AFSCME Feb. 22 Letter, at 5.

    \566\ See, e.g., AMG-SIFMA Letter, at 12; ASF Feb. 22 Letter, at

    3-6; BlackRock Feb. 22 Letter, at 7.

    \567\ MFA Feb. 22 Letter, at 6-7; SIFMA/ISDA Feb. 17 Letter, at

    29-30; BlackRock Feb. 22 Letter, at 7.

    \568\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 30.

    ---------------------------------------------------------------------------

    Further, from a pragmatic standpoint, one commenter maintained that

    it would be highly impractical to discharge heightened duties on the

    broad range of investors that participate in such vehicles and

    expressed concern that proposed suitability and diligence requirements

    would be problematic under a ``look through'' regime.\569\ The

    commenter suggested that heightened standards for collective investment

    vehicles would inappropriately subject those vehicles and their

    investors to increased costs, decreased efficiency and execution

    delays, and a ``look through'' provision could limit Special Entities'

    non-swap investment options.\570\ Other commenters believed collective

    investment vehicle managers would either limit or prohibit investments

    by Special Entities to avoid limitations on their swap trading

    activities.\571\ Such managers may be concerned that other non-Special

    Entity investors may redeem or not invest if they believe the fund may

    be subject to restrictions on trading due to investments by Special

    Entities.\572\

    ---------------------------------------------------------------------------

    \569\ AMG-SIFMA Feb. 22 Letter, at 12.

    \570\ Id., at 13.

    \571\ See, e.g., ASF Feb. 22 Letter, at 4; AMG-SIFMA Feb. 22

    Letter, at 13; MFA Feb. 22 Letter, at 6-7.

    \572\ See AMG-SIFMA Feb. 22 Letter, at 13.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.401(c) Special Entity Definitions

    The Commission has considered the comments and congressional

    intent, and has determined to clarify the scope of the Special Entity

    definitions and further refine prongs (ii) and (iii) of Section

    4s(h)(2)(C).\573\ For prong (ii), the Commission has determined to

    clarify that the definition of State and political subdivisions of a

    State includes instrumentalities, agencies or departments of States or

    political subdivisions of a State. For prong (iii), the Commission has

    determined to interpret the statute to apply only to employee benefit

    plans subject to ERISA rather than those defined in ERISA. For plans

    defined in ERISA but not otherwise covered by the Special Entity

    definition, the Commission has determined to permit such plans to opt

    in to the Special Entity protections under subpart H of part 23.

    ---------------------------------------------------------------------------

    \573\ In addition to the Commission's discretionary rulemaking

    authority in Section 4s(h), Section 721(b)(2) of the Dodd-Frank Act

    provides the Commission discretionary rulemaking authority to define

    terms included in an amendment to the CEA made by Title VII of the

    Dodd-Frank Act.

    ---------------------------------------------------------------------------

    a. Federal Agency

    The Commission did not receive any comments on the Federal agency

    prong (i) of the Special Entity definition, and thus, the Commission is

    adopting the definition as proposed (renumbered as Sec.

    23.401(c)(1)).\574\

    ---------------------------------------------------------------------------

    \574\ The definition of ``swap'' excludes ``any agreement,

    contract or transaction a counterparty of which is a Federal Reserve

    bank, the Federal Government, or a Federal agency that is expressly

    backed by the full faith and credit of the United States.'' Section

    1a(47)(B)(ix) of the CEA. Accordingly, the Commission expects that

    Special Entities that are Federal agencies will be a narrow category

    for purposes of these rules.

    ---------------------------------------------------------------------------

    b. State and Municipal Special Entities

    The Commission has determined to refine prong (ii) of Section

    4s(h)(2)(C), State and municipal Special Entities, to clarify that it

    also includes ``any instrumentality, agency, department, or a

    corporation of or established by'' States or political subdivisions of

    a State (renumbered as Sec. 23.401(c)(2)).\575\ This clarification is

    consistent with the Commission's modifications to Sec. 23.450(b)

    (requirements for a Special Entity's representative) and Sec. 23.451

    (political contributions by certain swap dealers).\576\ The Commission

    also determined that including instrumentalities, agencies, departments

    or corporations of or established by States or political subdivisions

    of a State is consistent with congressional intent to provide

    heightened protections for institutions backed by taxpayers.\577\ In

    [[Page 9776]]

    considering commenters' request for clarity on this issue, the

    Commission views Sec. 23.401(c)(2) to apply broadly to State and local

    governmental entities that are entrusted with public funds, including

    public corporations.

    ---------------------------------------------------------------------------

    \575\ In refining prong (ii), the Commission has considered

    other provisions of the CEA such as the ECP definition for

    governmental entities, which includes ``an instrumentality, agency,

    or department'' of a State or political subdivision of a State. See

    Section 1a(18)(A)(vii)(III) of the CEA.

    \576\ See Sections IV.C. and IV.D. of this adopting release for

    a discussion of Sec. Sec. 23.450(b)(1)(vii) and 23.451(a)(3),

    respectively.

    \577\ See Senator Lincoln floor colloquy stating that the

    Special Entity provisions in the Dodd-Frank Act ``should help

    protect both tax payers and plan beneficiaries.'' 156 Cong. Rec.

    S5923 (daily ed. Jul. 15, 2010) (statement of Sen. Lincoln).

    ---------------------------------------------------------------------------

    c. Employee Benefit Plans and Governmental Plans

    As a matter of statutory interpretation, Sections 4s(h)(2)(C)(iii)

    (employee benefit plans defined in Section 3 of ERISA) and

    4s(h)(2)(C)(iv) (governmental plans defined in Section 3 of ERISA)

    should be construed ``to avoid rendering superfluous'' the statutory

    language.\578\ Section 3(3) of ERISA defines ``employee benefit plan''

    broadly to encompass plans, funds, or programs established or

    maintained by an employer or employee organization for the purpose of

    providing medical benefits or retirement income.\579\ Section 3 of

    ERISA (the definitional section) also defines specific types of

    employee benefit plans, including governmental plans, which are

    excluded from regulation under ERISA by Section 4(b) (the coverage

    section of ERISA).\580\ Therefore, Section 4s(h)(2)(C)(iii) read

    literally as any employee benefit plan ``defined in'' Section 3 of

    ERISA would render Section 4s(h)(2)(C)(iv) superfluous because a

    ``governmental plan defined in section 3 of [ERISA]'' is subsumed by

    the definition of ``employee benefit plan defined in section 3 of

    [ERISA].''

    ---------------------------------------------------------------------------

    \578\ Astoria Fed. Sav. & Loan Assn. v. Solimino, 501 U.S. 104,

    112 (1991).

    \579\ See generally 29 U.S.C. 1002(3) (``employee benefit plan''

    means an employee welfare benefit plan or an employee pension

    benefit plan); 29 U.S.C. 1002(1) (``employee welfare benefit plan''

    means a plan, fund, or program established or maintained by an

    employer or by an employee organization, for the purpose of

    providing for its participants or their beneficiaries medical,

    surgical, or hospital care or benefits in the event of sickness,

    accident, disability, death or unemployment); 29 U.S.C. 1002(2)

    (``employee pension benefit plan'' means any plan, fund, or program

    established or maintained by an employer or by an employee

    organization that provides retirement income to employees).

    \580\ Section 4(b) of ERISA (29 U.S.C. 1003(b)) states that

    ERISA shall not apply to any employee benefit plan that is (1) a

    governmental plan (as defined in Section 3(32) of ERISA (29 U.S.C.

    1002(32)); (2) a church plan (as defined in Section 3(33) of ERISA

    (29 U.S.C. 1002(33)) with respect to which no election has been made

    to be subject to ERISA under 26 U.S.C. 410(d); (3) plans maintained

    solely to comply with workmen's compensation, unemployment

    compensation, or disability insurance laws; (4) plans maintained

    outside the United States primarily for the benefit of persons

    substantially all of whom are nonresident aliens (i.e., foreign

    pension plans); or (5) excess benefit plans (as defined in Section

    3(36) of ERISA (29 U.S.C. 1002(36)) that are unfunded.

    ---------------------------------------------------------------------------

    To resolve this ambiguity, the Commission is refining the

    definition of ``any employee benefit plan defined in section 3 of

    [ERISA]'' in proposed Sec. 23.401 as ``any employee benefit plan

    subject to Title I of [ERISA]'' (renumbered as Sec. 23.401(c)(3)).

    This clarifies that employee benefit plans listed in Section 4(b) of

    ERISA (29 U.S.C. 1003(b)) are not Special Entities within the meaning

    of 4s(h)(2)(C)(iii) or Sec. 23.401(c)(3). However, any employee

    benefit plan that is a governmental plan as defined in Section 3 of

    ERISA is a Special Entity within the meaning of Section 4s(h)(2)(C)(iv)

    and Sec. 23.401(c)(4).

    This refinement of the definition of ``employee benefit plan,''

    however, also excludes other types of employee benefit plans described

    in Section 4(b) of ERISA, including church plans and public and private

    foreign pension plans. In response to commenters who support providing

    protections broadly, including those commenters who assert that ``a

    church plan should be treated as a Special Entity,'' \581\ the

    Commission has determined to add a sixth prong to the Special Entity

    definition. Under the new prong in Sec. 23.401(c)(6), any employee

    benefit plan defined in Section 3 of ERISA, not otherwise defined as a

    Special Entity, may elect to be defined as a Special Entity by

    notifying its swap dealer or major swap participant of its election

    prior to entering into a swap with the particular swap dealer or major

    swap participant.\582\ Therefore, for example, under Sec.

    23.401(c)(6), any church plan defined in Section 3(33) of ERISA,

    including any plan described in Section 3(33)(C)(i), such as a church

    benefit board, could elect to be defined as a Special Entity.

    ---------------------------------------------------------------------------

    \581\ Church Alliance Feb. 22 Letter, at 4.

    \582\ This construction is similar to that of Section 4(b)(2) of

    ERISA, which excludes church plans unless the church plan has

    elected to be subject to ERISA. (29 U.S.C. 1003(b)(2)).

    ---------------------------------------------------------------------------

    The Commission has also considered the comments regarding the

    treatment of a master trust where the master trust holds the assets of

    more than one ERISA plan, as defined in Sec. 23.401(c)(3), sponsored

    by a single employer or by a group of employers under common

    control.\583\ In this regard, the Commission clarifies that it would

    not find a swap dealer or major swap participant to have failed to

    comply with the requirements of subpart H of part 23 of the

    Commission's Regulations with respect to an ERISA plan, if it otherwise

    complied with such requirements with respect to a master trust that

    holds the assets of such ERISA plan. The Commission understands that a

    single employer or a group of employers under common control may

    sponsor multiple ERISA plans that are combined into a master trust to

    achieve economies of scale and other efficiencies. In such cases, the

    Commission does not believe that any individual ERISA plan within the

    master trust would receive any additional protection if the swap dealer

    or major swap participant had to separately comply with requirements of

    subpart H of part 23 with respect to each ERISA plan whose assets are

    held in the master trust.

    ---------------------------------------------------------------------------

    \583\ See generally Section 403(a) of ERISA (in general,

    ``assets of an employee benefit plan shall be held in trust by one

    or more trustees'') (29 U.S.C. 1103(a)); see also DOL Regulation 29

    CFR 2520.103-1(e) (requiring the plan administrator of a Plan which

    participates in a master trust to file an annual report on IRS Form

    5500 in accordance with the instructions for the form relating to

    master trusts); see also IRS Form 5500 Instructions, at 9 (``For

    reporting purposes, a `master trust' is a trust * * * in which the

    assets of more than one plan sponsored by a single employer or by a

    group of employers under common control are held.'').

    ---------------------------------------------------------------------------

    d. Endowment

    The Commission agrees with commenters that the Special Entity prong

    with respect to endowments is limited to the endowment itself.

    Therefore, the endowment prong of the Special Entity definition under

    Section 4s(h)(2)(C)(v) and Sec. 23.401(c)(5) applies with respect to

    an endowment that is the counterparty to a swap with respect to its

    investment funds. The definition would not extend to counterparties

    that are charitable organizations generally. Additionally, where a

    charitable organization enters into a swap as a counterparty, the

    Special Entity definition would not apply where the organization's

    endowment is contractually or otherwise legally obligated to make

    payments on the swap. The Commission believes that this determination

    is consistent with a plain reading of the statute and is consistent

    with the Commission's determination regarding Special Entities and

    collective investment vehicles. Finally, the statute does not

    distinguish between foreign and domestic counterparties in Section

    4s(h). Therefore, the Commission has determined that prong (v) of

    Section 4s(h)(2)(C) and Sec. 23.401(c)(5) will apply to any endowment,

    whether foreign or domestic.

    e. Collective Investment Vehicles: The ``Look Through'' Issue

    The Commission has determined as a matter of statutory

    interpretation of Section 4s(h) that the definition of Special Entity

    does not include collective investment vehicles that have Special

    Entity participants. While DOL rules ``look through'' collective

    investment vehicles to determine

    [[Page 9777]]

    whether the managers and advisors of those vehicles that received plan

    assets should be subject to ERISA's fiduciary rules, there is no

    indication that Congress intended the Commission to ``look through''

    collective investment vehicles to apply the Dodd-Frank Act Special

    Entity protections.\584\ Given that the statutory definition of Special

    Entity does not mention collective investment vehicles, the Commission

    is not convinced that extending the Dodd-Frank Act definition of

    Special Entities to collective investment vehicles based on a DOL-type

    look through test is appropriate or necessary.\585\

    ---------------------------------------------------------------------------

    \584\ However, nothing in the Dodd-Frank Act or the business

    conduct standards rules would affect the application of the ERISA

    look-through requirements.

    \585\ The Commission clarifies, however, that this analysis is

    not intended to apply with respect to a master trust that holds the

    assets of more than one ERISA plan, as defined in Sec.

    23.401(c)(3), which includes a master trust in which the assets of

    more than one plan sponsored by a single employer or by a group of

    employers under common control are held. This determination is based

    on the language of Section 4s(h) of the CEA and ERISA's treatment of

    master trusts as subject to regulation under ERISA, and is

    consistent with the unanimous position of the comments received.

    Thus, the Commission would consider such a master trust to be a

    Special Entity within the meaning of Sec. 23.401(c)(3).

    ---------------------------------------------------------------------------

    Moreover, collective investment vehicles that trade swaps, known as

    commodity pools,\586\ generally are operated by CPOs and traded by

    CTAs, which some courts have held owe a fiduciary duty to the pool and

    pool participants.\587\ Therefore, treating collective investment

    vehicles as Special Entities if they receive investment funds from

    Special Entities would not materially enhance the protections afforded

    to such pool participants, but likely would create administrative

    burdens for swap dealers and major swap participants seeking to

    determine those pool participants' Special Entity status.

    ---------------------------------------------------------------------------

    \586\ Section 1a(10) of the CEA (7 U.S.C. 1a(10)).

    \587\ See, e.g., Commodity Trend Serv., Inc. v. CFTC, 233 F.3d

    981 (7th Cir. 2000); Savage v. CFTC, 548 F.2d 192 (7th Cir. 1977).

    ---------------------------------------------------------------------------

    B. Section 23.440--Requirements for Swap Dealers Acting as Advisors to

    Special Entities

    1. Proposed Sec. 23.440

    Proposed Sec. 23.440 follows the statutory framework in Section

    4s(h)(4)(B) of the CEA, which imposes a duty on any swap dealer that

    ``acts as an advisor to a Special Entity'' to ``act in the best

    interests of the Special Entity.'' Section 4s(h)(4)(C) also requires

    any swap dealer that ``acts as an advisor to a Special Entity'' to

    ``make reasonable efforts to obtain such information as is necessary to

    make a reasonable determination that any swap recommended by the swap

    dealer is in the best interests of the Special Entity * * *.'' The

    terms ``act as an advisor to a Special Entity,'' ``best interests,''

    ``make reasonable efforts'' and ``recommended'' are not defined in the

    statute.

    Proposed Sec. 23.440(a) defined the term ``acts as an advisor to a

    Special Entity'' and stated the term ``shall include where a swap

    dealer recommends a swap or trading strategy that involves the use of

    swaps to a Special Entity.'' \588\ Under proposed Sec. 23.440(a)(1)-

    (2), the term does not include where a swap dealer provides (1)

    information to a Special Entity that is general transaction, financial

    or market information, or (2) swap terms in response to a competitive

    bid request from a Special Entity.\589\ The Commission also discussed

    the meaning of the term ``recommendation'' in the preamble to proposed

    Sec. 23.434--Recommendations to counterparties--institutional

    suitability.\590\

    ---------------------------------------------------------------------------

    \588\ Proposing release, 75 FR at 80650 and 80659.

    \589\ The exclusions in proposed Sec. 23.440(a)(1)-(2) for

    general transaction, financial or market information and swap terms

    in response to a competitive bid request are consistent with the

    exclusions in proposed Sec. 23.434(c)(2)-Recommendations to

    counterparties-institutional suitability. Proposing release, 75 FR

    at 80647-48 and 80659.

    \590\ In the proposing release, the Commission stated that

    whether a recommendation has been made depends on the facts and

    circumstances of the particular case, and includes any communication

    by which a swap dealer provides information to a counterparty about

    a particular swap or trading strategy that is tailored to the needs

    or characteristics of the counterparty, but would not include

    information that is general transaction, financial, or market

    information, swap terms in response to a competitive bid request

    from the counterparty. Proposing release, 75 FR at 80647. See id. at

    80647 and fn. 81 (citing SRO guidance--NASD Notice to Members 01-23

    (April 2001)--interpreting the meaning of the term

    ``recommendation'' in the context of a securities suitability

    obligation). See Sections III.G. and IV.B. of this adopting release

    for a discussion of final Sec. Sec. 23.434 and 23.440,

    respectively, and Appendix A to subpart H of part 23 for

    clarification of the term ``recommendation.''

    ---------------------------------------------------------------------------

    Proposed Sec. 23.440(b)(1) restated the statutory duty to ``act in

    the best interests'' but did not define the term ``best interests.''

    \591\ The proposing release clarified that the meaning of the term

    would be informed by ``established principles in case law under the CEA

    with respect to the duties of advisors, which will inform the meaning

    of the term on a case-by-case basis.'' The ``best interests''

    principles, in the context of a recommended swap or swap trading

    strategy, would impose affirmative duties to act in good faith and make

    full and fair disclosure of all material facts and conflicts of

    interest * * *.'' \592\ The proposing release also stated that best

    interests principles would impose affirmative duties ``to employ

    reasonable care that any recommendation made to a Special Entity is

    designed to further the purposes of the Special Entity.''\593\

    ---------------------------------------------------------------------------

    \591\ Proposing release, 75 FR at 80650 and 80659.

    \592\ Id., at 80650 fn. 98 (citing similar language in SEC v.

    Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-94 (1963)).

    \593\ Id.

    ---------------------------------------------------------------------------

    The proposing release explained that the statutory language in

    Sections 4s(h)(4) and (5) and congressional intent guided the proposal.

    The proposal would permit a swap dealer to both recommend a swap to a

    Special Entity, prompting the duty to act in the best interests, and

    then enter into the same swap with the Special Entity as a counterparty

    if the Special Entity had a representative independent of the swap

    dealer on which it could rely.\594\ Finally, the proposing release

    stated that Sections 4s(h)(4) and (5) of the CEA and proposed rules

    Sec. Sec. 23.440 and 23.450, together, were ``intended to allow

    existing business relationships to continue, albeit subject to the new,

    higher statutory standards of care.'' \595\

    ---------------------------------------------------------------------------

    \594\ Id., at 80650 fn. 99 (citing 156 Cong. Rec. S5923 (daily

    ed. Jul. 15, 2010) (statement of Sen. Lincoln)).

    \595\ Id., at 80650.

    ---------------------------------------------------------------------------

    The proposed rule restated the duty in Section 4s(h)(4)(C) that

    ``any swap dealer that acts as an advisor to a Special Entity shall

    make reasonable efforts to obtain such information as is necessary to

    make a reasonable determination that any swap recommended by the swap

    dealer is in the best interests of the Special Entity.'' \596\ The

    statute also states that ``such information'' includes information

    relating to (1) the financial status, (2) the tax status, and (3) the

    investment or financing objectives of the Special Entity.\597\ The

    statute also grants the Commission discretionary authority to prescribe

    additional types of information to satisfy the ``reasonable efforts''

    and ``best interests'' standards.\598\ As a result, the Commission

    proposed that the swap dealer also be required to make reasonable

    efforts to obtain the following information: (1) The authority of the

    Special Entity to enter into a swap; (2) the experience of the Special

    Entity with respect to entering into swaps; (3) whether the Special

    Entity has a representative as provided in

    [[Page 9778]]

    proposed Sec. 23.450(b); (4) whether the Special Entity has the

    financial capability to withstand potential market-related changes in

    the value of the swap; and (5) such other information as is relevant to

    the particular facts and circumstances of the Special Entity.\599\

    ---------------------------------------------------------------------------

    \596\ Proposed Sec. 23.440(b)(2); proposing release, 75 FR at

    80659-60.

    \597\ Section 4s(h)(4)(C)(i)-(iii) of the CEA.

    \598\ Section 4s(h)(4)(C)(iv) of the CEA.

    \599\ Proposing release, 75 FR at 80650.

    ---------------------------------------------------------------------------

    Proposed Sec. 23.440(c) allowed a swap dealer to rely on the

    Special Entity's written representations to satisfy its duty to ``make

    reasonable efforts to obtain information'' under proposed Sec.

    23.440(b). The proposed rule required a swap dealer to have a

    reasonable basis to believe that the representations are reliable

    taking into consideration the facts and circumstances of a particular

    swap dealer-Special Entity relationship, assessed in the context of a

    particular transaction.\600\ The representations had to be sufficiently

    detailed.\601\

    ---------------------------------------------------------------------------

    \600\ Id., at 80660.

    \601\ See proposed Sec. 23.440(c)(2) requiring representations

    to be sufficiently detailed for the swap dealer to reasonably

    conclude that the Special Entity is (1) capable of evaluating

    independently the material risk inherent in the recommendation, (2)

    exercising independent judgment in evaluating the recommendation,

    and (3) capable of absorbing potential losses related to the

    recommended swap. Proposing release, 75 FR at 80660. The criteria in

    paragraph (c)(2) parallel and were modeled on the three criteria in

    Sec. 23.434(b)(1)--Recommendations to counterparties--institutional

    suitability. Id., at 80659.

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received a significant number of comments regarding

    proposed Sec. 23.440. The commenters raised a range of issues,

    including: What types of activities should fall within the scope of the

    rule; the definitions of the terms ``act as an advisor to a Special

    Entity'' and ``best interests''; whether Special Entities should be

    allowed to opt out of the protections; safe harbors for compliance;

    intersections with the CTA, ERISA fiduciary, investment adviser, and

    municipal advisor statutory and regulatory provisions; and the

    potential costs and benefits to swap dealers and Special Entities. The

    Commission also received late-filed comments comparing its proposed

    approach with the SEC's proposed approach to ``acts as an advisor to a

    Special Entity'' for SBS Dealers.

    A few commenters supported the Commission's proposed interpretation

    of Section 4s(h)(4)(B)-(C) and proposed Sec. 23.440.\602\ The

    overwhelming majority of commenters, however, raised concerns with the

    proposed rule and requested that the Commission further clarify the

    meaning of ``acts as an advisor to a Special Entity.'' \603\

    ---------------------------------------------------------------------------

    \602\ See, e.g., CFA/AFR Feb. 22 Letter, at 15-16; AFSCME Feb.

    22 Letter, at 2-5; CFA/AFR Nov. 3 Letter, at 1.

    \603\ See, e.g., APGA Feb. 22 Letter, at 3-5; APPA/LPPC Feb. 22

    Letter, at 3; CalSTRS Feb. 28 Letter, at 3-5; CEF Feb. 22 Letter, at

    16; GFOA Feb. 22 Letter, at 1-2; HOOPP Feb. 22 Letter, at 2-3;

    NACUBO Feb. 22 Letter, at 2-4; Ropes & Gray Feb. 22 Letter, at 2-3;

    Russell Feb. 18 Letter, at 1; SIFMA/ISDA Feb. 17 Letter, at 31-35;

    ERIC Feb. 22 Letter, at 13-16; SWIB Feb. 22 Letter, at 2-4; Texas

    VLB Feb. 22 Letter, at 1-2; and U. Tex. System Feb. 22 Letter, at 1-

    3.

    ---------------------------------------------------------------------------

    a. Scope of the Proposed ``Acts as an Advisor to a Special Entity'' and

    ``Recommendation'' Definitions

    Commenters generally discussed the following issues: (1)

    Congressional intent regarding the meaning of ``acts as an advisor to a

    Special Entity''; (2) the definition of ``advice'' or

    ``recommendation''; (3) whether activities other than advice or

    recommendations would trigger application of proposed Sec. 23.440; (4)

    whether compliance with other business conduct standards would trigger

    proposed Sec. 23.440; and (5) whether to permit an opt out or create a

    safe harbor for swap dealers dealing with Special Entities that meet

    certain criteria.

    The Commission received several comments discussing whether

    proposed Sec. 23.440 was consistent with congressional intent and

    Section 4s(h)(4). Some commenters stated that ``recommendations'' were

    an appropriate trigger for proposed Sec. 23.440 and consistent with

    congressional intent.\604\ Other commenters stated that proposed Sec.

    23.440 was inconsistent with or went beyond congressional intent.\605\

    One commenter stated that Congress sought to establish a clear, bright

    line between swap dealers that are advisors under Section 4s(h)(4) and

    those that are merely counterparties under Section 4s(h)(5).\606\ Other

    commenters asserted that the proposed rule imposed a fiduciary status

    on swap dealers, a result that Congress expressly rejected in the

    legislative history of the Dodd-Frank Act.\607\

    ---------------------------------------------------------------------------

    \604\ See, e.g., AFSCME Feb. 22 Letter, at 2-3; CFA/AFR Feb. 22

    Letter, at 14-15 and 19 (the goal of the statute was to ensure that

    swap dealers would act in the best interest of more vulnerable

    counterparties when providing advice and making recommendations).

    \605\ See, e.g., VRS Feb. 22 Letter, at 5 (Congress did not

    intend for the Commission to impose duties on a relationship that is

    potentially principal-to-principal); SIFMA/ISDA Feb. 17 Letter, at 4

    (Congress intended parties to a swap to clarify the nature of their

    relationship, and not to transform the nature of their relationship,

    noting the provision in 4s(h)(5)(A)(ii) that requires a swap dealer

    that offers to enter or enters into a swap with a Special Entity to

    disclose its capacity before initiation of the transaction); APPA/

    LPPC Feb. 22 Letter, at 3 (the Dodd-Frank Act does not mandate a

    ``recommendation'' standard for the acts as an advisor provision);

    Ropes & Gray Feb. 22 Letter, at 2 (the statute should be triggered

    when the dealer assumes a status, rather than simply performing a

    single act, and the phrase ``acts as an advisor'' intends a more

    formal relationship than providing advice); CalSTRS Feb. 28 Letter,

    at 4 (impairing Special Entities' access to derivatives markets was

    contrary to congressional intent).

    \606\ SIFMA/ISDA Feb. 17 Letter, at 4 fn. 11.

    \607\ See BlackRock Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22

    Letter, at 6 fn. 16.

    ---------------------------------------------------------------------------

    Several commenters stated that the Commission's description of

    ``recommendation'' in the proposed rule was too broad and would

    inappropriately limit communications between swap dealers and Special

    Entities.\608\ Similarly, some commenters stated that the rule creates

    a very low bar for tripping the ``best interests'' standard and would

    often apply in the normal course of interactions between swap dealers

    and Special Entities.\609\ Commenters asserted that a swap dealer that

    prepares a term sheet and recommends a swap for consideration is not

    necessarily providing advice as to whether or not to enter into the

    transaction.\610\ Another commenter asserted that the term

    ``recommends'' has the potential to be vastly expansive and should not

    extend to marketing activities.\611\ A number of commenters asserted

    that the enumerated exclusions from the term ``acts as an advisor to a

    Special Entity'' are too narrow and overlook circumstances that should

    not give rise to an advisory relationship.\612\

    ---------------------------------------------------------------------------

    \608\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 2; SWIB Feb. 22

    Letter, at 2-4; NACUBO Feb. 22 Letter, at 2; U. Tex. System Feb. 22

    Letter, at 1-2.

    \609\ See, e.g., U. Tex. System Feb. 22 Letter, at 2; Russell

    Feb. 18 Letter, at 1; GFOA Feb. 22 Letter, at 1-2; AMG-SIFMA Feb. 22

    Letter, at 3; ERIC Feb. 22 Letter, at 15; ABC/CIEBA Feb. 22 Letter,

    at 7; SIFMA/ISDA Feb. 17 Letter, at 33 (providing specific

    information while negotiating a swap should not constitute advising

    others); cf. CFA/AFR Feb. 22 Letter, at 19-20.

    \610\ SIFMA/ISDA Feb. 17 Letter, at 33; cf. Russell Feb. 18

    Letter, at 1.

    \611\ Ropes & Gray Feb. 22 Letter, at 2-3.

    \612\ See, e.g., AFSCME Feb. 22 Letter, at 3; NACUBO Feb. 22

    Letter, at 2; U. Tex. System Feb. 22 Letter, at 2; Ropes & Gray Feb.

    22 Letter, at 2-3; cf. SWIB Feb. 22 Letter, at 2-3 (the exclusion is

    too narrow because Special Entities do not always issue competitive

    bid requests); Texas VLB Feb. 22 Letter, at 2.

    ---------------------------------------------------------------------------

    Several commenters have stated that the Commission should clearly

    define activities that are recommendations or provide an alternative

    that clearly establishes when a swap dealer acts as an advisor to a

    Special Entity.\613\ Commenters stated the Commission should issue

    guidance to clearly define when a swap dealer will be classified as an

    ``advisor'' to avoid inadvertently

    [[Page 9779]]

    triggering that status.\614\ Other commenters stated that the proposed

    rule uses subjective criteria and is unworkable.\615\

    ---------------------------------------------------------------------------

    \613\ See ERIC Feb. 22 Letter, at 2; CEF Feb. 22 Letter, at 17;

    AGPA Feb. 22 Letter, at 4; Ropes & Gray Feb. 22 Letter, at 3;

    Russell Feb. 18 Letter, at 1.

    \614\ See ERIC Feb. 22 Letter, at 15; CEF Feb. 22 Letter, at 17.

    \615\ See Russell Feb. 18 Letter, at 1; VRS Feb. 22 Letter, at

    5; cf. Ropes & Gray Feb. 22 Letter, at 3 (a bright line test would

    be more appropriate than a facts-and-circumstances approach to a

    rule focused on the existence of a specific relationship).

    ---------------------------------------------------------------------------

    Commenters also suggested that the definition of ``advice'' or

    ``recommendations'' should be limited to communications that are

    individualized or tailored to the recipient. One commenter suggested

    that the ``acts as an advisor to a Special Entity'' definition should

    be limited to individualized advice based on the particular needs of

    the Special Entity.\616\ Another commenter suggested the Commission

    adopt a definition of advice as ``recommendations related to a swap or

    a swap trading strategy that are made to meet the objectives or needs

    of a specific counterparty after taking into account the counterparty's

    specific circumstances.'' \617\ Another commenter stated that the

    definition of ``recommendation'' should turn on whether the swap dealer

    suggested or indicated a particular preferred course of action.\618\

    ---------------------------------------------------------------------------

    \616\ SIFMA/ISDA Feb. 17 Letter, at 31-32.

    \617\ CFA/AFR Feb. 22 Letter, at 19-20; cf. SWIB Feb. 22 Letter,

    at 2-3 (a swap dealer should not be acting as an advisor where it

    provides research and recommendations that are not specifically

    designed for the specific Special Entity).

    \618\ APGA Feb. 22 Letter, at 4 (a ``recommendation'' should

    mean a firm indication by the swap dealer of a particular preferred

    transaction, swap or market strategy).

    ---------------------------------------------------------------------------

    Commenters also proposed alternatives to determining when a swap

    dealer ``acts as an advisor to a Special Entity.'' Some commenters

    requested the Commission specifically exclude certain activities from

    the meaning of ``advice'' or ``recommendation.'' \619\ Commenters also

    suggested the Commission should look to principles of agency to

    determine whether a swap dealer is acting as an advisor.\620\

    ---------------------------------------------------------------------------

    \619\ See CEF Feb. 22 Letter, at 17 (``recommending'' a swap

    should not apply to the negotiation or the marketing of a swap);

    APGA Feb. 22 Letter, at 5 (providing market color and alerting a

    Special Entity to a possible strategy or to new products that are

    being offered, even when based upon knowledge of the Special

    Entity's hedge positions or market strategy, should not constitute

    making a recommendation that causes a swap dealer to be deemed an

    advisor to a Special Entity); SIFMA/ISDA Feb. 17 Letter, at 33-34.

    \620\ See CEF Feb. 22 Letter, at 16; Ropes & Gray Feb. 22

    Letter, at 2 (providing advice is a narrower category than making a

    mere recommendation; therefore, ``acting as an advisor'' should

    require acknowledged agency, in which the Special Entity places

    trust, confidence, or reliance on the swap dealer); but cf. AFSCME

    Feb. 22 Letter, at 3 (many non-swap dealer market participants often

    assume that the swap dealer is a trusted advisor and is accountable

    for its advice).

    ---------------------------------------------------------------------------

    Commenters asserted that broad application of the term

    ``recommends'' in proposed Sec. 23.440, which imposes a best interests

    duty on a swap dealer, will chill normal commercial communications,

    restrict customary commercial interactions, and generally reduce market

    information shared between swap dealers and Special Entities.\621\

    Commenters asserted that swap dealers will decline to propose

    transactions, provide term sheets or transaction-specific information

    tailored to the Special Entity, and will be discouraged from providing

    education, suggestions, or other information with respect to a current

    or potential transaction that is customarily provided in the normal

    course of the business relationship.\622\

    ---------------------------------------------------------------------------

    \621\ See SIFMA/ISDA Feb. 17 Letter, at 22; APGA Feb. 22 Letter,

    at 3; APPA/LPPC Feb. 22 Letter, at 3; NACUBO Feb. 22 Letter, at 2;

    COPE Feb. 22 Letter, at 2; U. Tex. System Feb. 22 Letter, at 2; VRS

    Feb. 22 Letter, at 5; Ohio STRS Feb. 18 Letter, at 2-3; MHFA Feb. 22

    Letter, at 2; Russell Feb. 18 Letter, at 1; BlackRock Feb. 22

    Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3.

    \622\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 6 and 33; VRS

    Feb. 22 Letter, at 5; U. Tex. System Feb. 22 Letter, at 2; MHFA Feb.

    22 Letter, at 2; Russell Feb. 18 Letter, at 1; APPA/LPPC Feb. 22

    Letter, at 3; Ohio STRS Feb. 18 Letter, at 2-3; BlackRock Feb. 22

    Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3; Texas VLB Feb. 22

    Letter, at 1; NACUBO Feb. 22 Letter, at 2; AMG-SIFMA Feb. 22 Letter,

    at 3.

    ---------------------------------------------------------------------------

    Commenters asserted that swap dealers provide valuable information,

    but the broad application of the term ``recommends'' will preclude

    Special Entities from receiving this information. One commenter

    asserted that such communications serve an important informational

    function; even where the prospective counterparty's last inclination

    would be to follow guidance from the swap dealer, such communications

    can indicate where the dealer might be willing to execute before

    negotiation and the types of trades that are being circulated in the

    marketplace.\623\ Other commenters added that swap dealers provide

    valuable information that could not easily be obtained elsewhere, and

    informal and course-of-business communications where market ideas and

    structures are presented and discussed is invaluable.\624\ Other

    commenters asserted that the broad application of the term

    ``recommends'' will make compliance burdensome for swap dealers and

    will increase costs.\625\ Commenters requested the Commission clarify

    whether activities or conduct other than making a recommendation would

    cause a swap dealer to ``act as an advisor to a Special Entity'' within

    the meaning of Sec. 23.440, because language in the proposing release

    was ambiguous.\626\ Several commenters raised concerns that compliance

    with other business conduct rules could cause a swap dealer to act as

    an advisor. Commenters identified the following examples: Providing

    tailored disclosures, scenario analyses, daily marks, assessing the

    qualifications of a Special Entity's independent representative, the

    general provisions of proposed Sec. 23.402, and verification of

    counterparty eligibility.\627\

    ---------------------------------------------------------------------------

    \623\ Ropes & Gray Feb. 22 Letter, at 3.

    \624\ U. Tex. System Feb. 22 Letter, at 2; APPA/LPPC Feb. 22

    Letter, at 3, APGA Feb. 22 Letter, at 4; SWIB Feb. 22 Letter, at 3;

    Texas VLB Feb. 22 Letter, at 3; SFG Feb. 22 Letter, at 3; MHFA Feb.

    22 Letter, at 3; ERIC Feb. 22 Letter, at 15.

    \625\ COPE Feb. 22 Letter, at 2-3 (swap dealers may be forced to

    require personnel to read from an approved script to avoid

    violations; such compliance will require more compliance personnel

    and raise swap dealer costs); Ropes & Gray Feb. 22 Letter, at 3

    (compliance with the proposed rule would require the swap dealer to

    make difficult distinctions between general information and specific

    trade data).

    \626\ CalSTRS Feb. 28 Letter, at 3 and 5; ERIC Feb. 22 Letter,

    at 3, 14 and 16; see proposing release, 75 FR at 80650 (``The

    proposed definition does not address what it means to act as an

    advisor in connection with any other dealings between a swap dealer

    and a Special Entity.'').

    \627\ See SIFMA/ISDA Feb. 17 Letter, at 4 and 32; AFSCME Feb. 22

    Letter, at 3; NACUBO Feb. 22 Letter, at 3; U. Tex. System Feb. 22

    Letter, at 2-3; SWIB Feb. 22 Letter, at 3; CalPERS Feb. 18 Letter,

    at 3 fn. 4; BlackRock Feb. 22 Letter, at 6; ERIC Feb. 22 Letter, at

    15-16; ABC/CIEBA Feb. 22 Letter, at 7.

    ---------------------------------------------------------------------------

    Several commenters discussed whether the Commission should permit

    the intention of the parties, rather than a functional test, to

    determine whether a swap dealer ``acts as an advisor to a Special

    Entity.'' \628\ One commenter asserted that it would be impossible

    under the proposed rules for a swap dealer to confirm to a Special

    Entity counterparty that it was acting only as a counterparty and not

    acting as an advisor.\629\ Several commenters supported an approach to

    permit the Special Entity and swap dealer to agree that the swap dealer

    is not acting as an advisor, and, therefore, not subject to proposed

    Sec. 23.440.\630\ Another

    [[Page 9780]]

    commenter stated that permitting the swap dealer and Special Entity to

    determine whether the swap dealer ``acts as an advisor to the Special

    Entity'' is consistent with the business conduct standards requirement

    for a swap dealer to ``disclose to the Special Entity in writing the

    capacity in which the swap dealer is acting.'' \631\ By contrast,

    however, one commenter opposed an approach that would permit a swap

    dealer to avoid any obligation for giving advice where it discloses

    that it is not impartial and has an interest in the transaction being

    recommended.\632\

    ---------------------------------------------------------------------------

    \628\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 5; Ropes & Gray

    Feb. 22 Letter, at 2; NACUBO Feb. 22 Letter, at 2-3; U. Tex. System

    Feb. 22 Letter, at 2 and 3; CEF Feb. 22 Letter, at 16; VRS Feb. 22

    Letter, at 5; CalSTRS Feb. 28 Letter, at 3; MHFA Feb. 22 Letter, at

    2; Russell Feb. 18 Letter, at 1; ERIC Feb. 22 Letter, at 2; ABC/

    CIEBA Feb. 22 Letter, at 7; ABA/ABC Feb. 22 Letter, at 2; Davis &

    Harman Mar. 25 Letter, at 4; Rep. Smith July 25 Letter, at 2.

    \629\ SIFMA/ISDA Feb. 17 Letter, at 5.

    \630\ See Ropes & Gray Feb. 22 Letter, at 2; NACUBO Feb. 22

    Letter, at 2-3; CEF Feb. 22 Letter, at 16; VRS Feb. 22 Letter, at 5;

    CalSTRS Feb. 28 Letter, at 3; MHFA Feb. 22 Letter, at 2; Russell

    Feb. 18 Letter, at 1; ERIC Feb. 22 Letter, at 2; ABC/CIEBA Feb. 22

    Letter, at 7; ABA/ABC Feb. 22 Letter, at 2; Davis & Harman Mar. 25

    Letter, at 4; Rep. Smith July 25 Letter, at 2; cf. U. Tex. System

    Feb. 22 Letter, at 2-3 (a swap dealer should not be an advisor if

    (1) any swap dealer communications that would otherwise be deemed a

    recommendation were only made in response to the Special Entity's

    solicitation for information, and (2) the Special Entity certifies

    to the swap dealer that an advisory relationship does not arise).

    \631\ VRS Feb. 22 Letter, at 5; see Section 4s(h)(5)(A)(ii) of

    the CEA; proposing release, proposed Sec. 23.450(f), 75 FR at

    80661.

    \632\ AFSCME Feb. 22 Letter, at 4.

    ---------------------------------------------------------------------------

    Many commenters suggested that the Commission consider whether the

    Special Entity relied or depended on the swap dealer's advice or

    recommendations to determine whether a swap dealer ``acts as an advisor

    to a Special Entity.'' \633\ Commenters suggested a swap dealer should

    be deemed to ``act as an advisor to a Special Entity'' only where the

    advice will serve as a primary basis for the Special Entity's decision

    to take or refrain from taking a particular action.\634\ One commenter

    asserted that ``[i]mposing a `best interests' duty based only on

    recommendations in the context of particular transactions would

    effectively overturn * * * longstanding [Commission] precedent.'' \635\

    ---------------------------------------------------------------------------

    \633\ Ropes & Gray Feb. 22 Letter, at 2 (the definition of

    ``acts as an advisor'' should require acknowledged agency in which

    the Special Entity places trust, confidence, or reliance on the swap

    dealer); SIFMA/ISDA Feb. 17 Letter, at 31-32 fn. 76; APGA Feb. 22

    Letter, at 4; ATA Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at

    3; ERIC Feb. 22 Letter, at 16.

    \634\ SIFMA/ISDA Feb. 17 Letter, at 31-32; APGA Feb. 22 Letter,

    at 4; ATA Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter, at 3; cf.

    DOL's current fiduciary regulation, which deems a person that

    renders investment advice to an ERISA plan a ``fiduciary'' where

    ``the advice will serve as a primary basis for investment decisions

    with respect to plan assets.'' 29 CFR 2510.3-21(c); supra fn. 34.

    \635\ SIFMA/ISDA Feb. 17 Letter, at 32 fn. 76 (asserting that

    Commission precedent recognized ``the nature of the overall

    relationship between the customer and advisor--and the customer's

    dependence on the advisor--that gives rise to a fiduciary

    relationship'') citing In re Jack Savage, [1975-1977 Transfer

    Binder] Comm. Fut. L. Rep. (CCH) ] 20,139 (CFTC Mar. 1, 1976).

    ---------------------------------------------------------------------------

    Commenters suggested that the Commission permit Special Entities of

    a certain size or sophistication be exempted or permitted to opt out of

    the protections under Section 4s(h)(4)(B)-(C) and proposed Sec.

    23.440. Commenters suggested that Special Entities be permitted to

    represent to a swap dealer that an advisory relationship is not

    intended if the Special Entity meets a minimum threshold of assets

    under management, net financial assets, debt outstanding, or frequency

    of executing swaps.\636\ Commenters also asserted that the business

    conduct standards protections generally, and proposed Sec. 23.440 in

    particular, do not provide any benefit to sophisticated Special

    Entities.\637\ Additionally, one commenter suggested that the final

    rule should provide that a swap dealer is never an advisor to an ERISA

    plan.\638\

    ---------------------------------------------------------------------------

    \636\ NACUBO Feb. 22 Letter, at 2-4; U. Tex. System Feb. 22

    Letter, at 3; cf. VRS Feb. 22 Letter, at 4 (the Commission should

    exempt transactions between swap dealers and Special Entities that

    qualify as ``qualified institutional buyers'' as defined in Rule

    144A under the Securities Act); CEF Feb. 22 Letter, at 5; SIFMA/ISDA

    Feb. 17 Letter, at 3 fn. 17. (17 CFR 230.144A). Rule 144A exempts

    from certain federal securities law protections certain entities

    that own and invest on a discretionary basis at least $100 million

    in securities of issuers that are not affiliated with the entity.

    \637\ See, e.g., CEF Feb. 22 Letter, at 16; VRS Feb. 22 Letter,

    at 4.

    \638\ ERIC Feb. 22 Letter, at 2.

    ---------------------------------------------------------------------------

    Many commenters suggested that the Commission create a safe harbor

    for compliance with proposed Sec. 23.440 if the Special Entity is

    separately represented by a qualified independent representative as

    prescribed under Section 4s(h)(5) and proposed Sec. 23.450.\639\

    Several commenters suggested different refinements for such a safe

    harbor, for example, if (1) the communications are in response to the

    advisor's standing solicitation for information, and (2) the advisor

    certifies to the swap dealer that no advisory relationship is

    intended.\640\ Other commenters suggested the safe harbor should apply

    if the Special Entity is represented by a sophisticated, professional

    advisor such as a bank, registered investment adviser, insurance

    company, qualified professional asset manager \641\ (``QPAM''), or in-

    house asset manager \642\ (``INHAM'').\643\ Alternatively, the Special

    Entity's fiduciary could agree to the safe harbor if it is in the

    Special Entity's best interests, for example, where the Special Entity

    has the ability to solicit bids and trade with multiple

    counterparties.\644\

    ---------------------------------------------------------------------------

    \639\ SIFMA/ISDA Feb. 17 Letter, at 31; Ropes & Gray Feb. 22

    Letter, at 2; NACUBO Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at

    16; APPA/LPPC Feb. 22 Letter, at 3; APGA Feb. 22 Letter, at 5; SWIB

    Feb. 22 Letter, at 5; CalPERS Feb. 18 Letter, at 4; CalSTRS Feb. 28

    Letter, at 3; SFG Feb. 22 Letter, at 1; BlackRock Feb. 22 Letter, at

    5; AMG-SIFMA Feb. 22 Letter, at 2 and 5; ERIC Feb. 22 Letter, at 3

    and 15; ABC/CIEBA Feb. 22 Letter, at 7; contra CFA/AFR Nov. 3

    Letter, at 3.

    \640\ NACUBO Feb. 22 Letter, at 4.

    \641\ A qualified professional asset manager is defined in DOL

    prohibited transaction exemption 84-14 as a bank, insurance company,

    or registered investment adviser that meets certain capital, net

    worth, or assets under management tests. DOL QPAM PTE 84-14, 75 FR

    38837.

    \642\ An in-house asset manager is defined in DOL prohibited

    transaction exemption 96-23, 61 FR 15975, Apr. 10, 1996 (``DOL In-

    House Asset Manager PTE 96-23''), as a wholly-owned subsidiary of an

    ERISA plan sponsor that is a registered investment adviser that

    meets certain assets under management tests.

    \643\ SIFMA/ISDA Feb. 17 Letter, at 31; BlackRock Feb. 22

    Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 7.

    \644\ CalSTRS Feb. 28 Letter, at 4.

    ---------------------------------------------------------------------------

    Following the release of SEC's proposed business conduct standards

    for SBS Entities, the Commission received several comment letters

    addressing, among other things, a comparison of SEC's proposed Sec.

    240.15Fh-2(a) and Sec. 240.15Fh-4,\645\ Special Requirements for SBS

    Dealers Acting as Advisors to Special Entities, and the Commission's

    proposed Sec. 23.440,\646\ Requirements for Swap Dealers Acting as

    Advisors to Special Entities.

    ---------------------------------------------------------------------------

    \645\ SEC's proposed rules, 76 FR at 42423-25, 42454, and 42456-

    57.

    \646\ Proposing release, 75 FR at 80650-51 and 80659-60.

    ---------------------------------------------------------------------------

    The Commission's proposed Sec. 23.440(a) and the SEC's proposed

    Sec. 240.15Fh-2(a) both define a swap dealer or SBS Dealer,

    respectively, that recommends a swap, security-based swap or a trading

    strategy that uses a swap or security-based swap to a Special Entity to

    be ``acting as an advisor to a Special Entity.'' Under the Commission's

    proposed Sec. 23.440, a swap dealer that meets the definition of

    ``acts as an advisor to a Special Entity'' then has a duty to act in

    the best interests of the Special Entity. Under the SEC's proposed

    Sec. 240.15h-2(a), a SBS Dealer that recommends a security-based swap

    or trading strategy involving the use of a security-based swap meets

    the definition of ``acts as an advisor to a Special Entity,'' unless

    (1) the Special Entity represents in writing that: (i) It will not rely

    on recommendations provided by the SBS Dealer; and (ii) it will rely on

    advice from a qualified independent representative as defined in Sec.

    240.15Fh-5(a); \647\ (2) the SBS

    [[Page 9781]]

    dealer has a reasonable basis to believe that the Special Entity is

    advised by a qualified independent representative as defined in Sec.

    240.15Fh-5(a); and (3) the SBS Dealer discloses that it is not

    undertaking to act in the best interests of the Special Entity. Under

    the proposal, an SBS Dealer that exchanges the required representations

    with the Special Entity would not have a duty to act in the best

    interests of the Special Entity when making a recommendation.

    ---------------------------------------------------------------------------

    \647\ SEC's proposed rules, 76 FR at 42425-27 and 42457. SEC

    proposed Sec. 240.15Fh-5(a) is the parallel rule to the

    Commission's proposed Sec. 23.450-Requirements for swap dealers and

    major swap participants acting as counterparties to Special

    Entities. Both proposed rules further describe the duty for a swap

    dealer, major swap participant, or SBS Entity to have a reasonable

    basis to believe that a Special Entity has a qualified independent

    representative that meets certain statutory criteria described in

    Section 4s(h)(5) of the CEA or Section 15F(h)(5) of the Exchange

    Act.

    ---------------------------------------------------------------------------

    The Commission received comment letters in support of \648\ and

    against \649\ the SEC approach. The supporters generally asserted that

    the SEC's proposed rules represent workable solutions to some of the

    industry's concerns over the adverse consequences of the Commission's

    proposed rules.\650\ Commenters opposed to the SEC's approach generally

    asserted that it was inconsistent with congressional intent and would

    permit an SBS Entity to provide advice that may not be in the best

    interests of the Special Entity without accountability.\651\ Another

    commenter asserted that the SEC's approach would result in Special

    Entities signing away their right to the ``best interests'' protection

    as a condition of doing business.\652\

    ---------------------------------------------------------------------------

    \648\ See, e.g., FIA/ISDA/SIFMA Aug. 26 Letter, at 4-5;

    BlackRock Aug. 29 Letter, at 2 and 7; ABC Aug. 29 Letter, at 2 and

    6-8.

    \649\ Better Markets Aug. 29 Letter, at 2 and 14-15; CFA/AFR

    Aug. 29 Letter, at 1-2, 9, 13 and 26-29.

    \650\ See, e.g., BlackRock Aug. 29 Letter, at 2.

    \651\ Better Markets Aug. 29 Letter, at 15; see also CFA/AFR

    Aug. 29 Letter, at 26-29.

    \652\ CFA/AFR Aug. 29 Letter, at 26; CFA/AFR Nov. 3 Letter, at

    2.

    ---------------------------------------------------------------------------

    b. Meaning of ``Best Interests''

    Several commenters raised issues concerning the duty to act in the

    best interests of the Special Entity imposed under Section 4s(h)(4) and

    Sec. 23.440. Issues raised by commenters generally include: (1)

    Whether a ``best interests'' duty imposes a fiduciary duty; (2) whether

    imposing a ``best interests'' duty will improperly encourage Special

    Entities to rely on the swap dealer; (3) the meaning of the term ``best

    interests''; (4) whether a ``best interests'' duty also imposes

    specific disclosure obligations; and (5) whether swap dealers will

    continue to transact with Special Entities if they are subject to a

    ``best interests'' duty.

    The Commission sought comment on a number of questions regarding

    proposed Sec. 23.440, including whether swap dealers should be subject

    to an explicit fiduciary duty when acting as an advisor to a Special

    Entity.\653\ Some commenters cited the legislative history to support

    the view that Congress rejected an express fiduciary duty for swap

    dealers entering into a swap with a Special Entity.\654\ A number of

    commenters assert that a ``best interests'' duty creates a fiduciary

    relationship,\655\ or could give rise to fiduciary duties under other

    bodies of law including the common law, state pension laws, the CEA,

    the Advisers Act, and ERISA.\656\ Commenters also asserted that the

    inherent conflicts of interest in a counterparty relationship are

    incompatible with a fiduciary duty.\657\ Similarly, another commenter

    asked the Commission to clarify that complying with Sec. Sec. 23.440

    and 23.450 do not cause a swap dealer to be a fiduciary under any other

    body of law, including the securities laws or common law.\658\

    ---------------------------------------------------------------------------

    \653\ Proposing release, 75 FR at 80651.

    \654\ SIFMA/ISDA Feb. 17 Letter, at 4 (citing a Senate version

    of H.R. 4173); but cf. CFA/AFR Feb. 22 Letter, at 15 (asserting that

    the original Senate version imposed a fiduciary duty on all

    interactions between swap dealers and Special Entities that was

    ultimately an unworkable approach. However, the legislative history

    provides an insight into congressional intent that the ``best

    interests'' standard of care should be broadly applied).

    \655\ Ohio STRS Feb. 18 Letter, at 2; CPPIB Feb. 22 Letter, at

    3; AMG-SIFMA Feb. 22 Letter, at 4 and 6; SIFMA/ISDA Feb. 17 Letter,

    at 6; NACUBO Feb. 22 Letter, at 2; Calhoun Feb. 22 Letter, at 2-3.

    \656\ SIFMA/ISDA Feb. 17 Letter, at 6; CalSTRS Feb. 28 Letter,

    at 3; AMG-SIFMA Feb. 22 Letter, at 4; Comm. Cap. Mkts. May 3 Letter,

    at 3.

    \657\ SIFMA/ISDA Feb. 17 Letter, at 6; CalSTRS Feb. 28 Letter,

    at 4.

    \658\ ERIC Feb. 22 Letter, at 4; cf. BlackRock Feb. 22 Letter,

    at 5 (recommending the Commission should specify that proposed Sec.

    23.440 is not intended to cause a swap dealer to be considered an

    ERISA fiduciary).

    ---------------------------------------------------------------------------

    The Commission also sought comment in the proposing release on

    whether to define ``best interests,'' and if so, what should the

    definition be.\659\ Some commenters stated that the best interests duty

    should be removed from the final rules.\660\ One commenter suggested

    that the Commission revise the ``best interests'' standard to require

    only a duty of fair dealing and not import a fiduciary duty.\661\

    Another commenter asserted that a ``best interests'' standard of care

    is appropriate where a swap dealer provides advice tailored to the

    Special Entity's position; however, the standard would be inappropriate

    if the definition of ``advice'' was not sufficiently narrowed.\662\

    ---------------------------------------------------------------------------

    \659\ Proposing release, 75 FR at 80651.

    \660\ BlackRock Feb. 22 Letter, at 5; Calhoun Feb. 22 Letter, at

    2-3; cf. CalSTRS Feb. 28 Letter, at 3 (asserting that the term

    ``best interests'' is vague).

    \661\ AMG-SIFMA Feb. 22 Letter, at 6.

    \662\ SWIB Feb. 22 Letter, at 3.

    ---------------------------------------------------------------------------

    Other commenters supported the proposed ``best interests'' standard

    and suggested that the Commission should clarify that a ``best

    interests'' duty is a higher standard than a suitability

    obligation.\663\ The commenter also requested that the Commission

    clarify that certain practices should be identified as inherent

    violations of the best interests standard, including (1) designing

    swaps with features that expose the Special Entity to risks that are

    greater than those it intends to hedge, and (2) recommending customized

    swaps when the Special Entity could attain the same results at a lower

    risk-adjusted cost using standardized swaps.\664\

    ---------------------------------------------------------------------------

    \663\ CFA/AFR Feb. 22 Letter, at 15.

    \664\ Id.

    ---------------------------------------------------------------------------

    Other commenters discussed the scope of the duty. A commenter

    asserted, in the context of trading with a municipality, a swap dealer

    that demanded additional collateral could arguably violate its best

    interests duty because obtaining collateral is in the interest of the

    swap dealer and not the municipality.\665\ The commenter also stated

    that the Commission should clarify the scope of the ``best interests''

    standard and ``distinguish advice that is fiduciary in nature from

    advice rendered in the context of soliciting, structuring or executing

    a particular transaction.'' \666\ Conversely, another commenter

    asserted that customization by its very nature implies that the swap

    has been designed with the particular needs of the counterparty in

    mind, and, therefore, there is no benefit to allowing swap dealers to

    avoid regulatory duties when recommending customized swaps.\667\

    ---------------------------------------------------------------------------

    \665\ SIFMA/ISDA Feb. 17 Letter, at 6 fn. 19.

    \666\ SIFMA/ISDA Feb. 17 Letter, at 32 fn. 74 (asserting that

    such a distinction exists in other legal contexts, for example, a

    broker that provides advice on particular occasions does not trigger

    an ongoing duty to advise in the future and monitor all data

    potentially relevant to a customer's investment) (citing de

    Kwiatkowski v. Bears Stearns & Co., Inc., 306 F.3d 1293, 1302 (2d

    Cir. 2003); see id. (asserting that the Advisers Act generally does

    not apply to a person whose only advice consists of advising an

    issuer how to structure its financing) (citing SEC Staff Legal

    Bulletin No. 11 (Sept. 2000) and SEC no-action letter to David A.

    Kekich, The Arkad Company, 1992 WL 75601 (available Mar. 19, 1992)).

    \667\ CFA/AFR Feb. 22 Letter, at 13 (discussing customized swaps

    with respect to a suitability duty).

    ---------------------------------------------------------------------------

    Some commenters raised concerns that the ``best interests'' duty

    will inappropriately encourage a Special Entity to rely on a swap

    dealer. Commenters claim that reliance could create confusion regarding

    the parties' respective responsibilities and could inappropriately

    increase dependence on

    [[Page 9782]]

    the swap dealer and discourage counterparties from conducting their own

    investigations and taking responsibility for their own decisions and

    conduct.\668\ Conversely, other commenters stated that applying the

    ``best interests'' duty to recommendations would strike a reasonable

    balance by limiting the duty to instances in which Special Entities

    relied on the swap dealer and the standard should be scalable depending

    on the degree of reliance.\669\

    ---------------------------------------------------------------------------

    \668\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 2.

    \669\ CFA/AFR Feb. 22 Letter, at 5 and 15; cf. AFSCME Feb. 22

    Letter, at 3 (asserting that non-swap dealers will often assume that

    a swap dealer that represents itself as a ``trusted advisor'' will

    be accountable for the advice it provides).

    ---------------------------------------------------------------------------

    The Commission listed three questions in the proposing release

    requesting comment on whether a ``best interests'' duty should require

    additional specific disclosures regarding (1) conflicts of interest,

    (2) the profit the swap dealer expects to make on swaps it enters into

    with the Special Entity, and (3) any positions the swap dealer holds

    from which it may profit should the swap in question move against the

    Special Entity.\670\ Most commenters discussed material incentives and

    conflicts of interest generally in the context of proposed Sec.

    23.431(a)(3); \671\ however, some commenters discussed the Commission's

    request for comment in the context of a ``best interests'' duty.

    ---------------------------------------------------------------------------

    \670\ Proposing release, 75 FR at 80651.

    \671\ See Section III.D.3.d. of this adopting release for a

    discussion of Sec. 23.431(a)(3).

    ---------------------------------------------------------------------------

    One commenter asserted that a swap dealer should provide conflict

    of interest disclosures that go beyond the issue of compensation and

    third-party payments when dealing with a Special Entity and consider

    the full range of conflicts that may exist that are relevant to a

    particular recommendation.\672\ The commenter also stated that it is

    not necessary to require a swap dealer in all instances to disclose its

    pre-existing positions; however, disclosure should be required if those

    positions create a material conflict of interest.\673\

    ---------------------------------------------------------------------------

    \672\ CFA/AFR Feb. 22 Letter, at 16 (asserting a swap dealer

    must disclose if a swap is designed so that the dealer will profit

    if the transaction fails for the Special Entity); see id. (when

    recommending customized swaps, a swap dealer should be required to

    break out the pricing of the components of the swap, including the

    profit).

    \673\ CFA/AFR Feb. 22 Letter, at 7 (asserting that an example of

    such a material conflict would be where the swap dealer was taking a

    major short position in a type of swap that it was also recommending

    a Special Entity take a long position, therefore the swap dealer

    should be required to disclose that fact and its reasons for

    believing the counter position is nonetheless in the best interests

    of the Special Entity).

    ---------------------------------------------------------------------------

    Some commenters opposed requiring a swap dealer to disclose their

    profit or anticipated profit in connection with a particular swap.\674\

    Commenters also opposed requirements for swap dealers to disclose pre-

    existing positions to any counterparty because swap dealers may choose

    not to enter into swaps with Special Entities if they are required to

    disclose proprietary positions.\675\

    ---------------------------------------------------------------------------

    \674\ SIFMA/ISDA Feb. 17 Letter, at 22 (asserting that such

    disclosure is not required by the statute and is inconsistent with

    congressional intent as Congress rejected such a requirement when

    enacting the Dodd-Frank Act); CEF Feb. 22 Letter, at 21.

    \675\ See SWIB Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter,

    at 14-15 (opposing the disclosure of pre-existing positions because

    it could allow a counterparty to discern confidential information of

    the swap dealer's other clients, the disclosure is potentially

    misleading, the requirement would discourage swap dealers from

    providing liquidity, and compliance would be difficult when

    considering whether disclosure is required for non-standardized

    swaps whose relation to a pre-existing position of a recommended

    swap is a matter of degree).

    ---------------------------------------------------------------------------

    The Commission also requested comment on whether proposed Sec.

    23.440 would preclude swap dealers from continuing their current

    practice of both recommending and entering into swaps with Special

    Entities.\676\ One commenter asserted that Special Entities would

    retain their ability to engage in transactions with swap dealers as

    counterparties.\677\ Conversely, several commenters asserted that a

    duty to act in the ``best interests'' is incompatible with a

    counterparty relationship.\678\ These commenters asserted that there

    are several problems for a swap dealer that both acts as a counterparty

    and is required to act in the best interests of its counterparty in the

    same transaction, including that: (1) The duty of care is fundamentally

    at odds with an arm's length counterparty relationship, (2) it would

    result in an unresolvable conflict, and (3) the parties' interests are

    by definition adverse.\679\

    ---------------------------------------------------------------------------

    \676\ Proposing release, 75 FR at 80651.

    \677\ CFA/AFR Feb. 22 Letter, at 17; CFA/AFR Nov. 3 Letter, at

    3.

    \678\ SWIB Feb. 22 Letter, at 4; GFOA Feb. 22 Letter, at 2;

    Calhoun Feb. 22 Letter, at 2; ABC/CIEBA Feb. 22 Letter, at 7; ABA/

    ABC Feb. 22 Letter, at 2.

    \679\ SWIB Feb. 22 Letter, at 4; GFOA Feb. 22 Letter, at 2; ABC/

    CIEBA Feb. 22 Letter, at 7; contra CFA/AFR Nov. 3 Letter, at 3.

    ---------------------------------------------------------------------------

    Several commenters asserted that a ``best interests'' duty will

    discourage or prevent swap dealers from transacting with Special

    Entities.\680\ Commenters also asserted that a duty to act in the

    ``best interests'' of a Special Entity will increase burdens,

    compliance costs and liability exposure to swap dealers, and the

    additional costs and risks will be passed on to Special Entities

    through increased pricing.\681\ Thus, several commenters asserted that

    the proposed rules could increase costs for Special Entities, preclude

    them from hedging their risks, and do not provide corresponding

    benefits to Special Entities.\682\

    ---------------------------------------------------------------------------

    \680\ See SIFMA/ISDA Feb. 17 Letter, at 5-6; Ohio STRS Feb. 18

    Letter, at 2; CalSTRS Feb. 28 Letter, at 4; AMG-SIFMA Feb. 22

    Letter, at 4; SWIB Feb. 22 Letter, at 4; CalPERS Feb. 18 Letter, at

    3-4; VRS Feb. 22 Letter, at 3; OTPP Feb. 22 Letter, at 3; GFOA Feb.

    22 Letter, at 2; BlackRock Feb. 22 Letter, at 5; ERIC Feb. 22

    Letter, at 2; ABC/CIEBA Feb. 22 Letter, at 2; Texas VLB Feb. 22

    Letter, at 1; NACUBO Feb. 22 Letter, at 2-3; HOOPP Feb. 22 Letter,

    at 2.

    \681\ See, e.g., CEF Feb. 22 Letter, at 16; CalPERS Feb. 18

    Letter, at 4; Ropes & Gray Feb. 22 Letter, at 2; COPE Feb. 22

    Letter, at 2; VRS Feb. 22 Letter, at 3; BDA Feb. 22 Letter, at 2;

    AMG-SIFMA Feb. 22 Letter, at 4.

    \682\ See CEF Feb. 22 Letter, at 16; APGA Feb. 22 Letter, at 1;

    ETA May 4 Letter, at 8; CalPERS Feb. 18 Letter, at 4; SWIB Feb. 22

    Letter, at 3; VRS Feb. 22 Letter, at 4; CalSTRS Feb. 28 Letter, at 2

    and 4; OTPP Feb. 22 Letter, at 3; ERIC Feb. 22 Letter, at 2.

    ---------------------------------------------------------------------------

    c. Comments on Sec. 23.440(b)(2)--Duty to Make Reasonable Efforts

    The Commission sought comment in the proposing release on whether

    to prescribe additional information that would be relevant to a swap

    dealer's ``reasonable efforts'' and ``best interests'' duties under the

    proposed rule.\683\ One commenter suggested that the Commission should

    clarify whether there is certain information without which the swap

    dealer could not make a recommendation. The commenter also suggested

    that where a swap dealer makes a recommendation based on limited

    information, any disclosures about the limitations should be made to

    the board of the Special Entity and not simply to the investment

    officer.\684\ The commenter agreed that there should be a mechanism to

    allow a Special Entity to discuss various options with a swap dealer

    without divulging confidential information.\685\ The commenter warned,

    however, that an overly broad interpretation of proposed Sec.

    23.440(c) could undercut the protections of the best interests

    duty.\686\

    ---------------------------------------------------------------------------

    \683\ Proposing release, 75 FR at 80651.

    \684\ CFA/AFR Feb. 22 Letter, at 17.

    \685\ Id., at 16.

    \686\ Id. (asserting that some Special Entities may have

    incentives to evade the restrictions of their charters to hide the

    extent to which they are underfunded and, therefore, the Commission

    should ensure that the regulation does not provide a means for

    Special Entities to use swaps to assume unreasonably high investment

    risks to seek higher returns).

    ---------------------------------------------------------------------------

    Another commenter opposed requirements for swap dealers to seek

    extensive information about a Special Entity, including information for

    the swap dealer to reasonably conclude that the Special Entity has the

    financial capability to withstand potential market-related changes in

    the value of

    [[Page 9783]]

    the swap.\687\ The commenter asserted that if the Special Entity had to

    provide financial information as a prerequisite to enter into a swap,

    such a requirement would disadvantage the Special Entity and give swap

    dealers an informational advantage in negotiations.\688\

    ---------------------------------------------------------------------------

    \687\ ABC/CIEBA Feb. 22 Letter, at 7-8.

    \688\ Id.

    ---------------------------------------------------------------------------

    Other commenters asserted that the pre-execution duties to make

    reasonable efforts would require a swap dealer to undertake extensive

    diligence and obtain detailed representations.\689\ One commenter added

    that such requirements would significantly increase costs, delay

    execution, and leave Special Entities to pay more for swaps and expose

    them to extended periods of market risk.\690\ The commenter also

    requested that the Commission permit a swap dealer to rely on

    representations of the Special Entity to meet both its duty to act in

    the best interests and its obligation to make reasonable efforts to

    obtain necessary information.\691\ Other commenters asked the

    Commission to provide greater clarity as to what constitutes ``a

    reasonable basis to believe that the representations are reliable.''

    \692\ The commenters suggest that representations from the Special

    Entity's authorized employee or independent representative should be

    conclusive unless the swap dealer has actual knowledge that such

    representations are untrue.\693\ Other commenters stated that the

    proposing release did not provide estimates of the costs of the

    proposed rule to Special Entities, and that the additional costs and

    burdens do not have corresponding benefits.\694\

    ---------------------------------------------------------------------------

    \689\ SIFMA/ISDA Feb. 17 Letter, at 6-7; Ohio STRS Feb. 18

    Letter, at 2; BlackRock Feb. 22 Letter, at 5-6; ETA May 4 Letter, at

    8.

    \690\ SIFMA/ISDA Feb. 17 Letter, at 6-7 (asserting such

    requirements would reduce or eliminate swap transactions for Special

    Entities if the information gathering is required on a trade-by-

    trade basis).

    \691\ Id., at 35.

    \692\ APPA/LPPC Feb. 22 Letter, at 3; APGA Feb. 22 Letter, at 5.

    \693\ Id.

    \694\ BlackRock Feb. 22 Letter, at 5-6; ETA May 4 Letter, at 8.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.440

    Considering the comments, statutory construction and legislative

    history, the Commission has determined to adopt Sec. 23.440 with

    certain modifications. Final Sec. 23.440(a) defines the term ``acts as

    an advisor to a Special Entity'' to mean ``when the swap dealer

    recommends a swap or trading strategy involving a swap that is tailored

    to the particular needs or characteristics of the Special Entity.''

    Final Sec. 23.440(b) provides two safe harbors from the definition of

    ``acts as an advisor to a Special Entity'' for particular types of

    conduct: (1) Communications between a swap dealer and an ERISA plan

    that has an ERISA fiduciary; \695\ and (2) communications to any

    Special Entity (including a Special Entity that is an ERISA plan) or

    its representative that do 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 particular needs or

    characteristics of the Special Entity.\696\ Qualifying for either safe

    harbor requires an exchange of specified representations in writing by

    the swap dealer and Special Entity.

    ---------------------------------------------------------------------------

    \695\ An ERISA ``fiduciary'' is defined in Section 3(21) of

    ERISA (29 U.S.C. 1002(21)) and DOL Regulations at 29 CFR 2510.3-21.

    \696\ Swap dealers that choose to operate within the safe harbor

    would be permitted to recommend tailored swaps to a Special Entity,

    provided that the swap dealer does not express an opinion as to

    whether the Special Entity should enter into the particular swap or

    swap trading strategy. Therefore, the safe harbor carves out from

    the term ``acts as an advisor to a Special Entity'' recommendations

    that are trade ideas or alternatives, but does not carve out

    subjective opinions as to whether the Special Entity should enter

    into a particular bespoke swap or swap trading strategy.

    ---------------------------------------------------------------------------

    The final rule adopts the statutory ``best interests'' duty for

    swap dealers acting as advisors to Special Entities and ``reasonable

    efforts'' duty for swap dealers to make a determination that any swap

    or swap trading strategy is in the best interests of the Special

    Entity. The final rule allows a swap dealer to rely on the written

    representations of the Special Entity to satisfy its ``reasonable

    efforts'' duty. Such representations can be made on a relationship

    basis in counterparty relationship documentation rather than on a

    transaction basis, where appropriate. This adopting release and

    Appendix A to subpart H provide guidance for compliance with the second

    safe harbor in Sec. 23.440(b)(2).

    a. Acts as an Advisor to a Special Entity

    The Commission has determined that a swap dealer will act as an

    advisor to a Special Entity when it recommends a swap or swap trading

    strategy that is tailored to the particular needs or characteristics of

    the Special Entity. This approach differs from proposed Sec. 23.440 in

    two significant ways. First, the type of recommendation that will

    prompt the ``best interests'' duty in the final rule is limited to

    recommendations of bespoke swaps,\697\ i.e., swaps that are tailored to

    the particular needs or characteristics of the Special Entity.\698\

    ---------------------------------------------------------------------------

    \697\ Unlike Sec. 23.440, the suitability rule Sec. 23.434

    covers recommendations regarding any type of swap or trading

    strategy involving a swap and is not limited to recommendations of

    bespoke swaps.

    \698\ Whether a swap is tailored to the particular needs or

    characteristics of the Special Entity will depend on the particular

    facts and circumstances. Swaps with terms that are tailored or

    customized to a specific Special Entity's needs or objectives, or

    swaps with terms that are designed for a targeted group of Special

    Entities that share common characteristics, e.g., school districts,

    are likely to be viewed as tailored to the particular needs or

    characteristics of the Special Entity. Generally, however, the

    Commission would not view a swap that is ``made available for

    trading'' on a DCM or SEF, as provided in Section 2(h)(8) of the

    CEA, as tailored to the particular needs or characteristics of the

    Special Entity. See Section III.D.3.b. at fn. 394 for a discussion

    of final Sec. 23.431(b)'s requirement to provide scenario analysis

    when requested by the counterparty for any swap not ``made available

    for trading'' on a DCM or SEF; see also Proposed Rules, Trade

    Execution Requirements, 76 FR at 58191; Proposed Rules, Process to

    Make a Swap Available to Trade, 76 FR 77728.

    ---------------------------------------------------------------------------

    Second, in response to commenters' concerns, the Commission

    clarified in the discussion of the institutional suitability rule,

    Sec. 23.434, the types of communications that will be considered

    recommendations.\699\ These two changes clarify the circumstances that

    would cause a swap dealer to act as an advisor to a Special Entity,

    consistent with the statutory framework and considering the

    comments.\700\

    ---------------------------------------------------------------------------

    \699\ The facts and circumstances determination of whether a

    communication is a ``recommendation'' requires an analysis of the

    content, context, and presentation of the particular communication

    or set of communications. The determination of whether a

    ``recommendation'' has been made is an objective rather than a

    subjective inquiry. An important factor in this regard is whether,

    given its content, context, and manner of presentation, a particular

    communication from a swap dealer to a counterparty reasonably would

    be viewed as a ``call to action,'' or suggestion that the

    counterparty enter into a swap. An analysis of the content, context,

    and manner of presentation of a communication requires examination

    of the underlying substantive information transmitted to the

    counterparty and consideration of any other facts and circumstances,

    such as any accompanying explanatory message from the swap dealer.

    Additionally, the more individually tailored the communication to a

    specific counterparty or a targeted group of counterparties about a

    swap, group of swaps or trading strategy involving the use of a

    swap, the greater the likelihood that the communication may be

    viewed as a ``recommendation.'' See Section III.G. of this adopting

    release for a discussion of the suitability obligation under Sec.

    23.434.

    \700\ See, e.g., CFA/AFR Feb. 22 Letter, at 20 (``an appropriate

    definition of advice might be: `recommendations related to a swap or

    a swap trading strategy that are made to meet the objectives or

    needs of a specific counterparty after taking into account the

    counterparty's specific circumstances' ''); CFA/AFR Nov. 3 Letter,

    at 2; SIFMA/ISDA Feb. 17 Letter, at 32 (advice is ``individualized

    based on the particular needs of the Special Entity''); cf. SWIB

    Feb. 22 Letter, at 2-3; see also APGA Feb. 22 Letter, at 4 (``a

    `recommendation' which would trigger the advisor obligations should

    mean a firm indication by the swap dealer of a particular preferred

    transaction, swap, or market strategy''); id. (A presentation

    offering information concerning new products or services or new

    market strategies, without advancing a particular course of action,

    should not be considered advice); SIFMA/ISDA Feb. 17 Letter, at 33

    (``in preparing a term sheet, recommending a swap for consideration

    by a counterparty, and in other similar conduct, [a swap dealer] may

    well not be providing advice as to the advisability of entering into

    the relevant swap transaction'').

    ---------------------------------------------------------------------------

    [[Page 9784]]

    In addition, the Commission has determined to provide two safe

    harbors to the rule--one that will apply only to ERISA plans and

    another that would apply to all Special Entities (including a Special

    Entity that is an ERISA plan). These safe harbors reflect several

    considerations, including comments describing the benefits of a free

    flow of information between a swap dealer and Special Entity, clear

    congressional intent to raise the standard of care for swap dealers

    that transact with Special Entities, and the implications of the ``best

    interests'' duty for swap dealers and Special Entities.

    First, under Sec. 23.440(b)(1), a swap dealer will not be acting

    as an advisor to a Special Entity that is an ERISA plan if: (1) The

    ERISA plan represents in writing that it has an ERISA fiduciary; (2)

    the ERISA fiduciary represents in writing that it will not rely on

    recommendations provided by the swap dealer; and (3) the ERISA plan

    represents in writing that (A) it will comply in good faith with

    written policies and procedures reasonably designed to ensure that any

    recommendation the Special Entity receives from the swap dealer

    materially affecting a swap transaction is evaluated by a fiduciary

    before the transaction occurs, or (B) any recommendation the Special

    Entity receives from the swap dealer materially affecting a swap

    transaction will be evaluated by a fiduciary before that transaction

    occurs. In reaching this determination, the Commission has considered

    the comments, the comprehensive federal regulatory scheme that applies

    to ERISA fiduciaries, and the importance of harmonizing the Dodd-Frank

    Act requirements with ERISA to avoid unintended consequences.\701\

    Therefore, Sec. 23.440(b)(1) both harmonizes the federal regulatory

    regimes and ensures appropriate protections for ERISA plans.

    ---------------------------------------------------------------------------

    \701\ The Commission has considered commenters' suggestions that

    different categories of Special Entities should not be treated

    differently. See, e.g., CalSTRS Feb. 28 Letter, at 2 fn. 1. The

    Commission disagrees. Congress has established a comprehensive

    federal regulatory framework for ERISA plans, but has not done so

    for other Special Entities, which are subject to a wide range of

    state and local laws. Therefore, the Commission believes it is

    appropriate and consistent with congressional intent to harmonize

    regulation under the Dodd-Frank Act and CEA with ERISA requirements.

    Such harmonization avoids unintended consequences while maintaining

    protections for ERISA plans. With respect to other Special Entities,

    the Commission has considered commenters concerns and has provided

    compliance mechanisms under the final rules to address potential

    costs without undermining the benefits Congress intended.

    ---------------------------------------------------------------------------

    Second, under Sec. 23.440(b)(2), a swap dealer will not be

    ``acting as an advisor'' to any Special Entity (including a Special

    Entity that is an ERISA plan) \702\ if: (1) The swap dealer does not

    express an opinion as to whether the Special Entity should enter into a

    recommended swap or swap trading strategy that is tailored to the

    particular needs or characteristics of the Special Entity; (2) the

    Special Entity represents in writing that it will not rely on the swap

    dealer's recommendations and will rely on advice from a qualified

    independent representative within the meaning of Sec. 23.450; and (3)

    the swap dealer discloses that it is not undertaking to act in the best

    interests of the Special Entity. The Commission believes that this will

    provide greater clarity to the respective roles of the parties, and

    because a swap dealer must refrain from making statements or otherwise

    expressing an opinion to meet the safe harbor's requirements, the

    provision also provides meaningful protections to Special Entities.

    ---------------------------------------------------------------------------

    \702\ When dealing with an ERISA plan, a swap dealer may comply

    with either or both safe harbors under Sec. 23.440(b)(1) and

    (b)(2).

    ---------------------------------------------------------------------------

    Appendix A to subpart H provides additional guidance to market

    participants that choose to operate within the safe harbor. If a swap

    dealer complies with the terms of the safe harbor, it can be assured

    that the following types of communications, for example, would not be

    subject to the best interests duty: (1) Providing information that is

    general transaction, financial, educational, or market information; (2)

    offering a swap or trading strategy involving a swap, including swaps

    that are tailored to the needs or characteristics of a Special Entity;

    (3) providing a term sheet, including terms for swaps that are tailored

    to the needs or characteristics of a Special Entity; (4) responding to

    a request for a quote from a Special Entity; (5) providing trading

    ideas for swaps or swap trading strategies, including swaps that are

    tailored to the needs or characteristics of a Special Entity; and (6)

    providing marketing materials upon request or on an unsolicited basis

    about swaps or swap trading strategies, including swaps that are

    tailored to the needs or characteristics of a Special Entity. The list

    is illustrative and not exhaustive. It is intended to provide guidance

    to market participants. The safe harbor in Sec. 23.440(b)(2) allows a

    wide range of communications and interactions between swap dealers and

    Special Entities without invoking the ``best interests'' duty, provided

    that the swap dealer does not express its own subjective opinion to the

    Special Entity or its representative as to whether the Special Entity

    should enter into the swap or trading strategy that is customized or

    tailored to the Special Entity's needs or circumstances and the

    appropriate representations and disclosures are exchanged. The

    Commission notes, however, that depending on the facts and

    circumstances, some of the examples on the list in Appendix A could be

    a ``recommendation'' that would trigger a suitability obligation under

    Sec. 23.434. However, the Commission has determined that such

    activities would not, by themselves, prompt the ``best interests'' duty

    in Sec. 23.440 provided that the parties comply with the other

    requirements of Sec. 23.440(b)(2).

    The safe harbor draws a clear distinction between the activities

    that will and will not cause a swap dealer to be acting as an advisor

    to a Special Entity. Thus, a swap dealer that wishes to avoid engaging

    in activities that trigger a ``best interests'' duty must appropriately

    manage its communications. To clarify the type of communications that

    they will make under the safe harbor, the Commission expects that swap

    dealers may specifically represent that they will not express an

    opinion as to whether the Special Entity should enter into a

    recommended swap or trading strategy, and that for such advice the

    Special Entity should consult its own advisor. Nothing in the final

    rule would preclude such a representation from being included in

    counterparty relationship documentation. However, such a representation

    would not act as a safe harbor under the rule where, contrary to the

    representation, the swap dealer does express an opinion to the Special

    Entity as to whether it should enter into a recommended swap or trading

    strategy.

    The safe harbor permits a swap dealer to engage in a wide variety

    of discussions and communications with a Special Entity about

    individually tailored swaps and trading strategies, including the

    advantages or disadvantages of different swaps or trading strategies,

    without invoking the ``best interests'' duty. All of the swap dealer's

    communications, however, must be made in a fair and balanced manner

    based on principles of fair dealing and good faith in compliance with

    Sec. 23.433. Furthermore, where the communications are

    ``recommendations,'' the swap dealer

    [[Page 9785]]

    must comply with the suitability obligations under Sec. 23.434.

    Some commenters requested that the Commission clarify whether

    activities other than those described in Sec. 23.440 would cause a

    swap dealer to act as an advisor to a Special Entity. The Commission

    has determined that a swap dealer will only ``act as an advisor to a

    Special Entity'' as provided in final Sec. 23.440(a). Similarly, in

    response to commenters, the Commission confirms that compliance with

    the requirements of Section 4s(h) and the Commission's business conduct

    standards rules in subpart H of part 23, will not, by itself, cause a

    swap dealer to ``act as an advisor to a Special Entity'' within the

    meaning of Sec. 23.440.

    b. Commenters' Alternative Approaches

    The Commission considered comments asserting that Sections 4s(h)(4)

    and 4s(h)(5) of the CEA are mutually exclusive provisions and 4s(h)(4)

    should not apply where a swap dealer acts as a counterparty to a

    Special Entity. Similarly, the Commission considered comments

    requesting that the Commission provide a safe harbor to Sec. 23.440

    that would allow a swap dealer to avoid ``acting as an advisor to a

    Special Entity'' where the Special Entity is advised by a qualified

    independent representative. The Commission disagrees with commenters'

    statutory interpretation and declines to provide a safe harbor for all

    communications between a swap dealer and Special Entity provided that

    the Special Entity is advised by a qualified independent

    representative. A plain reading of Section 4s(h) does not provide that

    a swap dealer acting as a counterparty to a Special Entity may avoid

    Section 4s(h)(4)'s provisions.\703\ The Commission also believes that

    it would be inconsistent with the statutory language to allow a swap

    dealer to avoid Section 4s(h)(4)'s requirements when it provides

    subjective advice to a Special Entity, simply because the Special

    Entity has a representative on which it is relying. Such an

    interpretation of the statute would essentially render Section 4s(h)(4)

    a nullity and grant swap dealers unfettered discretion to provide

    subjective advice. Such a result would be inconsistent with

    congressional intent to raise standards for the protection of Special

    Entities.

    ---------------------------------------------------------------------------

    \703\ Legislative history supports that 4s(h)(4) and 4s(h)(5)

    are not mutually exclusive. ``[N]othing in [CEA Section 4s(h)]

    prohibits a swap dealer from entering into transactions with Special

    Entities. Indeed, we believe it will be quite common that swap

    dealers will both provide advice and offer to enter into or enter

    into a swap with a special entity. However, unlike the status quo,

    in this case, the swap dealer would be subject to both the acting as

    advisor and business conduct requirements under subsections (h)(4)

    and (h)(5).'' 156 Cong. Rec. S5923 (daily ed. Jul. 15, 2010)

    (statement of Sen. Lincoln).

    ---------------------------------------------------------------------------

    Many commenters suggested that a swap dealer should only be deemed

    to ``act as an advisor'' based on mutual agreement between the swap

    dealer and Special Entity. The Commission declines to adopt such an

    approach because it would be inconsistent with the statute. Section

    4s(h)(4) is self-effectuating and by its terms does not delegate the

    determination to the parties. The statute establishes an advisor test

    based on conduct-``acting'' as an advisor-not agreement. If the parties

    were permitted to agree that a swap dealer was not acting as an advisor

    subject to a ``best interests'' duty, irrespective of the swap dealer's

    conduct, the rule would essentially immunize swap dealers from

    complying with the obligations imposed by the statute when acting as an

    advisor. A statutory protection would not be meaningful if the default

    position were that protection only applies where the entity regulated

    by the provision, the swap dealer, agrees to be regulated.

    Commenters also suggest that the Commission should look to whether

    the Special Entity relied on the swap dealer's advice or

    recommendations or whether such communications were the primary basis

    for the Special Entity's trading decision to determine whether the swap

    dealer acted as an advisor. The Commission declines to adopt such a

    standard. Final Sec. 23.440 creates an objective test that analyzes

    the swap dealer's communications. Such a standard is appropriate

    considering that the business conduct standards rules regulate the swap

    dealer's conduct. The commenters' suggestion would shift the inquiry

    from an analysis of the swap dealer's conduct to an analysis of whether

    the Special Entity actually relied on the swap dealer.\704\ Such a

    shift would not achieve the purposes of the statue and would create

    uncertainty.

    ---------------------------------------------------------------------------

    \704\ One commenter asserted that Commission precedent

    recognizes that dependence or reliance is necessary to give rise to

    an advisory relationship. SIFMA/ISDA Feb. 17 Letter, at 32 fn. 76

    (citing In re Jack Savage, [1975-1977 Transfer Binder] Comm. Fut. L.

    Rep. (CCH) ] 20,139 (CFTC Mar. 1, 1976)). The Commission disagrees

    that Savage can be applied so broadly. In Savage, the Commission

    denied a newsletter publisher's commodity trading advisor

    registration application. Although the Commission acknowledges in

    Savage that the duties attendant to an advisory relationship exist

    where a customer may rely on a commodity trading advisor's advice,

    reliance is not a required element for the creation of an advisory

    status nor the duties that flow from it. The fact that a customer

    does not rely would have no bearing on a regulatory action. An

    advisory relationship and related duties do not arise by the

    subjective understanding of the customer but by operation of law. A

    person becomes a commodity trading advisor when advising others for

    compensation or profit as to the value or advisability of trading in

    a commodity for future delivery or swap, among others. Once the

    advice is rendered for compensation or profit, regardless of the

    customer's reliance, the advisor owes the duties attendant to such

    advice.

    ---------------------------------------------------------------------------

    Commenters also suggested that the Commission adopt rules that

    permit sophisticated Special Entities to opt out of the protections

    provided in Section 4s(h)(4) and Sec. 23.440. Neither the statute nor

    legislative history distinguishes between sophisticated and

    unsophisticated Special Entities. Congress intended to provide

    heightened protections to Special Entities, and the Commission is not

    convinced that there is an objective proxy for sophistication with

    respect to participants in the swaps markets.\705\ Therefore, the

    Commission has determined not to permit Special Entities to opt out of

    the protections of the statute and the rules. Instead, the Commission

    has adopted clear, objective criteria for a swap dealer to determine

    whether it is acting as an advisor to a Special Entity, subject to a

    ``best interests'' duty, or operating within the safe harbors provided

    in the rule.

    ---------------------------------------------------------------------------

    \705\ See Section III.A.1. of this adopting release for a

    discussion of ``Opt in or Opt out for Certain Classes of

    Counterparties.''

    ---------------------------------------------------------------------------

    Those commenters that advocated an opt out regime, a qualified

    independent representative safe harbor, or to limit application of the

    rule were primarily concerned that a broad application of the

    definition of ``acts as an advisor to a Special Entity'' and that

    potential new costs or liability could chill communications between

    swap dealers and Special Entities, raise hedging costs for Special

    Entities, or reduce the number of swap dealers that would be willing

    counterparties to Special Entities. The Commission believes that the

    final rule appropriately addresses these concerns. Under the final rule

    a swap dealer can appropriately manage its communications to its

    counterparties and can take reasonable steps to avoid ``act[ing] as an

    advisor to a Special Entity.'' Thus, the Commission believes that Sec.

    23.440 is designed appropriately to mitigate costs associated with the

    statutory requirements and the rule. The rule also achieves the

    intended regulatory protections by either (1) limiting the types of

    communications from the swap dealer that could have the greatest

    potential to mislead a Special Entity, or (2) where the swap dealer

    ``acts as an advisor,'' subjecting such communications to the ``best

    interests'' standard of care.

    [[Page 9786]]

    c. Best Interests

    The final rule (renumbered as Sec. 23.440(c)(1)) adopts the

    statutory ``best interests'' duty for swap dealers acting as advisors

    to Special Entities and ``reasonable efforts'' duty for swap dealers

    making a determination that the swap or swap trading strategy is in the

    best interests of the Special Entity. The Commission has determined not

    to define the term ``best interests,'' but rather to provide further

    guidance as to the meaning of the term and the scope of the duty.

    The Commission has considered commenters' views and the legislative

    history \706\ in regard to whether Section 4s(h)(4) imposes a fiduciary

    duty. The Commission has determined that the ``best interests'' duty

    under Section 4s(h)(4) is not a fiduciary duty. Additionally, the

    Commission 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 with respect to any other party.

    ---------------------------------------------------------------------------

    \706\ In the Senate bill, the business conduct standards

    provision stated ``a swap dealer that provides advice regarding, or

    offers to enter into, or enters into a swap with [a Special Entity]

    shall have a fiduciary duty to the [Special Entity].'' Restoring

    American Financial Stability Act of 2010, H.R. 4173, Section 731

    (May 20, 2010) (Public Print version as passed in the Senate of the

    United States May 27 (legislative day, May 26, 2010) (proposed

    amendments to Section 4s(h)(2)(A) and (B) of the CEA), available at

    http://www.gpo.gov). The House and Senate Conference Committee did

    not adopt the fiduciary duty language and instead adopted the

    following: ``Any swap dealer that acts as an advisor to a Special

    Entity shall have a duty to act in the best interests of the Special

    Entity.'' See Section 4s(h)(4)(B) of the CEA.

    ---------------------------------------------------------------------------

    Whether a recommended swap is in the ``best interests'' of the

    Special Entity will turn on the facts and circumstances of the

    particular recommendation and particular Special Entity. However, the

    Commission will consider a swap dealer that ``acts as an advisor to a

    Special Entity'' to have complied with its duty under final Sec.

    23.440(c)(1) where the swap dealer (1) complies with final Sec.

    23.440(c)(2) to make a reasonable effort to obtain necessary

    information, (2) acts in good faith and makes full and fair disclosure

    of all material facts and conflicts of interest with respect to the

    recommended swap,\707\ and (3) employs reasonable care that any

    recommendation made to a Special Entity is designed to further the

    Special Entity's stated objectives.\708\

    ---------------------------------------------------------------------------

    \707\ Where a swap dealer ``acts as an advisor to a Special

    Entity,'' the nature and content of the conflicts of interest

    disclosures will depend on the facts and circumstances of the

    particular swap dealer-Special Entity relationship and the

    recommended swap or trading strategy. See Section III.D. of this

    adopting release for a discussion of Sec. 23.431-Disclosures of

    material information, including whether a swap dealer is required to

    disclose that it is trying to move a particular position off its

    books at Section III.D.3.d.

    \708\ A swap dealer would be expected to evaluate the ``best

    interests'' in accordance with reasonably designed policies and

    procedures and document how it arrived at a ``reasonable

    determination'' that a recommended swap is in the best interests of

    the Special Entity.

    ---------------------------------------------------------------------------

    For a recommendation of a swap to be in the best interests of the

    Special Entity, the swap does not need to be the ``best'' of all

    possible alternatives that might hypothetically exist, but should be

    assessed in comparison to other swaps, such as swaps offered by the

    swap dealer or ``made available for trading'' on a SEF or DCM.\709\ To

    be in the best interests of a Special Entity, the recommended bespoke

    swap would have to further the Special Entity's hedging, investing or

    other stated objectives. Additionally, whether a recommended swap is in

    the best interests of the Special Entity will be analyzed based on

    information known to the swap dealer (after it has employed its

    reasonable efforts required under Section 4s(h)(4)(C) and final Sec.

    23.440(c)(2)) at the time the recommendation is made. The ``best

    interests'' duty does not prohibit a swap dealer from negotiating swap

    terms in its own interests,\710\ nor does it prohibit a swap dealer

    from making a reasonable profit from a recommended transaction.\711\

    Depending on the facts and circumstances, the ``best interests'' duty

    also does not require an ongoing obligation to act in the best

    interests of the Special Entity.\712\ For example, a swap dealer would

    be able to exercise its rights under the terms and conditions of the

    swap when determining whether to make additional collateral calls in

    response to the Special Entity's deteriorating credit rating, whether

    or not such collateral calls would be, from the Special Entity's

    perspective, in the Special Entity's ``best interests.''

    ---------------------------------------------------------------------------

    \709\ See Section IV.B.3.a. at fn. 698 for a discussion of

    Section 2(h)(8) and swaps ``made available for trading'' on a DCM or

    SEF; see also Section III.D.3.b. for a related discussion of swaps

    ``made available for trading'' for scenario analysis disclosures

    under final Sec. 23.431(b) at fn. 394 and accompanying text at fn.

    405.

    \710\ For example, the swap dealer may negotiate appropriate

    provisions relating to collateral calls and termination rights to

    manage its risks related to the swap.

    \711\ Some commenters suggested that a swap dealer that ``acts

    as an advisor to a Special Entity'' should be required to break out

    the pricing components of the swap, including the profit. See, e.g.,

    CFA/AFR Feb. 22 Letter, at 16. The Commission declines to require

    any particular disclosures under this principles based standard.

    Whether such disclosure would be required to comply with the duty to

    act in the best interests of the Special Entity will depend on the

    facts and circumstances of the particular recommended swap or

    trading strategy.

    \712\ However, whenever the swap dealer engages in activity that

    would cause it to be acting as an advisor to the Special Entity, the

    best interests duty would be prompted. For example, if a swap dealer

    acted as an advisor in connection with a material amendment to, or

    termination of, a swap, the ``best interests'' duty would apply.

    ---------------------------------------------------------------------------

    d. Commenters' Alternative ``Best Interests'' Approaches

    The Commission declines some commenters' suggestions that the

    Commission delete the best interests duty or interpret best interests

    to be a fair dealing standard. Such an approach is inconsistent with

    the statute which uses the terms, ``fair dealing'' and ``best

    interests,'' in different provisions, indicating that they impose

    different duties.\713\ Another commenter requested that the Commission

    identify certain practices as inherent violations of the ``best

    interests'' duty including where a swap dealer designs a swap with

    features that expose the Special Entity to risks that are greater than

    those they intend to hedge. In the Commission's view, a swap dealer

    that ``acts as an advisor to a Special Entity'' could not recommend a

    swap or trading strategy that is inconsistent with the Special Entity's

    stated objectives. Where a swap dealer that is acting as an advisor

    concludes that the stated objectives are inconsistent with the Special

    Entity's best interests, the swap dealer would be expected to so inform

    the Special Entity and its independent representative.

    ---------------------------------------------------------------------------

    \713\ Compare Section 4s(h)(3)(C) (``duty for a swap dealer * *

    * to communicate in a fair and balanced manner based on principles

    of fair dealing and good faith'') with Section 4s(h)(4)(B) (``a duty

    to act in the best interests'').

    ---------------------------------------------------------------------------

    The Commission has considered commenters' assertions that a Special

    Entity may be less likely to undertake its own due diligence when

    dealing with a swap dealer that is subject to the ``best interests''

    duty. The Commission, however, believes that final Sec. 23.440

    appropriately clarifies the duties and roles of the parties consistent

    with congressional intent. The Commission also notes that prior to

    entering into any swap with a swap dealer, a Special Entity will have a

    qualified independent representative that will evaluate the swap

    dealer's advice in light of the Special Entity's ``best interests.''

    e. Final Sec. 23.440(c)(2)--Duty to Make Reasonable Efforts

    Consistent with Section 4s(h)(4)(C), proposed Sec. 23.440(b)(2)

    (renumbered as Sec. 23.440(c)(2)) required a swap dealer that ``acts

    as an advisor to a Special Entity'' to make reasonable efforts to

    obtain information necessary to make a reasonable determination that

    any recommended swap or trading strategy

    [[Page 9787]]

    involving a swap is in the best interests of the Special Entity.\714\

    The proposed rule listed eight specific types of information that the

    swap dealer must make reasonable efforts to obtain and consider when

    making a determination that a recommendation is in the best interests

    of the Special Entity.\715\ The Commission has determined to delete two

    of the listed types of information, proposed Sec. 23.440(b)(2)(i)

    \716\ and (vi).\717\ Additionally, the Commission is refining the

    criteria in proposed Sec. 23.440(b)(2)(iv) \718\ and (vii) \719\

    (renumbered as Sec. 23.440(c)(2)(iii) and (v)). These changes are for

    clarification only and do not substantively change the rule.

    ---------------------------------------------------------------------------

    \714\ Proposing release, 75 FR at 80650 and 80659-60.

    \715\ Id., at 80659-60.

    \716\ Under proposed Sec. 23.440(b)(2)(i), a swap dealer would

    have to make reasonable efforts to obtain such information regarding

    ``the authority of the Special Entity to enter into a swap.'' Id.,

    at 80660. The Commission has determined that the regulatory

    objective intended by this provision is already achieved in final

    Sec. 23.402(b)--Know your counterparty.

    \717\ Under proposed Sec. 23.440(b)(2)(vi), a swap dealer would

    have to make reasonable efforts to obtain such information regarding

    ``whether the Special Entity has an independent representative that

    meets the criteria enumerated in [proposed] Sec. 23.450(b).'' Id.,

    at 80660. The Commission has determined that this would be

    duplicative of the requirements in Sec. 23.450.

    \718\ Id., at 80660. The provision as adopted clarifies that a

    Special Entity's objectives in using swaps may be broader than

    investment or financing needs.

    \719\ Id., at 80660. The provision as adopted clarifies that the

    intent of the provision concerns changes in market conditions.

    ---------------------------------------------------------------------------

    The Commission also clarifies how a swap dealer can satisfy its

    best interests duty where a Special Entity does not provide complete

    information with respect to the criteria in final Sec. 23.440(c)(2).

    Commenters have asserted that Special Entities may be reluctant to

    provide complete information to swap dealers about their investment

    portfolio or other information that might be relevant to the

    appropriateness of a particular recommendation. Nothing in the rule is

    intended to disadvantage a Special Entity in its negotiations with a

    swap dealer or require it to disclose proprietary information.

    However, to comply with its ``best interests'' duty where the

    Special Entity does not provide complete information, the swap dealer

    must make clear to the Special Entity that the recommendation is based

    on the limited information known to the swap dealer and that the

    recommendation might be different if the swap dealer had more complete

    information. The Commission has also considered comments suggesting

    that disclosures about a recommendation's limitations should be made to

    the board of the Special Entity and not to the investment officer.\720\

    The Commission agrees that the best practice for a swap dealer that

    ``acts as an advisor to a Special Entity'' within the meaning of Sec.

    23.440(a) would be to ensure that disclosures about the limitations of

    its recommendation are communicated to the governing board or to a

    person or persons occupying a similar status or performing similar

    functions.

    ---------------------------------------------------------------------------

    \720\ See CFA/AFR Feb. 22 Letter, at 17.

    ---------------------------------------------------------------------------

    Furthermore, where a swap dealer's reasonable efforts to obtain

    necessary information results in limited or incomplete information, the

    swap dealer must assess whether it is able to make a reasonable

    determination that a particular recommendation is in the ``best

    interests'' of the Special Entity. For example, a fundamental

    requirement to making a determination that a recommendation is in the

    best interests is to understand the objectives of the Special Entity

    with respect to the swap. If, after the swap dealer makes reasonable

    efforts to obtain information about the Special Entity's objectives,

    the Special Entity does not provide sufficient information to the swap

    dealer, then the swap dealer would be unable to make a determination

    that a recommendation is in the best interests of the Special Entity.

    Therefore, a swap dealer that ``acts as an advisor to a Special

    Entity'' would have to refrain from making a recommendation to the

    Special Entity in such circumstances.

    A commenter asserted that any mechanism to allow a Special Entity

    to avoid divulging confidential information should not be interpreted

    so broadly as to undercut the protections of a best interests duty or

    permit Special Entities to engage in swaps with unreasonably high

    risk.\721\ The Commission has considered the comment and has determined

    that the rule is designed to provide appropriate protections to Special

    Entities.

    ---------------------------------------------------------------------------

    \721\ Id., at 16.

    ---------------------------------------------------------------------------

    f. Final Sec. 23.440(d)--Reasonable Reliance on Representations

    Proposed Sec. 23.440(c) (renumbered as Sec. 23.440(d)) permitted

    a swap dealer to rely on written representations of the Special Entity

    to satisfy its obligation to ``make reasonable efforts'' to obtain

    necessary information. However, the proposed rule listed additional

    criteria that a swap dealer would have to consider to determine that

    the representations were reliable.\722\ The Commission has determined

    to delete from the final rule text the additional criteria that a swap

    dealer would be expected to consider. Commenters found the proposed

    rule text confusing and unworkable.\723\ In light of the comments, the

    Commission has determined to provide additional guidance as to when a

    swap dealer would not be able to rely on written representations.

    ---------------------------------------------------------------------------

    \722\ See proposed Sec. 23.440(c)(1)-(3), proposing release, 75

    FR at 80660 (``(1) The swap dealer has a reasonable basis to believe

    that the representations are reliable taking into consideration the

    facts and circumstances of a particular swap dealer-Special Entity

    relationship, assessed in the context of a particular transaction;

    and (2) The representations include information sufficiently

    detailed for the swap dealer to reasonably conclude that the Special

    Entity is: (i) Capable of evaluating independently the material

    risks inherent in the recommendation; (ii) Exercising independent

    judgment in evaluating the recommendation; and (iii) Capable of

    absorbing potential losses related to the recommended swap; and (3)

    The swap dealer has a reasonable basis to believe that the Special

    Entity has a representative that meets the criteria enumerated in

    Sec. 23.450(b).'').

    \723\ See, e.g., BlackRock Feb. 22 Letter, at 6.

    ---------------------------------------------------------------------------

    A swap dealer would be able to rely on representations unless it

    had information that would cause a reasonable person to question the

    accuracy of the representation.\724\ The Commission declines to adopt

    other commenters' suggestion that a swap dealer or major swap

    participant be permitted to rely on representations unless it had

    actual knowledge that the representations were untrue. The Commission

    has determined that an actual knowledge standard may inappropriately

    encourage the swap dealer to ignore red flags. The Commission also

    confirms that such representations, where appropriate, can be contained

    in counterparty relationship documentation consistent

    [[Page 9788]]

    with Sec. 23.402(d) to avoid transaction-by-transaction

    compliance.\725\

    ---------------------------------------------------------------------------

    \724\ The Commission's determination is consistent with several

    commenters' suggestions. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36

    (``[swap dealers] should be permitted to rely on a written

    representation * * * that the counterparty and/or its representative

    satisfies the standards * * * absent actual notice of countervailing

    facts (or facts that reasonably should have put [a swap dealer] 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.'').

    \725\ As the Commission stated in the proposing release, such

    representations can be included in counterparty relationship

    documentation or other written agreement between the parties and

    that the representations can be deemed applicable or renewed, as

    appropriate, to subsequent swaps between the parties if the

    representations continue to be accurate and relevant with respect to

    the subsequent swaps. Proposing release, 75 FR at 80641-42.

    ---------------------------------------------------------------------------

    C. Section 23.450--Requirements for Swap Dealers and Major Swap

    Participants Acting as Counterparties to Special Entities

    1. Proposed Sec. 23.450

    Proposed Sec. 23.450 followed the statutory language in Section

    4s(h)(5) of the CEA, which requires swap dealers and major swap

    participants \726\ that offer to enter or enter into swaps with Special

    Entities \727\ to comply with any duty established by the Commission

    that they have a reasonable basis to believe that the Special Entity

    has an independent representative that meets certain enumerated

    criteria. The enumerated criteria include that a Special Entity

    representative: (1) Has sufficient knowledge to evaluate the

    transaction and risks; (2) is not subject to a statutory

    disqualification; \728\ (3) is independent of the swap dealer or major

    swap participant; \729\ (4) undertakes a duty to act in the best

    interests of the Special Entity it represents; \730\ (5) makes

    appropriate and timely disclosures to the Special Entity; \731\ (6)

    evaluates, consistent with any guidelines provided by the Special

    Entity, fair pricing and the appropriateness of the swap; \732\ (7) in

    the case of employee benefit plans subject to ERISA, is a fiduciary as

    defined in Section 3 of ERISA (29 U.S.C. 1002); \733\ and (8) in the

    case of a municipal entity as defined in proposed Sec. 23.451, is

    subject to restrictions on certain political contributions imposed by

    the Commission, the SEC or an SRO subject to the jurisdiction of the

    Commission or the SEC.\734\

    ---------------------------------------------------------------------------

    \726\ Although the title of Section 4s(h)(5) refers only to swap

    dealers, the specific requirements in Section 4s(h)(5)(A) are

    imposed on both swap dealers and major swap participants that offer

    to or enter into a swap with a Special Entity. Accordingly, the

    Commission proposed to apply the counterparty requirements to major

    swap participants as well as to swap dealers. Proposing release, 75

    FR at 80651 fn. 104.

    \727\ The Commission interpreted the statute as imposing this

    duty on swap dealers and major swap participants in connection with

    swaps entered into with all categories of Special Entities. The

    statutory language is ambiguous as to whether the duty is intended

    to apply with respect to all types of Special Entity counterparties,

    or just a sub-group. The ambiguities arise, in part, from the

    reference to subclauses (I) and (II) of Section 1a(18)(A)(vii) of

    the CEA, which include certain governmental entities and

    multinational or supranational government entities. Yet,

    multinational and supranational government entities do not fall

    within the definition of Special Entity in Section 4s(h)(2)(C), and

    State agencies, which are defined as Special Entities, are not

    included in Section 1a(18)(A)(vii)(I) and (II) but are included in

    (III). The Commission's interpretation is consistent with

    legislative history. See H.R. Rep. No. 111-517, at 869 (June 29,

    2010) (Conf. Rep.) (``When acting as counterparties to a pension

    fund, endowment fund, or state or local government, dealers are to

    have a reasonable basis to believe that the fund or governmental

    entity has an independent representative advising them.'').

    Proposing release, 75 FR at 80651 fn. 106 and 108.

    \728\ To guide swap dealers and major swap participants, the

    proposed rule defined ``statutory disqualification'' as grounds for

    refusal to register or to revoke, condition or restrict the

    registration of any registrant or applicant for registration as set

    forth in Sections 8a(2) and 8a(3) of the CEA. Proposing release, 75

    FR at 80651.

    \729\ The proposed rule clarified that ``independent'' as it

    relates to a representative of a Special Entity means independent of

    the swap dealer or major swap participant, not independent of the

    Special Entity. Proposing release, 75 FR at 80652 fn. 113 and 115.

    \730\ The Commission did not define ``best interests'' in this

    context, but noted the scope of the duty would be related to the

    nature of the relationship between the independent representative

    and the Special Entity, and established principles in case law would

    inform the meaning of the term on a case-by-case basis. At a

    minimum, the swap dealer or major swap participant would have a

    reasonable basis for believing that the representative could assess:

    (1) How the proposed swap fits within the Special Entity's

    investment policy; (2) what role the particular swap plays in the

    Special Entity's portfolio; and (3) the Special Entity's potential

    exposure to losses. The swap dealer or major swap participant would

    also need to have a reasonable basis for believing that the

    representative has sufficient information to understand and assess

    the appropriateness of the swap prior to the Special Entity entering

    into the transaction. Proposing release, 75 FR at 80652.

    \731\ The proposed rule refined the criterion under Section

    4s(h)(5)(A)(i)(V), ``appropriate disclosures'' to mean ``appropriate

    and timely disclosures.'' Proposing release, 75 FR at 80652.

    \732\ The proposed rule refined the statutory language to

    provide that the representative ``evaluate[], consistent with any

    guidelines provided by the Special Entity, [the] fair pricing and *

    * * appropriateness of the swap.'' Swap dealers and major swap

    participants could rely on appropriate legal arrangements between

    Special Entities and their independent representatives in applying

    this criterion. For example, where a pension plan has a plan

    fiduciary that by contract has discretionary authority to carry out

    the investment guidelines of the plan, the swap dealer or major swap

    participant would be able to rely, absent red flags, on the Special

    Entity's representations regarding the legal obligations of the

    fiduciary. Evidence of the legal relationship between the plan and

    its fiduciary would enable the swap dealer or major swap participant

    to conclude that the fiduciary is evaluating fair pricing and the

    appropriateness of all transactions prior to entering into such

    transactions on behalf of the plan. To comply with this criterion,

    the swap dealer or major swap participant also would consider

    whether the independent representative is documenting its decisions

    about appropriateness and pricing of all swap transactions and that

    such documentation is being retained in accordance with any

    regulatory requirements that might apply to the independent

    representative. This approach was applied to in-house independent

    representatives as well. Proposing release, 75 FR at 80652-53.

    \733\ Notwithstanding comments from ERISA plans and their

    fiduciaries, the Commission determined that independent

    representatives of plans subject to ERISA would have to meet all the

    independent representative criteria in Section 4s(h)(5)(A). The

    Commission sought further comment on this interpretation of the

    statute. Proposing release, 75 FR at 80653 fn. 122.

    \734\ Criterion 8--restrictions on certain political

    contributions--is not in the statutory text under Section

    4s(h)(5)(A)(i)(I)-(VII). The Commission proposed this criterion

    using its discretionary authority under Section 4s(h)(5)(B). The

    requirement would not apply to in-house independent representatives

    of a municipal entity following the definition of ``municipal

    advisor'' in Section 15B of the Exchange Act (15 U.S.C. 78o-4),

    which excludes employees of a municipal entity. For examples of pay-

    to-play rules, see, e.g., SEC Rule 206(4)-5 under the Advisers Act

    (17 CFR 275.206(4)-5) (``SEC Advisers Act Rule 206(4)-5''); MSRB

    Rule G-37: Political Contributions and Prohibitions on Municipal

    Securities Business. The Commission proposed to impose comparable

    requirements on swap dealers and major swap participants that act as

    counterparties to Special Entities in proposed Sec. 23.451. The

    Commission stated in the proposing release that it would propose

    comparable requirements on registered CTAs when they advise

    municipal entities in a separate release. Proposing release, 75 FR

    at 80653 fn. 125.

    ---------------------------------------------------------------------------

    The proposed rule set out several factors to be considered by swap

    dealers and major swap participants in determining whether the Special

    Entity's representative satisfies the enumerated criteria, including

    (1) the nature of the Special Entity-representative relationship; (2)

    the representative's ability to make hedging or trading decisions; (3)

    the use of consultants or, with respect to employee benefit plans

    subject to ERISA, use of a Qualified Professional Asset Manager \735\

    or In-House Asset Manager; \736\ (4) the representative's general level

    of experience in the financial markets and particular experience with

    the type of product under consideration; (5) the representative's

    ability to understand the economic features of the swap; (6) the

    representative's ability to evaluate how market developments would

    affect the swap; and (7) the complexity of the swap.\737\

    ---------------------------------------------------------------------------

    \735\ See DOL QPAM PTE 84-14, 75 FR 38837.

    \736\ See DOL In-House Asset Manager PTE 96-23, 61 FR 15975;

    Proposed Amendment to PTE 96-23, 75 FR 33642, June 14, 2010.

    \737\ Proposing release, 75 FR at 80651; see also id., at 80660-

    61 (proposed Sec. 23.450(d)(2)).

    ---------------------------------------------------------------------------

    The proposed rule provided that a representative would be deemed to

    be independent if: (1) It was not (with a one-year look back) an

    associated person of the swap dealer or major swap participant within

    the meaning of Section 1a(4) of the CEA; (2) there was no ``principal

    relationship'' between the representative and the swap dealer or major

    swap participant within the meaning of Sec. 3.1(a) \738\ of the

    [[Page 9789]]

    Commission's Regulations; and (3) the representative did not have a

    material business relationship with the swap dealer or major swap

    participant.\739\ However, if the representative received any

    compensation from the swap dealer or major swap participant within one

    year of an offer to enter into a swap, the swap dealer or major swap

    participant would have to ensure that the Special Entity is informed of

    the compensation and that the Special Entity agrees in writing, in

    consultation with the representative, that the compensation does not

    constitute a material business relationship between the representative

    and the swap dealer or major swap participant.\740\ The proposed rule

    defined a material business relationship as any relationship with a

    swap dealer or major swap participant, whether compensatory or

    otherwise, that reasonably could affect the independent judgment or

    decision making of the representative.\741\

    ---------------------------------------------------------------------------

    \738\ 17 CFR 3.1(a).

    \739\ Proposing release, 75 FR at 80652.

    \740\ Id.

    \741\ Id.

    ---------------------------------------------------------------------------

    To address concerns that the statute places undue influence in the

    hands of the swap dealer or major swap participant by allowing it to

    control who qualifies as an independent representative of a Special

    Entity, the proposed rule provided that negative determinations be

    reviewed by the swap dealer's or major swap participant's chief

    compliance officer.\742\ Under the proposed rule, if a swap dealer or

    major swap participant determined that an independent representative

    did not meet the enumerated criteria, the swap dealer or major swap

    participant would be required to make a written record of the basis for

    such determination and submit such determination to its chief

    compliance officer for review.\743\ Such review would ensure that the

    swap dealer or major swap participant had a substantial, unbiased basis

    for the determination.\744\

    ---------------------------------------------------------------------------

    \742\ Id., at 80653.

    \743\ Id.

    \744\ Id.

    ---------------------------------------------------------------------------

    Proposed Sec. 23.450(f) also required, as provided in Section

    4s(h)(5)(A)(ii), that swap dealers and major swap participants disclose

    in writing to Special Entities the capacity in which they are acting

    before initiation of a swap transaction. In addition, if a swap dealer

    or major swap participant were to engage in business with the Special

    Entity in more than one capacity, the swap dealer or major swap

    participant would have to disclose the material differences between the

    capacities.\745\

    ---------------------------------------------------------------------------

    \745\ For example, the Commission stated that when the swap

    dealer acts both as an advisor and a counterparty to the Special

    Entity, or when firms act both as underwriters in a bond offering

    and counterparties in swaps used to hedge such financing, a swap

    dealer's duties to the Special Entity would vary depending on the

    capacities in which it is operating. Id., at 80653.

    ---------------------------------------------------------------------------

    Finally proposed Sec. 23.450(g) stated that the rule would not

    apply with respect to a swap that is initiated on a DCM or SEF where

    the swap dealer or major swap participant does not know the Special

    Entity's identity.\746\

    ---------------------------------------------------------------------------

    \746\ Proposed Sec. 23.450(g) is informed by the statutory

    language in Section 4s(h)(7) of the CEA.

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received many comments on the various aspects of

    proposed Sec. 23.450. The Commission has grouped the comments by the

    following issues: (1) Types of Special Entities that should be included

    in final Sec. 23.450; (2) duty to assess the qualifications of a

    Special Entity's representative; (3) representative qualifications;

    \747\ (4) reasonable reliance on representations; (5) unqualified

    representatives; and (6) disclosure of capacity.

    ---------------------------------------------------------------------------

    \747\ The comments related to representative qualifications

    address the following issues: (1) Regulated advisors; (2)

    independence; (3) best interests, disclosures, fair pricing and

    appropriateness; and (4) employee benefit plans subject to ERISA.

    ---------------------------------------------------------------------------

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

    Several commenters asserted that Section 4s(h)(5)(A)(i) only

    applies to the governmental Special Entities that are described in

    Section 1a(18)(A)(vii)(I) and (II) of the CEA, contrary to the approach

    taken in proposed Sec. 23.450.\748\ Commenters also asserted that it

    is unclear whether the Commission has the authority to apply the rule

    to swaps with ERISA plans, governmental plans, and endowments.\749\

    Some commenters urged the Commission to resolve any ambiguity in the

    statutory language by applying the final rule only to the State and

    municipal Special Entities defined in Section 4s(h)(C)(2)(ii).\750\ One

    commenter stated that if the final rule is applied to ERISA plans, then

    such plans should only be subject to subclause (VII) of Section

    4s(h)(5)(A)(i),\751\ which requires a Special Entity that is an

    employee benefit plan subject to ERISA to have an independent

    representative that ``is a fiduciary as defined in Section 3 of

    [ERISA].'' \752\ Commenters asserted that requirements for ERISA

    fiduciaries are comparable to those required in subclauses (I)-(VI) of

    Section 4s(h)(5)(A)(i), rendering the protections of Section 4s(h)(5)

    and proposed Sec. 23.450 unnecessary, and potentially harmful.\753\

    Conversely, one commenter opposed any carve-outs for ERISA plans and

    stated the Special Entity provisions are not served by deferring to

    ERISA's regulatory regime.\754\

    ---------------------------------------------------------------------------

    \748\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS

    Feb. 18 Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 2-3 and 8; ERIC

    Feb. 22 Letter, at 6-7; Davis & Harman Mar. 25 Letter, at 2.

    \749\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS

    Feb. 18 Letter, at 5; ABC/CIEBA Feb. 22 Letter, at 8.

    \750\ See, e.g., Ropes & Gray Feb. 22 Letter, at 4-5; CalPERS

    Feb. 18 Letter, at 5; ERIC Feb. 22 Letter, at 6-7.

    \751\ ABC/CIEBA Feb. 22 Letter, at 9 fn. 1; ABC Aug. 29 Letter,

    at 9.

    \752\ Section 4s(h)(5)(A)(i)(VII).

    \753\ See, e.g., ERIC Feb. 22 Letter, at 6-9.

    \754\ AFSCME Feb. 22 Letter, at 5.

    ---------------------------------------------------------------------------

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

    Representative

    Commenters asserted that proposed Sec. 23.450 will allow a swap

    dealer or major swap participant to veto a Special Entity's decision to

    select a particular representative,\755\ and will unduly limit a

    Special Entity's choice regarding its own advisor.\756\ Commenters also

    assert that proposed Sec. 23.450 inappropriately gives additional

    leverage to a swap dealer or major swap participant dealing with

    Special Entities, undermines the representative's ability or

    willingness to negotiate, and may be used to pressure Special Entities

    to share otherwise confidential information.\757\ Furthermore,

    commenters assert that the duty under the proposed rule is intrusive,

    creates an inherent conflict of interest, and undermines the Special

    Entity's own selection process.\758\ Other commenters asserted that

    proposed Sec. 23.450 will not benefit Special Entities and will make

    dealing with swap dealers more costly and problematic.\759\ Conversely,

    one commenter asserted that proposed Sec. 23.450 created a reasonable

    and workable approach that is consistent with congressional

    intent.\760\

    ---------------------------------------------------------------------------

    \755\ ABA/ABC Feb. 22 Letter, at 2; Davis & Harman Mar. 25

    Letter, at 2-3; Rep. Smith July 25 Letter, at 2; ABC/CIEBA June 3

    Letter, at 5-6;

    \756\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36; ABC/CIEBA

    Feb. 22 Letter, at 9; CEF Feb. 22 Letter, at 23; Calhoun Feb. 22

    Letter, at 5.

    \757\ ABC/CIEBA Feb. 22 Letter, at 9; ABA/ABC Feb. 22 Letter, at

    2; AMG-SIFMA Feb. 22 Letter, at 10.

    \758\ See, e.g., BlackRock Feb. 22 Letter, at 3; CalPERS Feb. 18

    Letter, at 3; Cityview Feb. 22 Submission; Texas VLB Feb. 22 Letter,

    at 2; GFOA Feb. 22 Letter, at 1.

    \759\ See, e.g., ASF Feb. 22 Letter, at 5; GFOA Feb. 22 Letter,

    at 1.

    \760\ CFA/AFR Feb. 22 Letter, at 17.

    ---------------------------------------------------------------------------

    Commenters also asserted that proposed Sec. 23.450 may conflict

    with current law under ERISA or with DOL's proposed fiduciary rule. The

    commenters asserted that proposed Sec. 23.450 requires a swap dealer

    or major

    [[Page 9790]]

    swap participant to review the qualifications of the Special Entity's

    representative which could be considered providing advice as to the

    selection of the Special Entity's advisor. Commenters asserted this

    could make the swap dealer or major swap participant a fiduciary to an

    ERISA plan under ERISA and DOL's existing regulations \761\ or under

    DOL's proposed fiduciary rule.\762\

    ---------------------------------------------------------------------------

    \761\ ABA/ABC Feb. 22 Letter, at 1; Davis & Harman Mar. 25

    Letter, at 1; ERIC Feb. 22 Letter, at 9; MFA Feb. 22 Letter, at 6-7

    fn. 13; ABC/CIEBA June 3 Letter, at 2.

    \762\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA Feb. 22

    Letter, at 5; ABA/ABC Feb. 22 Letter, at 1; Davis & Harman Mar. 25

    Letter, at 1; ERIC Feb. 22 Letter, at 9; ABC/CIEBA June 3 Letter, at

    2.

    ---------------------------------------------------------------------------

    Commenters also asserted that proposed Sec. 23.450 may conflict

    with DOL's QPAM prohibited transaction exemption.\763\ The QPAM

    exemption sets out several conditions an ERISA fiduciary must satisfy

    to be a ``qualified professional asset manager'' within the meaning of

    the exemption. According to commenters, proposed Sec. 23.450 permits a

    swap dealer or major swap participant to veto or implicitly cause the

    Special Entity to replace its advisor which may render the QPAM

    exemption unavailable to ERISA plans and their ERISA fiduciaries.\764\

    ---------------------------------------------------------------------------

    \763\ See DOL QPAM PTE 84-14, 75 FR 38837.

    \764\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA June 3 Letter,

    at 5.

    ---------------------------------------------------------------------------

    c. Representative Qualifications

    i. Regulated Advisors

    Several commenters recommended that the Commission deem

    representatives that have a particular regulatory status to meet some

    or all of independent representative criteria in proposed Sec.

    23.450(b). Several commenters suggested that banks, investment

    advisers, insurance companies, QPAMs, and INHAMs \765\ be deemed to

    meet the statutory criteria.\766\ Commenters also stated that

    requirements under ERISA should automatically qualify an ERISA plan's

    fiduciary under the proposed criteria.\767\ Other commenters asserted

    that municipal advisors,\768\ fiduciaries to governmental plans,\769\

    and employees of a Special Entity should be deemed to satisfy the

    enumerated criteria.\770\

    ---------------------------------------------------------------------------

    \765\ Cf. DOL In-House Asset Manager PTE 96-23, 61 FR 15975.

    \766\ See SIFMA/ISDA Feb. 17 Letter, at 36; ERIC Feb. 22 Letter,

    at 2 and 12; AMG-SIFMA Feb. 22 Letter, at 2; BlackRock Feb. 22

    Letter, at 3.

    \767\ See, e.g., ERIC Feb. 22 Letter, at 6-9.

    \768\ SIFMA/ISDA Feb. 17 Letter, at 36; Texas VLB Feb. 22

    Letter, at 2.

    \769\ CalSTRS Feb. 28 Letter, at 3.

    \770\ APGA Feb. 22 Letter, at 6-7.

    ---------------------------------------------------------------------------

    Several commenters requested that the Commission or an SRO develop

    a voluntary certification and proficiency examination program for

    independent representatives. The commenters proposed that the

    Commission should permit a swap dealer or major swap participant to

    conclude that any certified representative would automatically satisfy

    the criteria in proposed Sec. 23.450(b).\771\ Conversely, one

    commenter asserted that representations and warranties from the

    representative should not amount to a waiver of compliance for a swap

    dealer.\772\

    ---------------------------------------------------------------------------

    \771\ See, e.g., CalPERS Feb. 18 Letter, at 5-6; CalPERS Aug. 29

    Letter, 4-6; SWIB Feb. 22 Letter, at 4; CEF Feb. 22 Letter, at 23;

    Cityview Feb. 22 Submission; Riverside Feb. 22 Letter, at 1-2; SFG

    Feb. 22 Letter, at 1; CFA/AFR Aug. 29 Letter, at 23; CFA/AFR Nov. 3

    Letter, at 5.

    \772\ AFSCME Feb. 22 Letter, at 6.

    ---------------------------------------------------------------------------

    ii. Independence

    The proposing release clarified that the Special Entity's

    representative must be ``independent'' of the swap dealer or major swap

    participant; however, the representative does not have to be

    independent of the Special Entity.\773\ Several commenters agreed with

    the Commission's proposed interpretation.\774\ Commenters also

    requested that the Commission clarify that an independent

    representative may be an employee, officer, agent, associate, trustee,

    director, subsidiary, or affiliate, such as an INHAM.\775\

    ---------------------------------------------------------------------------

    \773\ Proposing release, 75 FR at 80652 fn. 113.

    \774\ See CFA/AFR Feb. 22 Letter, at 17; ERIC Feb. 22 Letter, at

    3 and 9; APPA/LPPC Feb. 22 Letter, at 2; NACUBO Feb. 22 Letter, at

    4; U. Tex. System Feb. 22 Letter, at 3-4; APGA Feb. 22 Letter, at 6.

    \775\ See, e.g., NACUBO Feb. 22 Letter, at 4; U. Tex. System

    Feb. 22 Letter, at 3-4; ERIC Feb. 22 Letter, at 9. Cf. DOL In-House

    Asset Manager PTE 96-23, 61 FR 15975.

    ---------------------------------------------------------------------------

    The Commission received comments concerning the proposed

    independence test in general and specifically regarding the ``material

    business relationship'' prong. Some commenters recommended that the

    Commission delete the ``material business relationship''

    requirement.\776\ Alternatively, commenters suggested the Commission

    consider other existing standards which, according to the commenters,

    would be more workable such as ownership \777\ or affiliate tests.\778\

    Commenters stated that the Commission's proposed standard was

    unnecessarily duplicative of or not harmonized with other independence

    standards under the federal securities laws and ERISA.\779\ Commenters

    also asserted that the final regulation should permit a swap dealer or

    major swap participant to conclude that a plan's representative is

    ``independent'' if the representative is an ERISA fiduciary,\780\ or at

    a minimum, if the representative is an ERISA fiduciary that is also a

    regulated entity such as a QPAM.\781\

    ---------------------------------------------------------------------------

    \776\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 11-12; SIFMA/ISDA

    Feb. 17 Letter, at 38; contra CFA/AFR Feb. 22 Letter, at 17 (``the

    proposed standard generally provides the appropriate level of

    independence'').

    \777\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 11-12, fn. 38

    (recommending the Commission consider ``standards of ownership''

    such as those in DOL's QPAM exemption); see also DOL QPAM PTE 84-14,

    75 FR 38837.

    \778\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 37-38 (``the

    Commission should adopt one of several other well-established and

    workable tests of independence (such as excluding all `affiliates,'

    as * * * defined under * * * the CEA)''); BlackRock Feb. 22 Letter,

    at 4.

    \779\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38; ABC/CIEBA

    Feb. 22 Letter, at 11; ERIC Feb. 22 Letter, at 11-12; AMG-SIFMA Feb.

    22 Letter, at 2; BlackRock Feb. 22 Letter, at 4.

    \780\ ERIC Feb. 22 Letter, at 6 and 8; ABC/CIEBA Feb. 22 Letter,

    at 11 (``we urge the CFTC to provide that a `major [sic] business

    relationship' does not exist if the relationship between the dealer

    or [major swap participant] and the [ERISA] Plan * * * would not

    give rise to a prohibited transaction under ERISA''); ABC Aug. 29

    Letter, at 14.

    \781\ See, e.g., BlackRock Feb. 22 Letter, at 4; FIA/ISDA/SIFMA

    Aug. 29 Letter, at 20; AMG-SIFMA Feb. 22 Letter, at 11-12 fn. 38;

    see also DOL QPAM PTE 84-14, Part (VI)(a), 75 FR at 38843 (a QPAM

    must be a bank, savings and loan association, insurance company, or

    registered investment adviser).

    ---------------------------------------------------------------------------

    Commenters also assert that the proposed ``material business

    relationship'' standard is unclear, vague and overly broad, and swap

    dealers will refrain from transacting with Special Entities without

    further clarifications.\782\ These commenters stated that the

    ``material business relationship'' standard may inappropriately

    preclude many qualified asset managers from acting as independent

    representatives.\783\ According to the commenters, many asset managers

    have multiple relationships with financial services firms that have

    swap dealer affiliates, and a requirement to survey all business

    relationships to determine whether and what compensation was paid would

    be very burdensome, require the development of costly new recordkeeping

    systems not currently in place, and provide little or no benefit to

    Special Entities.\784\ The commenters

    [[Page 9791]]

    also assert that the ``material business relationship'' standard

    reduces Special Entities' choices for qualified representatives and

    increases costs for representatives and Special Entities.\785\ A number

    of commenters also requested that the Commission clarify that the

    disclosure requirement is limited to compensation received in

    connection with the relevant swap transaction.\786\ Conversely, one

    commenter asserted the rule should require disclosure of all business

    relationships.\787\

    ---------------------------------------------------------------------------

    \782\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38 (``the

    proposing standard is so broad and vague that [swap dealers] wary of

    the consequence of misinterpreting its requirements will likely

    simply abstain from affected trades''); APPA/LPPC Feb. 22 Letter, at

    5 (the ``standard is both broad and somewhat vague * * * and dealers

    may be reluctant to take on the potential liability related to this

    determination''); AMG-SIFMA Feb. 22 Letter, at 11; BlackRock Feb. 22

    Letter, at 11.

    \783\ SIFMA/ISDA Feb. 17 Letter, at 38; ABC/CIEBA Feb. 22

    Letter, at 11; AMG-SIFMA Feb. 22 Letter, at 11; BlackRock Feb. 22

    Letter, at 4 fn. 9, but see CFA/AFR Nov. 3 Letter, at 3-4.

    \784\ BlackRock Feb. 22 Letter, at 4 (``an asset manager may

    trade securities through the broker affiliate of the swap dealer;

    use an affiliated broker dealer as distributor/underwriter for

    mutual funds managed by the asset manager; or license an index from

    an affiliate of the dealer''); SIFMA/ISDA Feb. 17 Letter, at 38 (a

    swap dealer's ``affiliated broker-dealer [that] is the underwriter

    for mutual funds managed by the investment adviser'' should not

    constitute a ``material business relationship''); ABC/CIEBA Feb. 22

    Letter, at 11 (requiring representatives to determine all

    compensation received from a swap dealer in connection with all

    other transactions worldwide would impose staggering administrative

    burdens and is likely impracticable); AMG-SIFMA Feb. 22 Letter, at

    11 (large investment advisers are affiliated with banks and broker-

    dealers that would also be, or be affiliated with, swap dealers and

    would be precluded from entering into trades with many swap dealers

    on behalf of their customers).

    \785\ SIFMA/ISDA Feb. 17 Letter, at 38; AMG-SIFMA Feb. 22

    Letter, at 11; BlackRock Feb. 22 Letter, at 4; APPA/LPPC Feb. 22

    Letter, at 5.

    \786\ ABC/CIEBA Feb. 22 Letter, at 11; SIFMA/ISDA Feb. 17

    Letter, at 38 (disclosure should not be required where a swap dealer

    in its capacity as broker provided soft dollar research unrelated to

    any swap transaction to a Special Entity's investment adviser);

    BlackRock Feb. 22 Letter, at 4; APPA/LPPC Feb. 22 Letter, at 5; CEF

    Feb. 22 Letter, at 23.

    \787\ Better Markets Feb. 22 Letter, at 8 (asserting swap

    dealers have provided advantageous allocations of securities in

    public offerings to influence advisors that should be disclosed).

    ---------------------------------------------------------------------------

    The proposed definition of ``material business relationship'' also

    excluded payment of fees by the swap dealer or major swap participant

    to the Special Entity's representative at the written direction of the

    Special Entity for services provided in connection with the swap.\788\

    Some commenters expressed concerns that the exclusion could be used for

    abuse or would undermine the independence of their advice.\789\ These

    commenters stated the exclusion should be deleted and such practices

    should be prohibited.\790\

    ---------------------------------------------------------------------------

    \788\ Proposing release, 75 FR at 80652 and 80660.

    \789\ CFA/AFR Feb. 22 Letter, at 17; Better Markets Feb. 22

    Letter, at 4 and 8; Calhoun Feb. 22 Letter, at 2; see also CFA/AFR

    Nov. 3 Letter, at 4; but cf. APPA/LPPC Feb. 22 Letter, at 5

    (limiting such arrangements may make it difficult for governmental

    entities to find qualified swap advisors).

    \790\ Better Markets Feb. 22 Letter, at 7-8; Better Markets June

    3 Letter, at 13; Calhoun Feb. 22 Letter, at 3.

    ---------------------------------------------------------------------------

    The proposed definition of ``material business relationship'' also

    stated that the term is subject to a one-year look back, including any

    compensation received within one year of an offer to enter into the

    swap.\791\ Some commenters recommended that the Commission extend the

    relevant time period.\792\ Conversely, another commenter stated that a

    one-year look back would be problematic in instances where corporate

    identities change through corporate transactions or

    consolidations.\793\

    ---------------------------------------------------------------------------

    \791\ Proposed Sec. 23.450(a)(3), proposing release, 75 FR at

    80652 and 80660.

    \792\ CFA/AFR Aug. 29 Letter, at 33; Better Markets Feb. 22

    Letter, at 8.

    \793\ BlackRock Aug. 29 Letter, at 6 (asserting that DOL

    eliminated a one-year look back rule in the QPAM Exemption in

    response to industry concerns regarding the workability in light of

    consolidation and changes in the financial services industry).

    ---------------------------------------------------------------------------

    Under proposed Sec. 23.450(c)(3), the Special Entity may agree in

    writing that any compensation the representative received from the swap

    dealer or major swap participant does not constitute a ``material

    business relationship.'' \794\ One commenter requested that the

    Commission clarify that the disclosure of any such compensation is made

    to the Special Entity's board and the written agreement comes from the

    board.\795\ Other commenters asserted that a Special Entity may be

    reluctant to make a determination that a relationship was not a

    ``material business relationship'' because the Special Entity could be

    held liable if the determination is later deemed inaccurate.\796\

    ---------------------------------------------------------------------------

    \794\ Proposing release, 75 FR at 80660.

    \795\ CFA/AFR Feb. 22 Letter, at 17; CFA/AFR Nov. 3 Letter, at

    4.

    \796\ APPA/LPPC Feb. 22 Letter, at 5; AMG-SIFMA Feb. 22 Letter,

    at 4.

    ---------------------------------------------------------------------------

    Following the release of the SEC's proposed business conduct

    standards for SBS Entities, the Commission received comment letters

    addressing harmonization of the agencies' independence tests.\797\ Some

    commenters requested that both agencies adopt the Commission's proposed

    approach with ``minor adjustments.'' \798\ Other commenters supported

    the SEC's associated person and gross revenue tests \799\ and requested

    that the agencies coordinate the independence tests.\800\

    ---------------------------------------------------------------------------

    \797\ The SEC proposed that a Special Entity's representative

    would be ``independent'' of an SBS Entity if the representative does

    not have a relationship with the SBS Entity, whether compensatory or

    otherwise, that reasonably could affect the independent judgment or

    decision-making of the representative. The SEC's proposal, however,

    would consider a representative deemed to be independent of the SBS

    Entity if, within one year, the representative was not an associated

    person of the SBS Entity and had not received more than ten percent

    of its gross revenues from the SBS Entity. SEC's proposed rules, 76

    FR at 42426.

    \798\ See, e.g., CFA/AFR Aug. 29 Letter, at 33.

    \799\ See, e.g., FIA/ISDA/SIFMA Aug. 26 Letter, at 6.

    \800\ See, e.g., FIA/ISDA/SIFMA Sept. 14 Letter, at passim; see

    also SIFMA/ISDA Feb. 17 Letter, at 37-38.

    ---------------------------------------------------------------------------

    iii. Best Interests, Disclosures, Fair Pricing and Appropriateness

    Section 4s(h)(5) and proposed Sec. 23.450(b) would require a swap

    dealer or major swap participant to have a reasonable basis to believe

    that a Special Entity's representative (1) undertakes a duty to act in

    the Special Entity's ``best interests''; (2) makes appropriate

    disclosures; and (3) will provide written representations regarding

    fair pricing and appropriateness of the transaction.\801\ To assess the

    ``best interests'' criterion, the Commission proposed by example that a

    swap dealer or major swap participant would be able to rely, absent red

    flags, on duties established by appropriate legal arrangements between

    Special Entities and their independent representatives.\802\ One

    commenter requested that the Commission clarify that a swap dealer or

    major swap participant could also rely on an employment relationship to

    satisfy the ``best interests'' duty, disclosure obligation, and duty to

    evaluate fair pricing and appropriateness of the swap.\803\ Other

    commenters similarly stated that legal obligations under ERISA or state

    law would require the fiduciary to an ERISA plan or governmental plan

    to comply with a best interests duty, disclosure obligations, and a

    duty to evaluate fair pricing and appropriateness.\804\

    ---------------------------------------------------------------------------

    \801\ Section 4s(h)(5)(A)(i)(IV)-(VI) of the CEA and proposed

    Sec. 23.450(b)(4)-(6); proposing release, 75 FR at 80652-53 and

    80660.

    \802\ Proposing release, 75 FR at 80652-53. Such legal

    arrangements could include, for example, a contract between a

    pension plan and a plan fiduciary that required the fiduciary to

    evaluate, consistent with any guidelines provided by the Special

    Entity, fair pricing and the appropriateness of the swap.

    \803\ APGA Feb. 22 Letter, at 6; cf. CFA/AFR Aug. 29 Letter, at

    34 (asserting that a representative that is subject to separate

    legal requirements, such as an investment adviser or ERISA

    fiduciary, could be presumed to satisfy the ``best interests''

    criterion).

    \804\ See, e.g., ERIC Feb. 22 Letter, at 8-9; CalSTRS Feb. 28

    Letter, at 3.

    ---------------------------------------------------------------------------

    iv. Employee Benefit Plans Subject to ERISA

    The Commission sought comment on whether the statutory

    representative criteria under Section 4s(h)(5)(A)(i)(I)-(VI) were

    duplicative or inconsistent with ERISA's fiduciary requirements.\805\

    Commenters asserted that ERISA imposes comparable requirements to the

    statute and proposed Sec. 23.450(b)(1)-(6), and the rule adds

    administrative costs without corresponding benefits.\806\

    ---------------------------------------------------------------------------

    \805\ Proposing release, 75 FR at 80653.

    \806\ SIFMA/ISDA Feb. 17 Letter, at 36-37; ERIC Feb. 22 Letter,

    at 2 and 6-9 (asserting that ERISA imposes ``duties that are

    similar, but more exacting,'' with respect to the knowledge

    requirement, statutory disqualification, independence, best

    interests, disclosures, and fair pricing and appropriateness); ABC/

    CIEBA June 3 Letter, at 6.

    ---------------------------------------------------------------------------

    [[Page 9792]]

    Another commenter stated that it was unclear whether the criteria

    in Section 4s(h)(5)(A)(i)(I)-(VI) apply to governmental plans that are

    defined in but not subject to ERISA. The commenter requested that the

    Commission clarify that a governmental plan's representative does not

    need to satisfy the first six criteria if it is represented by a

    fiduciary under state or local law.\807\

    ---------------------------------------------------------------------------

    \807\ CalSTRS Feb. 28 Letter, at 6.

    ---------------------------------------------------------------------------

    d. Reasonable Reliance on Representations

    Proposed Sec. 23.450(d) permitted a swap dealer or major swap

    participant \808\ to rely on Special Entity representations to satisfy

    its duty to assess the qualifications of the Special Entity's

    independent representative, if the representations were reliable and

    sufficiently detailed.\809\ Several commenters expressed concern with

    the language in proposed Sec. 23.450(d)(1) that would require the swap

    dealer or major swap participant to ``consider the facts and

    circumstances of a particular Special Entity-representative

    relationship, assessed in the context of a particular transaction.''

    \810\ Similarly, several commenters expressed concern with the language

    in proposed Sec. 23.450(d)(2) that would require the representations

    to be ``sufficiently detailed.'' \811\ Conversely, one commenter

    supported the Commission's approach and requested that the Commission

    require record retention that would permit the Commission to determine

    compliance.\812\

    ---------------------------------------------------------------------------

    \808\ Two commenters noted that the rule text of proposed Sec.

    23.450(d) provided that a swap dealer may rely on written

    representations but was silent as to whether major swap participants

    could rely. See SIFMA/ISDA Feb. 17 Letter, at 36 fn. 85; ABC/CIEBA

    Feb. 22 Letter, at 9 fn. 2. The Commission intended this provision

    to be available to both swap dealers and major swap participants and

    expressly references both in final Sec. 23.450(e).

    \809\ Proposing release, 75 FR at 80660.

    \810\ SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA Feb. 22

    Letter, at 9; BlackRock Feb. 22 Letter, at 3; proposing release, 75

    FR at 80660.

    \811\ Id.

    \812\ CFA/AFR Feb. 22 Letter, at 6; CFA/AFR Nov. 3 Letter, at 5.

    ---------------------------------------------------------------------------

    A majority of commenters asserted that proposed Sec. 23.450(d)

    would require extensive and burdensome transaction-by-transaction

    diligence that would significantly delay execution and increase costs

    for swap dealers, major swap participants and Special Entities.\813\

    Commenters also asserted that the conditions for reliance, which

    include a nonexclusive list of seven factors under proposed Sec.

    23.450(d)(2), were unnecessarily complex and could cause swap dealers

    or major swap participants to overreach in their requests for

    information.\814\ Many commenters requested that the Commission permit

    swap dealers and major swap participants to rely on representations

    from the Special Entity or the independent representative that simply

    repeat the enumerated criteria in proposed Sec. 23.450(b).\815\

    Commenters also requested that the Commission permit representations to

    be made on a relationship basis and only updated periodically \816\ or

    upon a material change such as a change in the Special Entity's

    representative.\817\ Another commenter stated that to avoid giving the

    swap dealer or major swap participant unfair leverage when dealing with

    Special Entities, the required representations must be unambiguous, and

    determinations of accuracy must be within the sole judgment of the

    Special Entity.\818\

    ---------------------------------------------------------------------------

    \813\ 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; ABA/ABC

    Feb. 22 Letter, at 2-3; AMG-SIFMA Feb. 22 Letter, at 9; SWIB Feb. 22

    Letter, at 4-5; Ropes & Gray Feb. 22 Letter, at 3-4; APPA/LPPC Feb.

    22 Letter, at 4.

    \814\ See, e.g., Ropes & Gray Feb. 22 Letter, at 3-4; APPA/LPPC

    Feb. 22 Letter, at 4; SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA

    Feb. 22 Letter, at 9-10.

    \815\ SIFMA/ISDA Feb. 17 Letter, at 35-36; ABC/CIEBA Feb. 22

    Letter, at 10; SWIB Feb. 22 Letter, at 4-5; CEF Feb. 22 Letter, at

    16 and 23; VRS Feb. 22 Letter, at 5; APPA/LPPC Feb. 22 Letter, at 4;

    Comm. Cap. Mkts. May 3 Letter, at 2; Comm. Cap. Mkts. Aug. 29

    Letter, at 2-3.

    \816\ Ropes & Gray Feb. 22 Letter, at 4.

    \817\ APGA Feb. 22 Letter, at 6-7.

    \818\ CalPERS Oct. 4 Letter, at 1.

    ---------------------------------------------------------------------------

    A number of commenters also discussed the circumstances in which a

    swap dealer or major swap participant could rely on a representation

    without further inquiry. Some commenters suggested the Commission

    permit a swap dealer or major swap participant to rely if it did not

    have actual knowledge that the representations were incorrect.\819\

    Conversely, some commenters suggested the Commission permit reliance

    unless the swap dealer or major swap participant knows of facts that

    reasonably should put it on notice that would trigger a duty to inquire

    further.\820\ Two commenters requested that the Commission clarify that

    the exchange of representations will not give any party any additional

    rescission, early termination, or monetary compensation rights.\821\

    ---------------------------------------------------------------------------

    \819\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 10-11; Davis &

    Harman Mar. 25 Letter, at 5-6; APGA Feb. 22 Letter, at 6; SIFMA/ISDA

    Feb. 17 Letter, at 36; contra CFA/AFR Nov. 3 Letter, at 5.

    \820\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36 (``[swap

    dealers] should be permitted to rely on a written representation * *

    * that the counterparty and/or its representative satisfies the

    standards * * * absent actual notice of countervailing facts (or

    facts that reasonably should have put [a swap dealer] on notice),

    which would trigger a consequent duty to inquire further.''); see

    also supra fn. 724. Contra CFA/AFR Nov. 3 Letter, at 5.

    \821\ ABC/CIEBA Feb. 22 Letter, at 12-13 (asserting that a swap

    dealer faced with a highly volatile market and disadvantageous swap

    position could claim that a Special Entity provided inaccurate

    representations to avoid its obligations); AMG-SIFMA Feb. 22 Letter,

    at 10.

    ---------------------------------------------------------------------------

    e. Unqualified Representatives

    Proposed Sec. 23.450(e) provided that any swap dealer or major

    swap participant that determines a Special Entity's representative does

    not meet the relevant criteria must submit a written record of the

    basis of its determination to the chief compliance officer for review

    that the determination was unbiased. Two commenters asserted that the

    proposed rule does not provide meaningful protection to Special

    Entities from a swap dealer or major swap participant that abuses its

    discretion.\822\ Another commenter recommended the Commission require

    the swap dealer or major swap participant to submit the written record

    to the Commission in addition to the chief compliance officer.\823\ A

    commenter also asserted the Commission should require the written

    determination be made to the trading supervisor rather than the chief

    compliance officer.\824\

    ---------------------------------------------------------------------------

    \822\ ABC/CIEBA Feb. 22 Letter, at 9; CalPERS Feb. 18 Letter, at

    3.

    \823\ CFA/AFR Feb. 22 Letter, at 18.

    \824\ SIFMA/ISDA Feb. 17 Letter, at 38-39.

    ---------------------------------------------------------------------------

    A commenter requested that the Commission confirm that the swap

    dealer or major swap participant would not have any liability to the

    Special Entity or its representative as a result of its good faith

    determination that the representative was not qualified.\825\

    ---------------------------------------------------------------------------

    \825\ Id.

    ---------------------------------------------------------------------------

    f. Disclosure of Capacity

    Proposed Sec. 23.450(f) requires a swap dealer or major swap

    participant to disclose to the Special Entity the capacity in which it

    is acting in connection with the swap and, if in more than one

    capacity, to disclose the material differences between such capacities

    in connection with the swap and any other financial transaction or

    service involving the Special Entity. Two commenters requested that the

    Commission clarify that required disclosures of other capacities be

    limited only to those capacities in connection with the swap.\826\

    [[Page 9793]]

    Commenters also requested the Commission clarify the meaning of

    ``before the initiation of a swap'' and to confirm that such

    disclosures could be made in a master agreement.\827\ One commenter

    asserted that ERISA plans typically have many different types of

    relationships with swap dealers, and listing all such relationships

    prior to each transaction would impose significant burdens and not

    provide meaningful information to an ERISA plan.\828\

    ---------------------------------------------------------------------------

    \826\ SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA Feb. 22

    Letter, at 11-12.

    \827\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 39; ABC/CIEBA

    Feb. 22 Letter, at 11-12; APGA Feb. 22 Letter, at 7.

    \828\ ABC/CIEBA Feb. 22 Letter, at 12.

    ---------------------------------------------------------------------------

    g. Transaction Costs and Risks

    Commenters asserted that compliance with proposed Sec. 23.450

    would be burdensome, costly, or impractical.\829\ Commenters also

    stated that the proposed rule may expose swap dealers and major swap

    participants to new litigation risks from Special Entities and

    representatives.\830\ Commenters asserted that swap dealers and major

    swap participants will either pass additional risk and compliance costs

    onto Special Entities or refuse to transact with Special Entities

    altogether, and such results are ultimately harmful to Special Entities

    and outweigh any benefits.\831\

    ---------------------------------------------------------------------------

    \829\ See, e.g., ABC/CIEA Feb. 22 Letter, at 3; ERIC Feb. 22

    Letter, at 9; CalSTRS Feb. 28 Letter, at 2 and 6; MFA Feb. 22

    Letter, at 2; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22 Letter, at

    16; HOOPP Feb. 22 Letter, at 2.

    \830\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; SIFMA/ISDA

    Feb. 17 Letter, at 39; VRS Feb. 22 Letter, at 3; HOOPP Feb. 22

    Letter, at 2; CEF Feb. 22 Letter, at 16.

    \831\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; ERIC Feb. 22

    Letter, at 9-10; CalSTRS Feb. 28 Letter, at 2 and 6; MFA Feb. 22

    Letter, at 2; CalPERS Feb. 18 Letter, at 3-4; CEF Feb. 22 Letter, at

    16; HOOPP Feb. 22 Letter, at 2.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.450

    Based on consideration of the comments, the Commission has

    determined to adopt proposed Sec. 23.450 with several changes. The

    principal changes include, first, under Sec. 23.450(b)(2), a

    representative of an ERISA plan will have to meet only one criterion to

    qualify under the section: That it is a fiduciary as defined in Section

    3 of ERISA (29 U.S.C. 1002).\832\ Second, under Sec. 23.450(d)(1)

    certain counterparty representations will be deemed to provide a

    reasonable basis for a swap dealer or major swap participant to believe

    that a representative of a Special Entity, other than an ERISA plan,

    meets the enumerated criteria in Sec. 23.450(b).\833\ Third, under

    Sec. 23.450(c) compliance with certain criteria will be deemed to

    establish that a representative is ``independent'' of the swap dealer

    or major swap participant within the meaning of Sec.

    23.450(b)(1)(iii).\834\ The following discussion addresses comments on

    proposed Sec. 23.450 and the changes in final Sec. 23.450.

    ---------------------------------------------------------------------------

    \832\ Section 23.450(b)(2) provides: ``Any swap dealer or major

    swap participant that offers to enter or enters into a swap with a

    Special Entity as defined in Sec. 23.401(c)(3) shall have a

    reasonable basis to believe that the Special Entity has a

    representative that is a fiduciary as defined in Section 3 of

    [ERISA] (29 U.S.C. 1002).'' A swap dealer or major swap participant

    will have a reasonable basis to believe that an ERISA plan has a

    qualified independent representative under Sec. 23.450(b)(2) if it

    receives a representation in writing identifying the representative

    and stating that the representative is a fiduciary as defined in

    Section 3 of ERISA (29 U.S.C. 1002) as provided in Sec.

    23.450(d)(2).

    \833\ Section 23.450(d)(1) provides: Safe Harbor. (1) A swap

    dealer or major swap participant shall be deemed to have a

    reasonable basis to believe that the Special Entity, other than a

    Special Entity defined in Sec. 23.401(c)(3), has a representative

    that satisfies the applicable requirements of paragraph (b)(1) of

    this section provided that: (i) The Special Entity represents in

    writing to the swap dealer or major swap participant that it has

    complied in good faith with written policies and procedures

    reasonably designed to ensure that it has selected a representative

    that satisfies the applicable requirements of paragraph (b) of this

    section, and that such policies and procedures provide for ongoing

    monitoring of the performance of such representative consistent with

    the requirements of paragraph (b) of this section; and (ii) The

    representative represents in writing to the Special Entity and swap

    dealer or major swap participant that the representative: (A) Has

    policies and procedures reasonably designed to ensure that it

    satisfies the applicable requirements of paragraph (b) of this

    section; (B) Meets the independence test in paragraph (c) of this

    section; and (C) Is legally obligated to comply with the applicable

    requirements of paragraph (b) of this section by agreement,

    condition of employment, law, rule, regulation, or other enforceable

    duty.

    \834\ Section 23.450(c) provides: Independent. For purposes of

    paragraph (b)(1)(iii) of this section, a represenative of a Special

    Entity will be deemed to be independent of the swap dealer or major

    swap participant if: (1) The representative is not and, within one

    year of representing the Special Entity in connection with the swap,

    was not an associated person of the swap dealer or major swap

    participant within the meaning of Section 1a(4) of the Act; (2)

    There is no principal relationship between the representative of the

    Special Entity and the swap dealer or major swap participant; (3)

    The representative: (i) Provides timely and effective disclosures to

    the Special Entity of all material conflicts of interest that could

    reasonably affect the judgment or decision making of the

    representative with respect to its obligations to the Special

    Entity; and(ii) Complies with policies and procedures reasonably

    designed to manage and mitigate such material conflicts of interest;

    (4) The representative is not directly or indirectly, through one or

    more persons, controlled by, in control of, or under common control

    with the swap dealer or major swap participant; and (5) The swap

    dealer or major swap participant did not refer, recommend, or

    introduce the representative to the Special Entity within one year

    of the representative's representation of the Special Entity in

    connection with the swap.

    ---------------------------------------------------------------------------

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

    The Commission has determined based on the statutory framework and

    legislative intent that final Sec. 23.450, like the proposed rule,

    shall apply to swaps offered or entered into with all types of Special

    Entities. The Commission declines to adopt commenters' position that

    the rule be limited to the entities described under Section

    1a(18)(A)(vii)(I) and (II).\835\ The Commission also disagrees with

    commenters' assertion that the Commission does not have the authority

    to apply the rule to swaps with all types of Special Entities.

    ---------------------------------------------------------------------------

    \835\ The Commission is persuaded, however, that with respect to

    ERISA plans, the swap dealer or major swap participant need only

    assess whether the plan representative is a fiduciary as defined in

    Section 3 of ERISA (29 U.S.C. 1002) as provided in Section

    4s(h)(5)(A)(VII). See Section IV.C.3.d. for a discussion of

    qualification criteria for independent representatives.

    ---------------------------------------------------------------------------

    Requiring swap dealers or major swap participants to comply with

    Sec. 23.450 when dealing with all types of Special Entities resolves

    the ambiguities in the statutory text.\836\ The determination is also

    consistent with the legislative history \837\ and the clear statutory

    intent to raise the standard of care for swap dealers and major swap

    participants dealing with Special Entities, generally. Finally, Section

    4s(h)(5)(B) provides the Commission with discretionary rulemaking

    authority to 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. The Commission believes that ensuring all Special

    Entities have a sufficiently knowledgeable and independent

    representative that is capable of providing disinterested, expert

    advice is an essential component of the statutory framework that

    Congress established for Special Entities.\838\

    ---------------------------------------------------------------------------

    \836\ See fn. 727 discussing the ambiguities in Section 4s(h)(5)

    of the CEA as to whether the duty is intended to apply with respect

    to all types of Special Entity counterparties or just a sub-group.

    \837\ See H.R. Rep. No. 111-517 at 869 (June 29, 2010) (Conf.

    Rep.) (``When acting as counterparties to a pension fund, endowment

    fund, or state or local government, dealers are to have a reasonable

    basis to believe that the fund or governmental entity has an

    independent representative advising them.'').

    \838\ For ERISA plans, the Commission has determined that the

    statute deems a fiduciary as defined in Section 3 of ERISA (29

    U.S.C. 1002) to be a qualified independent representative within the

    meaning of Section 4s(h)(5)(A).

    ---------------------------------------------------------------------------

    b. ERISA Plan Representatives That Are ERISA Fiduciaries

    The Commission has considered the statutory language in Section

    4s(h)(5)

    [[Page 9794]]

    and issues raised by commenters \839\ and is persuaded that, for

    transactions with an ERISA plan under final Sec. 23.450, swap dealers

    and major swap participants need only have a reasonable basis to

    believe that an ERISA plan representative is an ERISA fiduciary. This

    interpretation of Section 4s(h)(5) of the CEA is informed by the

    comprehensive federal regulatory scheme that applies to plans subject

    to regulation under ERISA, the importance of harmonizing the Dodd-Frank

    Act requirements with ERISA to avoid unintended consequences, and the

    Commission's view that ERISA plans will continue to benefit from the

    many other protections under subpart H of part 23 of the Commission's

    rules. The Commission declines to opine on commenters claims that

    requirement's under ERISA for plan fiduciaries are comparable,\840\ or

    not,\841\ to those criteria in subclauses (I)-(VI) of Section

    4s(h)(5)(A)(i). That is more appropriately addressed by DOL, the

    primary regulator of ERISA plans.

    ---------------------------------------------------------------------------

    \839\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36-37; ERIC Feb.

    22 Letter, at 2 and 6; ABC/CIEBA June 3 Letter, at 6.

    \840\ See, e.g., ERIC Feb. 22 Letter, at 6-9.

    \841\ AFSCME Feb. 22 Letter, at 5.

    ---------------------------------------------------------------------------

    Thus, the Commission is adopting proposed Sec. 23.450(b)(7)

    (renumbered as Sec. 23.450(b)(2)) as a separate provision that applies

    only with respect to ERISA plans as defined in Sec. 23.401(c)(3). A

    swap dealer or major swap participant that offers or enters into a swap

    with an ERISA plan need only have a reasonable basis to believe that

    the ERISA plan's representative is an ERISA fiduciary.

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

    Representative

    The Commission has determined to clarify the final rule text to

    address commenters' concerns that a swap dealer or major swap

    participant could use the statutory framework prescribed for assessing

    the qualifications of a Special Entity representative to overreach in

    requesting information from the Special Entity or to otherwise gain a

    negotiating advantage. Thus, the Commission has added Sec. 23.450(d),

    which states that a swap dealer or major swap participant shall have a

    reasonable basis to believe a Special Entity's chosen representative

    complies with all criteria under Sec. 23.450 where the swap dealer or

    major swap participant receives certain representations from the

    Special Entity and its representative.\842\ The representations under

    Sec. 23.450(d) may be made, as appropriate, on a relationship basis in

    counterparty relationship documentation consistent with Sec. Sec.

    23.402(d) and 23.450(e). Finally, Sec. 23.450(f) requires a swap

    dealer or major swap participant's chief compliance officer to review

    any determination that the swap dealer or major swap participant does

    not have a reasonable basis to believe that a Special Entity's

    representative meets the criteria in Sec. 23.450. The chief compliance

    officer's review must ensure that there is a substantial, unbiased

    basis for the determination.

    ---------------------------------------------------------------------------

    \842\ Section 23.450(d) supra fn. 833. See also Section

    IV.C.3.e. of this adopting release for a discussion of Sec.

    23.450(d).

    ---------------------------------------------------------------------------

    d. Representative Qualifications

    i. Regulated Entities and Suggested Certification Regime

    The Commission declines commenters' suggestion that a swap dealer

    or major swap participant be permitted to conclude that a Special

    Entity's representative is per se qualified because it has a particular

    status such as CTA, bank, investment adviser, insurance company,

    municipal advisor, state law pension fiduciary, or is an employee of

    the Special Entity.\843\ The statutory language does not reference any

    ``status'' other than a fiduciary as defined in ERISA. As a result the

    Commission is not inclined to conclude that regulatory status alone is

    a sufficient proxy for the enumerated criteria in Section 4s(h)(5)(A).

    ---------------------------------------------------------------------------

    \843\ The Commission's determination that ERISA plan

    representatives that are ERISA fiduciaries will meet the

    requirements of the rule is premised on the statutory language

    referencing the comprehensive Federal regulatory scheme under ERISA.

    See also Section IV.C.3.b. of this adopting release for a discussion

    of representatives of ERISA plans.

    ---------------------------------------------------------------------------

    The Commission is continuing to consider commenters' suggestion

    that the Commission or an SRO develop a voluntary certification and

    proficiency examination program for independent representatives that

    would permit a swap dealer or major swap participant to rely on such

    certification as satisfying the enumerated criteria.\844\ In this

    regard, the Commission notes, that it has begun informal consultations

    with the staffs of the SEC, NFA, and MSRB to harmonize regulatory

    requirements for municipal advisors and CTAs that advise municipalities

    on swaps. The Commission intends to continue to explore whether such

    efforts could be incorporated into a broader application for the

    independent representatives of all Special Entities.

    ---------------------------------------------------------------------------

    \844\ The Commission is considering both legal and practical

    issues raised by commenters' certification proposal. See, e.g.,

    Section 4o(2) of the CEA makes it unlawful for any CTA or commodity

    pool operator registered under the CEA to ``represent or imply in

    any manner whatsoever that such person has been sponsored,

    recommended, or approved by the United States or any agency or

    officer thereof.'' From a practical standpoint, the proposal would

    depend on resources committed by an SRO or private certification

    board.

    ---------------------------------------------------------------------------

    In the meantime, however, the Commission believes that final Sec.

    23.450 provides a manageable approach for qualifying Special Entity

    representatives that addresses the commenters' concerns about the role

    of swap dealers and major swap participants under the statutory

    framework and proposed Sec. 23.450. The Commission has clarified the

    means of compliance for a swap dealer or major swap participant,

    including compliance through representations made on a relationship

    basis, as appropriate. Furthermore, the Commission is adopting an

    alternative means of compliance under Sec. 23.450(d) \845\ with clear,

    objective criteria that will permit a swap dealer or major swap

    participant to form a reasonable basis to believe that a Special

    Entity's representative meets the relevant criteria, without undue

    influence on the selection process.

    ---------------------------------------------------------------------------

    \845\ See Section IV.C.3.e. of this adopting release for a

    discussion of Sec. 23.450(d) (under Sec. 23.450(d), as adopted, a

    swap dealer or major swap participant shall have a reasonable basis

    to believe a Special Entity's chosen representative complies with

    all criteria under Sec. 23.450 where the swap dealer or major swap

    participant receives certain representations from the Special Entity

    and its representative).

    ---------------------------------------------------------------------------

    ii. Sufficiently Knowledgeable

    The Commission requested comment on whether there are other

    qualifications that should be considered regarding whether an

    independent representative has sufficient knowledge to evaluate the

    transaction and risks.\846\ The Commission did not receive comments

    addressing any additional qualifications other than a representative

    that holds a particular regulatory, state law, or employment

    status.\847\ Therefore, the Commission is adopting Sec. 23.450(b)(1)

    as proposed (renumbered as Sec. 23.450(b)(1)(i)).

    ---------------------------------------------------------------------------

    \846\ Proposing release, 75 FR at 80653.

    \847\ The Commission separately addressed comments regarding a

    Special Entity's representative that holds a particular regulatory,

    state law or employment status. See Section IV.C.3.d.i. of this

    adopting release.

    ---------------------------------------------------------------------------

    The Commission has determined to delete from the final rule text

    the list of factors that a swap dealer or major swap participant would

    be expected to consider in determining whether an independent

    representative meets the enumerated criteria in the proposed rule.\848\

    Commenters found the

    [[Page 9795]]

    proposed rule text confusing and unworkable.\849\ In light of the

    comments, the Commission has determined that such considerations are

    more appropriate as guidance regarding whether a representative is

    sufficiently knowledgeable, and would be relevant where the Special

    Entity did not provide the representations specified in Sec. 23.450(d)

    for establishing the qualifications of a representative.

    ---------------------------------------------------------------------------

    \848\ The proposed rule set out several factors to be considered

    by swap dealers and major swap participants in determining whether

    the Special Entity's representative satisfies certain of the

    enumerated criteria, including (1) the nature of the Special Entity-

    representative relationship; (2) the representative's ability to

    make hedging or trading decisions; (3) the use of consultants or,

    with respect to employee benefit plans subject to ERISA, use of a

    QPAM or INHAM; (4) the representative's general level of experience

    in the financial markets and particular experience with the type of

    product under consideration; (5) the representative's ability to

    understand the economic features of the swap; (6) the

    representative's ability to evaluate how market developments would

    affect the swap; and (7) the complexity of the swap. These criteria

    will serve as guidance to swap dealers and major swap participants

    required to undertake due diligence to assess the sophistication of

    a Special Entity's representative.

    \849\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 3.

    ---------------------------------------------------------------------------

    Where a swap dealer or major swap participant is required to

    undertake due diligence to assess whether it has a reasonable basis to

    believe that a representative has sufficient knowledge to evaluate the

    transaction and risks, it should consider: (1) The representative's

    capability to make hedging or trading decisions, and the resources

    available to the representative to make informed decisions; (2) the use

    by the representative of one or more consultants; (3) the general level

    of experience of the representative in financial markets and specific

    experience with the type of instruments, including the specific asset

    class, under consideration; (4) the representative's ability to

    understand the economic features of the swap involved; (5) the

    representative's ability to evaluate how market developments would

    affect the swap; and (6) the complexity of the swap or swaps involved.

    Additional considerations may also include the representative's ability

    to analyze the credit risk, market risk, and other relevant risks posed

    by a particular swap and its ability to determine the appropriate

    methodologies used to evaluate relevant risks and the information which

    must be collected to do so. The listed considerations are illustrative

    guidance.\850\

    ---------------------------------------------------------------------------

    \850\ The Commission does not intend to imply that each

    consideration is necessarily a prerequisite for a swap dealer or

    major swap participant to form a reasonable basis to believe the

    representative is sufficiently knowledgeable. For example, an

    employee of a Special Entity, in some cases, may not use one or more

    third party consultants. However, this would not mean, in and of

    itself, that the representative is not sufficiently knowledgeable.

    ---------------------------------------------------------------------------

    iii. Statutory Disqualification

    The Commission did not receive any comments regarding this

    criterion under proposed Sec. 23.450(b)(2); therefore, the Commission

    adopts Sec. 23.450(b)(2) (renumbered as Sec. 23.450(b)(1)(ii)) and

    the definition of ``statutory disqualification'' in Sec. 23.450(a)(3)

    as proposed with respect to Special Entities other than ERISA plans.

    The Commission also clarifies that a representative must satisfy the

    criterion regardless of whether it is registered or is required to

    register with the Commission, such as an employee of the Special

    Entity.

    iv. Independence

    The Commission proposed a three prong test to determine whether the

    Special Entity representative was ``independent'' of the swap dealer or

    major swap participant. A representative would be deemed to be

    independent if: (1) It was not, within one year, an associated person

    of the swap dealer or major swap participant (proposed Sec.

    23.450(c)(1)); (2) there was no ``principal relationship'' between the

    representative and the swap dealer or major swap participant (proposed

    Sec. 23.450(a)(2) and (c)(2)); and (3) the representative did not have

    a ``material business relationship'' with the swap dealer or major swap

    participant (proposed Sec. 23.450(a)(1) and (c)(3)).\851\

    ---------------------------------------------------------------------------

    \851\ Proposing release, 75 FR at 80651-52 and 80660.

    ---------------------------------------------------------------------------

    a. Associated Person

    The Commission is adopting the ``associated person'' prong in

    proposed Sec. 23.450(c)(1) and clarifies that ``within one year''

    means ``within one year of representing the Special Entity in

    connection with the swap.'' The Commission clarifies that where the

    Special Entity's representative is an entity, the representative could

    still satisfy the ``associated person prong'' in final Sec.

    23.450(c)(1) if the representative had an employee that was an

    associated person of the swap dealer or major swap participant within

    the preceding twelve months (``restricted associated person'').\852\ To

    satisfy the ``associated person'' prong in this situation, a Special

    Entity's representative must comply with policies and procedures

    reasonably designed to manage and mitigate the conflict. Such policies

    and procedures, for example, should impose compensation restrictions to

    avoid having the restricted associated person benefit from the Special

    Entity's transactions with the swap dealer or major swap participant

    and provide for informational barriers, as appropriate, between any

    restricted associated person and those employees that directly provide

    advice, make trading decisions or otherwise manage and supervise the

    Special Entity's account with respect to swaps with the swap dealer or

    major swap participant.

    ---------------------------------------------------------------------------

    \852\ The definition of ``associated person of a swap dealer or

    major swap participant'' under Section 1a(4) of the CEA (7 U.S.C.

    1a(4)) is limited by its terms to natural persons. Section 1a(4)

    states in relevant part that the term ``means a person who is

    associated with a swap dealer or major swap participant as a

    partner, officer, employee, or agent (or any person occupying a

    similar status or performing similar function) in any capacity that

    involves--(i) the solicitation or acceptance of swaps; or (ii) the

    supervision of any person or persons so engaged.''

    ---------------------------------------------------------------------------

    b. Principal Relationship

    The Commission is also adopting the ``principal relationship''

    prong of the proposed independence test with one clarification. Section

    23.450(a)(2) (renumbered as Sec. 23.450(a)(1)) is amended to clarify

    that the term ``principal,'' with respect to any swap dealer, major

    swap participant, or Special Entity's representative, means any person

    listed in Sec. 3.1(a)(1)-(3) as opposed to a person defined in Sec.

    3.1(a).

    c. Material Business Relationship

    Proposed Sec. 23.450(a)(1) defined ``material business

    relationship'' as any relationship, whether compensatory or otherwise,

    that could reasonably affect the independent judgment or decision

    making of the representative. The Commission has determined to delete

    the ``material business relationship'' prong of the independence test

    in proposed Sec. 23.450(a)(1) and (c)(3) and to substitute the

    following three criteria that were encompassed within the definition.

    First, under Sec. 23.450(c)(3), to be deemed ``independent,'' a

    representative must (1) provide timely and effective disclosures of all

    material conflicts of interest that could reasonably affect the

    judgment or decision making of the representative with respect to its

    obligations to the Special Entity, and (2) comply with policies and

    procedures reasonably designed to manage and mitigate all such material

    conflicts of interest. In the Commission's view, to be ``timely and

    effective'' the disclosures would be have to be sufficient to permit

    the Special Entity to assess the conflict of interest and take steps to

    mitigate any materially adverse effect on the Special Entity that could

    be created by the conflict. In determining whether a conflict of

    interest exists, a representative would be expected to review its

    relationships with the swap dealer or major swap participant and their

    affiliates, including lines of

    [[Page 9796]]

    business in which the representative will solicit business on an

    ongoing basis.\853\ Additionally, where applicable, the representative

    should review relationships of its principals and employees who could

    reasonably affect the judgment or decision making of the representative

    with respect to its obligations to the Special Entity. The

    representative must also manage and mitigate its material conflicts of

    interest to avoid having a materially adverse effect on the Special

    Entity. A representative should establish and comply in good faith with

    written policies and procedures that identify, manage and mitigate

    material conflicts of interest including, where appropriate, those

    arising from (1) compensation or incentives for employees that carry

    out the representative's obligations to the Special Entity, and (2)

    lines of business, functions and types of activities conducted by the

    representative for the swap dealer or major swap participant.\854\

    ---------------------------------------------------------------------------

    \853\ For example, a representative may have separate lines of

    business in which it provides services to swap dealers, major swap

    participants, or their affiliates. The representative should

    consider whether such ongoing relationships where it has an interest

    in maintaining existing business or soliciting future business could

    reasonably affect its judgment or decision making with respect to

    its obligations to the Special Entity.

    \854\ Similarly, the Special Entity and representative should

    consider the basis upon which the representative will be compensated

    by the Special Entity to ensure that the representative's

    compensation is not contingent upon executing, for example, a

    particular swap, or a swap with a particular dealer or major swap

    participant. The Commission understands based on industry practice

    that representative fees are sometimes paid at the time of execution

    of the swap by the swap dealer or major swap participant at the

    direction of the Special Entity for services provided by the

    representative in connection with the swap. In the proposed rule,

    the Commission recognized that such transfer of payment on behalf of

    the Special Entity would not necessarily be a material conflict of

    interest between the representative and the swap dealer or major

    swap participant. See proposed definition of material business

    relationship in proposed Sec. 23.450(a)(1). Proposing release, 75

    FR at 80660. However, Special Entities and representatives must

    ensure that the compensation arrangement does not undermine the

    independence and ``best interests'' duty of the representative as a

    result of the contingent nature of the fee arrangement. As a

    nonexclusive example, where a representative's compensation is

    contingent on execution by the Special Entity of a specific

    transaction with a specific swap dealer, the representative will

    have a material conflict of interest and will not be incentivized to

    act in the best interests of the Special Entity. Special Entities

    should ensure that the fee arrangements with their representatives

    do not compromise the independence of the representative, create

    conflicts of interest or otherwise undermine the quality of the

    advice provided by the representative.

    ---------------------------------------------------------------------------

    Second, the Commission has added Sec. 23.450(c)(4) to the

    independence test to clarify that a representative may not, directly or

    indirectly, control, be controlled by, or be under common control with

    the swap dealer or major swap participant. This provision is consistent

    with the ``principal relationship'' prong and clarifies that a

    representative would not be deemed ``independent'' where there is

    indirect control through one or more persons or common control with the

    swap dealer or major swap participant.

    Finally, the Commission is adopting Sec. 23.450(c)(5), which

    clarifies that a representative will not be deemed independent if the

    swap dealer or major swap participant refers, recommends, or introduces

    the representative to the Special Entity within one year of the

    representative's representation of the Special Entity in connection

    with the swap. The Commission believes a Special Entity should retain a

    representative without input from the swap dealer or major swap

    participant. If a swap dealer or major swap participant is asked by a

    Special Entity for a name or list of names of potential

    representatives, the swap dealer or major swap participant would be

    expected either to decline to answer or direct the Special Entity to,

    for example, an independently maintained repository of business

    listings such as a list of registrants with a relevant SRO, a trade

    association unaffiliated with the swap dealer or major swap

    participant, or a widely-available independent publication that

    provides industry contact information.

    The Commission has considered the comments and believes that

    deleting the ``material business relationship'' prong and substituting

    the enumerated criteria in Sec. 23.450(c) resolves commenters' primary

    issues about clarity and workability. In addition, the reformulation of

    the treatment of ERISA plans under Sec. 23.450(b)(2) eliminates any

    potential conflict with the independence test under ERISA.\855\ The

    final rule also resolves commenters' concern that the standard would

    inappropriately preclude qualified asset managers with complex business

    relationships with swap dealers or major swap participants from acting

    as Special Entity representatives. Furthermore, any added costs

    associated with the duty to disclose and mitigate material conflicts of

    interest will only be incremental because many third party independent

    representatives will already be subject to similar or identical

    disclosure obligations by virtue of being a CTA, investment adviser,

    municipal advisor, or other fiduciary to the Special Entity. The

    Commission has also determined that a conflicts disclosure regime

    paired with an obligation to manage and mitigate conflicts

    appropriately balances the statutory independence criterion with any

    associated costs.

    ---------------------------------------------------------------------------

    \855\ See Section IV.C.3.b. of this adopting release.

    ---------------------------------------------------------------------------

    v. Duty To Act in the Best Interests

    The Commission agrees with commenters that a swap dealer or major

    swap participant could rely \856\ on evidence of legal arrangements

    between the Special Entity and its representative that the

    representative is obligated to act in the best interests of the Special

    Entity, including by contract, an employment agreement, or requirements

    under state or federal law.\857\ Having considered the comments, the

    Commission is adopting Sec. 23.450(b)(4) as proposed (renumbered as

    Sec. 23.450(b)(1)(iv)).

    ---------------------------------------------------------------------------

    \856\ In making the representations specified in Sec. 23.450(d)

    for establishing the qualifications of a representative Special

    Entities are encouraged to ensure that their policies and procedures

    are sufficiently robust to evaluate the effectiveness and

    enforceability of the obligations of the representative to act in

    the best interests of the Special Entity, to make appropriate and

    timely disclosures, and to evaluate the appropriateness and pricing

    of any swaps entered into by the Special Entity.

    \857\ This is also consistent with proposed Sec.

    23.450(d)(2)(i), which stated that relevant considerations for a

    swap dealer or major swap participant include: ``The nature of the

    relationship between the Special Entity and the representative and

    the duties of the representative, including the obligation to act in

    the best interests of the Special Entity.'' As with proposed Sec.

    23.450(d)(2)(ii) (vii), the Commission has decided to delete

    proposed Sec. 23.450(d)(2)(i) and adopt it as guidance.

    ---------------------------------------------------------------------------

    As more fully discussed in connection with Sec. 23.440, the

    Commission has determined that a best interests duty under Sec. Sec.

    23.440 and 23.450 will be the duty to act in good faith, make full and

    fair disclosure of all material facts and conflicts of interest, and to

    employ reasonable care to advance the Special Entity's stated

    objectives.\858\

    ---------------------------------------------------------------------------

    \858\ Section IV.B.3.c. of this adopting release.

    ---------------------------------------------------------------------------

    vi. Appropriate and Timely Disclosures

    The Commission also agrees with commenters and confirms that a swap

    dealer or major swap participant could rely on appropriate legal

    arrangements between a Special Entity and its representative to form a

    reasonable basis to believe the representative makes appropriate and

    timely disclosures. Therefore, the Commission is adopting Sec.

    23.450(b)(5) as proposed (renumbered as Sec. 23.450(b)(1)(v)).\859\

    ---------------------------------------------------------------------------

    \859\ See supra, fn. 856.

    ---------------------------------------------------------------------------

    The Commission expects that ``appropriate disclosures'' will be

    assessed in the context of the Special Entity-representative

    relationship. For example, a third party advisor would be expected to

    disclose all compensation it receives, directly or indirectly, with

    [[Page 9797]]

    respect to the swap, and it would be expected to disclose all material

    conflicts of interest. Disclosures should also include all fees and

    compensation structures in a manner that is clearly understandable to

    the Special Entity.\860\ A representative that is a Special Entity's

    employee would be expected to disclose material information not

    otherwise known to a Special Entity through the employment relationship

    such as any material compensation the representative receives from a

    third party or where the representative trades for its own account in

    the same or a related market. The Commission also expects that a

    representative would timely disclose to the Special Entity (or to

    appropriate supervisors in the case of an employee), where appropriate,

    unexpected gains or losses, unforeseen changes in the market place,

    compliance irregularities or violations, and other material

    information.\861\

    ---------------------------------------------------------------------------

    \860\ For example, where a representative's fee is expressed as

    basis points on the notional amount of the transaction, the

    representative should also disclose a calculation of the fee in

    dollars.

    \861\ The Commission encourages Special Entities to consider the

    factors discussed in this adopting release in developing appropriate

    policies and procedures for selecting a qualified representative and

    monitoring their ongoing performance.

    ---------------------------------------------------------------------------

    vii. Fair Pricing and Appropriateness

    Section 4s(h)(5)(A)(i)(VI) states that the representative will

    provide ``written representations to the Special Entity regarding fair

    pricing and the appropriateness of the transaction.'' Proposed Sec.

    23.450(b)(6) refined the statutory language to state that the

    representative ``evaluates, consistent with any guidelines provided by

    the Special Entity, fair pricing and the appropriateness of the

    swap.''\862\ Having considered the comments, the Commission is adopting

    Sec. 23.450(b)(6) as proposed (renumbered as Sec. 23.450(b)(1)(vi)).

    ---------------------------------------------------------------------------

    \862\ Proposing release, 75 FR at 80652-53 and 80660. A

    commenter requested that the Commission confirm that implementation

    of a hedge policy and periodic review of compliance with the policy

    would be sufficient to meet the fair pricing and appropriateness

    criterion. APGA Feb. 22 Letter, at 6. The Commission declines to

    endorse any particular method of compliance with the statutory

    criteria in light of the principles based nature of the rule but

    believes such considerations would be relevant to an assessment of

    compliance with the criterion.

    ---------------------------------------------------------------------------

    The Commission also clarifies that this provision does not require

    that the representative provide transaction-by-transaction

    documentation to the Special Entity with respect to fair pricing and

    appropriateness of the swap. The Commission expects that in

    circumstances where the representative is given discretionary trading

    authority, for example, the representative could undertake in an

    investment management agreement or other agreement to ensure that the

    representative will evaluate pricing and appropriateness of each swap

    consistent with any guidelines provided by the Special Entity prior to

    entering into the swap. The Commission notes, however, that the

    independent representative would be expected to prepare and maintain

    adequate documentation of its evaluation of pricing and appropriateness

    to enable both the representative and Special Entity to audit for

    compliance with the duty.

    viii. Restrictions on Political Contributions by the Independent

    Representative of a Governmental Special Entity

    The Commission is adopting Sec. 23.450(b)(8) (renumbered as Sec.

    23.450(b)(1)(vii)) with modifications to the term ``municipal entity.''

    \863\ Consistent with the modifications to Sec. 23.451, the phrase

    ``municipal entity as defined in Sec. 23.451'' has been replaced with

    the phrase ``Special Entity as defined in Sec. 23.401(c)(2) or (4).''

    This modification clarifies that the rule only applies to

    representatives of State and municipal Special Entities and

    governmental plans. The Commission also clarifies that the exclusion

    for employees of such Special Entities is limited to paragraph Sec.

    23.450(b)(1)(vii).

    ---------------------------------------------------------------------------

    \863\ Although the Commission did not receive any comments

    regarding the requirements of proposed Sec. 23.450(b)(8), two

    commenters requested the Commission clarify the differences between

    the term ``municipal entity'' in proposed Sec. 23.450(b)(8) and

    Sec. 23.451 and the definition of Special Entity. See, APGA Feb. 22

    Letter, at 2; AMG-SIFMA Feb. 22 Letter, at 13. The Commission has

    addressed the substance of those comments in the definitions section

    (see Section IV.A.3.b. of this adopting release) and the section on

    Sec. 23.451 (see Section IV.D.3. of this adopting release).

    ---------------------------------------------------------------------------

    The Commission also notes that while the provision requires an

    assessment of whether the representative is subject to restrictions on

    certain political contributions imposed by the Commission, SEC, or an

    SRO, neither the Commission nor a registered futures association has,

    as of the adoption of these rules, promulgated such requirements for

    CTAs that advise State and municipal Special Entities or governmental

    plans.\864\ Therefore, the Commission has set a separate implementation

    schedule for Sec. 23.450(b)(1)(vii).\865\

    ---------------------------------------------------------------------------

    \864\ Investment advisers registered with the SEC are currently

    subject to SEC Advisers Act Rule 206(4)-5, Political Contributions

    by Certain Investment Advisers, effective date Sept. 13, 2010, 17

    CFR 275.206(4)-5; see also SEC's proposed rules, 76 FR 41018.

    Pending final adoption of the SEC's registration rule for municipal

    advisors, the MSRB has withdrawn the Proposed Interpretive Notice

    Concerning the Application of Rule G-17, on Conduct of Municipal

    Securities and Municipal Advisory Activities, to Municipal Advisors,

    SR-MSRB-2011-15 (August 24, 2011). In a press release, the MSRB

    stated, ``Upon the SEC's adoption of a permanent definition of the

    term `municipal advisor' under the Exchange Act, the MSRB plans to

    resubmit these rule proposals,'' MSRB Notice 2011-51 (Sept. 9,

    2011).

    \865\ See Section V at fn. 926 of this adopting release for a

    discussion of the implementation schedule for Sec.

    23.450(b)(1)(vii).

    ---------------------------------------------------------------------------

    e. Reasonable Reliance on Representations

    Final Sec. 23.450 allows swap dealers and major swap participants

    to comply with the rule by relying on representations of counterparties

    with respect to the qualifications of their independent

    representatives. Commenters were particularly concerned with the

    language in proposed Sec. 23.450(d) (renumbered as Sec. 23.450(e))

    that the representations be reliable ``taking into consideration the

    facts and circumstances of a particular Special Entity-representative

    relationship, assessed in the context of a particular transaction'' and

    that the representations be ``sufficiently detailed.'' \866\ New final

    Sec. 23.450(d) (safe harbor) and final Sec. 23.450(e) (reasonable

    reliance on representations of the Special Entities) together address

    many of the commenters' concerns by clarifying the content of

    representations that will be deemed to provide a swap dealer or major

    swap participant a reasonable basis to believe a Special Entity's

    representative meets the qualification criteria.\867\ The

    [[Page 9798]]

    Commission also confirms that such representations, where appropriate,

    can be contained in counterparty relationship documentation to avoid

    transaction-by-transaction compliance.\868\

    ---------------------------------------------------------------------------

    \866\ See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36; proposing

    release, 75 FR at 80660.

    \867\ Final Sec. 23.450(d) and (e) provide:

    (d) Safe Harbor. (1) A swap dealer or major swap participant

    shall be deemed to have a reasonable basis to believe that the

    Special Entity, other than a Special Entity defined in Sec.

    23.401(c)(3), has a representative that satisfies the applicable

    requirements of paragraph (b)(1) of this section, provided that: (i)

    The Special Entity represents in writing to the swap dealer or major

    swap participant that it has complied in good faith with written

    policies and procedures reasonably designed to ensure that it has

    selected a representative that satisfies the applicable requirements

    of paragraph (b) of this section, and that such policies and

    procedures provide for ongoing monitoring of the performance of such

    representative consistent with the requirements of paragraph (b) of

    this section; and (ii) The representative represents in writing to

    the Special Entity and swap dealer or major swap participant that

    the representative: (A) Has policies and procedures reasonably

    designed to ensure that it satisfies the applicable requirements of

    paragraph (b) of this section; (B) Meets the independence test in

    paragraph (c) of this section; and (C) Is legally obligated to

    comply with the applicable requirements of paragraph (b) of this

    section by agreement, condition of employment, law, rule,

    regulation, or other enforceable duty. (2) A swap dealer or major

    swap participant shall be deemed to have a reasonable basis to

    believe that a Special Entity defined in Sec. 23.401(c)(3) has a

    representative that satisfies the applicable requirements in

    paragraph (b)(2) of this section provided that the Special Entity

    provides in writing to the swap dealer or major swap participant the

    representative's name and contact information, and represents in

    writing that the representative is a fiduciary as defined in Section

    3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C.

    1002).

    (e) Reasonable reliance on representations of the Special

    Entity. A swap dealer or major swap participant may rely on written

    representations of a Special Entity and, as applicable under this

    section, the Special Entity's representative to satisfy any

    requirement of this section as provided in Sec. 23.402(d).

    \868\ As the Commission stated in the proposing release, such

    representations can be included in counterparty relationship

    documentation or other written agreement between the parties and

    that the representations can be deemed applicable or renewed, as

    appropriate, to subsequent swaps between the parties if the

    representations continue to be accurate and relevant with respect to

    the subsequent swaps. Proposing release, 75 FR at 80641.

    ---------------------------------------------------------------------------

    Some commenters suggested that the Commission permit a simple

    representation that a Special Entity's representative satisfies the

    criteria in the statute and rule. The Commission does not believe that

    such an approach is consistent with the statutory framework or the

    intent of Congress to provide meaningful protections for Special

    Entities. Nevertheless, the Commission believes it is appropriate to

    limit the ability of swap dealers and major swap participants to

    subvert the purpose of the independent representative provisions in

    Section 4s(h)(5). The Commission further believes that the final rule

    addresses commenters concerns while encouraging processes to ensure

    that the quality of representation is consistent with the statutory

    criteria. The Commission's formulation of the representations will

    encourage Special Entities and independent representatives to undertake

    appropriate due diligence to ensure that they incorporate the statutory

    criteria in the selection and ongoing performance of the independent

    representative.\869\ For example, a representative with specific

    expertise in interest rate swaps might not be qualified to advise on an

    oil swap. Under the rule, the Special Entity and independent

    representative would have to undertake to ensure that their policies

    and procedures were sufficiently robust to take account of changing

    circumstances. In addition, Special Entities and their representatives

    should ensure that their policies and procedures require that the

    representations provided to the swap dealer or major swap participant

    are authorized at the appropriate decision making level of the Special

    Entity or representative.\870\

    ---------------------------------------------------------------------------

    \869\ See, e.g., SEC and DOL guidance--Selecting and Monitoring

    Pension Consultants: Tips for Plan Fiduciaries, available at http://www.dol.gov/ebsa/newsroom/fs053105.html; also available at http://www.sec.gov/investor/pubs/sponsortips.htm.

    \870\ Such representations would also apply to representatives

    that are employees of the Special Entity. For example, the Special

    Entity could represent that it has (1) complied in good faith with

    policies and procedures reasonably designed to ensure that its

    representative employee meets the criteria, and (2) has reasonably

    designed policies and procedures that the employee must follow to

    ensure that it satisfies the criteria. The employee could represent

    that it has complied in good faith with the Special Entity's

    policies and procedures and that it is legally obligated under its

    employment agreement or by law to comply with the applicable

    criteria of Sec. 23.450(b).

    ---------------------------------------------------------------------------

    A swap dealer or major swap participant would be able to rely on

    representations unless it had information that would cause a reasonable

    person to question the accuracy of the representation.\871\ The

    Commission declines to adopt other commenters' suggestion that swap

    dealers and major swap participants be permitted to rely on

    representations unless it had actual knowledge that the representations

    were untrue. The Commission has determined that an actual knowledge

    standard may inappropriately encourage the swap dealer or major swap

    participant to ignore red flags.\872\

    ---------------------------------------------------------------------------

    \871\ The Commission's determination is consistent with several

    commenters' suggestions. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 36

    (``[swap dealers] should be permitted to rely on a written

    representation * * * that the counterparty and/or its representative

    satisfies the standards * * * absent actual notice of countervailing

    facts (or facts that reasonably should have put [a swap dealer] on

    notice), which would trigger a consequent duty to inquire

    further.''); see also supra fn. 724 and 820.

    \872\ See Section III.A.3.d. of this adopting release for a

    discussion of Sec. 23.402(d)--Reasonable reliance on

    representations.

    ---------------------------------------------------------------------------

    Commenters requested that the Commission clarify that the exchange

    of representations will not give parties any additional rescission,

    early termination, or monetary compensation rights.\873\ The Commission

    declines to opine as to potential liability in disputes between private

    parties, which will depend on the facts and circumstances of the

    particular case and applicable law.\874\

    ---------------------------------------------------------------------------

    \873\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 12-13 (asserting

    that a swap dealer faced with a highly volatile market and

    disadvantageous swap position could claim that a Special Entity

    provided inaccurate representations to avoid its obligations); AMG--

    SIFMA Feb. 22 Letter, at 10.

    \874\ For the same reasons, the Commission declines to opine as

    to whether a swap dealer or major swap participant would have

    liability to the Special Entity or its representative as a result of

    its good faith determination that the representative was not

    qualified. See, e.g., SIFMA/ISDA Feb. 17 Letter, at 38-39. The

    Commission notes, however, that the duty under Section 4s(h)(5)(A)

    and final Sec. 23.450 only requires a swap dealer to have a

    reasonable basis to believe that a representative is qualified.

    Thus, any determination under proposed Sec. 23.450(e), as clarified

    in the final rule (renumbered as Sec. 23.450(f)), would not be a

    determination by the swap dealer or major swap participant that the

    representative is unqualified.

    ---------------------------------------------------------------------------

    f. Chief Compliance Officer Review

    The Commission has determined to adopt proposed Sec. 23.450(e)

    (renumbered as Sec. 23.450(f)) with one modification. The phrase

    ``determines that the representative * * * does not meet the criteria''

    has been changed to read ``determines that [the swap dealer or major

    swap participant] does not have a reasonable basis to believe that the

    representative * * * meets the criteria.'' This clarifies the

    Commission's view that Sec. 23.450 does not give swap dealers and

    major swap participants the authority to determine whether a

    representative meets the criteria under Sec. 23.450(b). Rather,

    consistent with the duty, a swap dealer or major swap participant is

    required to have a reasonable basis to believe the representative

    satisfies the criteria. The Commission has determined that the

    clarifications and modifications to Sec. 23.450 provide meaningful

    protections against commenters' concerns that a swap dealer or major

    swap participant may overreach or otherwise gain a negotiating

    advantage when requesting information from the Special Entity. The

    Commission declines to adopt a commenter's suggestion that the written

    determination be made by the trading supervisor instead of the chief

    compliance officer. As stated in the rule, the Commission expects the

    chief compliance officer to review such determination to ensure that

    the swap dealer or major swap participant has a substantial, unbiased

    basis for the determination.\875\ The Commission believes that a chief

    compliance officer is in a better position to review such a

    determination for compliance with the rules. A trading supervisor is

    more likely to be directly involved with the Special Entity and to have

    direct material incentives or bonus structures that could be affected

    by such a determination.

    ---------------------------------------------------------------------------

    \875\ The Commission believes that reviewing the determination

    is part of the CCO's duty to ``take reasonable steps to ensure

    compliance.'' See proposed Sec. 3.3(d)(3), CCO proposed rules, 75

    FR at 70887.

    ---------------------------------------------------------------------------

    One commenter also requested that the rule require the written

    record also be submitted to the Commission for review. The Commission

    notes that such records of compliance must be kept and made available

    to the Commission for

    [[Page 9799]]

    inspection.\876\ In addition, chief compliance officers are required

    under Section 4s(k) of the CEA and proposed Sec. 3.3 to report to the

    Commission annually about the firm's compliance record.\877\ Thus, the

    Commission will be apprised of material compliance failures on an

    annual basis.

    ---------------------------------------------------------------------------

    \876\ Section 23.402(g) requires swap dealers and major swap

    participants to create a record of their compliance and retain and

    make available for inspection such records in accordance with Sec.

    1.31 (17 CFR 1.31).

    \877\ See Section 4s(k) of the CEA and proposed Sec. 3.3, CCO

    proposed rules, 75 FR at 70887.

    ---------------------------------------------------------------------------

    g. Disclosure of Capacity

    The Commission is adopting Sec. 23.450(f) (renumbered as Sec.

    23.450(g)) as proposed. A swap dealer or major swap participant that

    acts in a capacity other than as a swap counterparty to a Special

    Entity must disclose the material differences between such capacities.

    For example, a swap dealer that is also a registered FCM would have to

    disclose that when it acts as an FCM it is the Special Entity's agent

    with respect to executing orders; however, when it acts as a swap

    dealer it is the Special Entity's counterparty and its interests are

    adverse to the Special Entity's. Such disclosure would be required, at

    a minimum, at a reasonably sufficient time prior to entering into a

    swap.\878\ The Commission declines commenters' suggestion that the

    required disclosure should be limited to different capacities in

    connection with the swap. Such a limitation would not address

    counterparty confusion that could arise when a swap dealer changes

    status from transaction to transaction. The Commission clarifies that

    such disclosures could be made on a relationship basis in counterparty

    relationship documentation, where appropriate. Permitting such

    disclosure on a relationship basis implements the statutory duty while

    appropriately mitigating associated costs.

    ---------------------------------------------------------------------------

    \878\ See, e.g., Section III.D. of this adopting release for a

    discussion of Sec. 23.431 (Sec. 23.431(a) requires disclosures

    ``at a reasonably sufficient time prior to entering into a swap'').

    ---------------------------------------------------------------------------

    D. Section 23.451--Political Contributions by Certain Swap Dealers

    1. Proposed Sec. 23.451

    Pursuant to the Commission's discretionary rulemaking authority

    under Section 4s(h) of the CEA, proposed Sec. 23.451 prohibited swap

    dealers and major swap participants from entering into swaps with

    ``municipal entities'' if they make certain political contributions to

    officials of such entities.\879\ The Commission stated that the

    proposed rule was meant to deter undue influence and other fraudulent

    practices that harm the public and to promote consistency in the

    business conduct standards that apply to financial market professionals

    dealing with municipal entities. Proposed Sec. 23.451 complemented

    existing pay-to-play prohibitions imposed by the SEC and the MSRB.

    ---------------------------------------------------------------------------

    \879\ Proposing release, 75 FR at 80654.

    ---------------------------------------------------------------------------

    In a manner similar to the prohibitions contained in SEC Advisers

    Act Rule 206(4)-5 \880\ and MSRB Rules G-37 and G-38,\881\ proposed

    Sec. 23.451, generally, made it unlawful for a swap dealer or major

    swap participant to offer to enter or to enter into a swap with a

    municipal entity for a two-year period after the swap dealer or major

    swap participant or any of its covered associates makes a contribution

    to an official of the municipal entity. The proposed rule also

    prohibited a swap dealer or major swap participant from paying a third-

    party to solicit municipal entities to enter into a swap, unless the

    third-party is a ``regulated person'' that is itself subject to a so-

    called pay-to-play restriction under applicable law.

    ---------------------------------------------------------------------------

    \880\ 17 CFR 275.206(4)-5 (``SEC Advisers Act Rule 206(4)-5'').

    \881\ See MSRB Rule G-37, Political Contributions and

    Prohibitions on Municipal Securities Business; MSRB Rule G-38,

    Solicitation of Municipal Securities Business.

    ---------------------------------------------------------------------------

    The Commission proposed to define ``regulated person,'' for

    purposes of Sec. 23.451, to mean, generally, a person that is subject

    to rules of the SEC, the MSRB, an SRO or the Commission prohibiting it

    from engaging in specified activities if certain political

    contributions have been made, or its officers or employees.\882\

    Similar to SEC Advisers Act Rule 206(4)-5, the proposing release

    defined ``covered associate'' of a swap dealer or major swap

    participant as: ``(i) any general partner, managing member or executive

    officer, or other individual with a similar status or function; (ii)

    any employee who solicits a municipal entity for the swap dealer or

    major swap participant and any person who supervises, directly or

    indirectly, such employee; and (iii) any political action committee

    controlled by the swap dealer or major swap participant or any of its

    covered associates.'' \883\

    ---------------------------------------------------------------------------

    \882\ Proposing release, 75 FR at 80654 fn. 133.

    \883\ Id., at 80654.

    ---------------------------------------------------------------------------

    The proposed rule barred a swap dealer or major swap participant

    from soliciting or coordinating contributions to an official of a

    municipal entity with which the swap dealer or major swap participant

    is seeking to enter into or has entered into a swap, or payments to a

    political party of a state or locality with which the swap dealer or

    major swap participant is seeking to enter into or has entered into a

    swap.\884\ The proposed rule also included a provision that would make

    it unlawful for a swap dealer or major swap participant to do

    indirectly or through another person or means anything that would, if

    done directly, result in a violation of the prohibitions contained in

    the proposed rule.\885\

    ---------------------------------------------------------------------------

    \884\ Id.

    \885\ Id.

    ---------------------------------------------------------------------------

    The Commission's proposal included three exceptions. First, the

    proposed rule permitted an individual that is a covered associate to

    make aggregate contributions up to $350 per election, without being

    subject to the two-year time out period, to any one official for whom

    the individual is entitled to vote, and up to $150 per election to an

    official for whom the individual is not entitled to vote. Second, the

    proposed rule did not apply to contributions by an individual made more

    than six months prior to becoming a covered associate of the swap

    dealer or major swap participant, unless such individual solicits the

    municipal entity after becoming a covered associate. Third, the

    prohibitions did not apply to a swap that is initiated on a DCM or SEF,

    for which the swap dealer or major swap participant does not know the

    identity of the counterparty.

    In addition to the above-mentioned exceptions, proposed Sec.

    23.451 included an automatic exemption for those cases where (1) a

    contribution made by a covered associate did not exceed $150 or $350,

    as applicable, (2) was discovered by the swap dealer or major swap

    participant within four months of the date of contribution, and (3) was

    returned to the contributor within 60 calendar days of the date of

    discovery.\886\ In addition, the Commission proposed that a swap dealer

    or major swap participant could apply to the Commission for an

    exemption from the two-year ban and, when considering the exemption

    application, the Commission would consider certain factors enumerated

    in the proposing release, including, for example, whether the exemption

    is necessary or appropriate in the public

    [[Page 9800]]

    interest and consistent with the protection of investors and the

    purposes of the CEA.\887\

    ---------------------------------------------------------------------------

    \886\ The scope of this proposed exception was limited to the

    types of contributions that are less likely to raise pay-to-play

    concerns, and the exception is intended to provide swap dealers with

    the ability to undo certain mistakes. Because it would operate

    automatically, the proposed exception was subject to conditions that

    are objective and limited to capture only those contributions that

    are unlikely to raise pay-to-play concerns. See also SEC Final

    Rules, Political Contributions by Investment Advisors, 75 FR 41035-

    36, Jul. 14, 2010.

    \887\ Id., at 80655.

    ---------------------------------------------------------------------------

    The Commission sought general and specific comment on a number of

    questions regarding proposed Sec. 23.451, including whether the term

    ``municipal entity'' was appropriately defined or whether certain

    alternatives should be considered. The Commission also sought comment

    on whether the proposed rule should apply only to swap dealers.\888\

    ---------------------------------------------------------------------------

    \888\ Id.

    ---------------------------------------------------------------------------

    2. Comments

    The Commission received several comments representing a diversity

    of views on proposed Sec. 23.451. Where one commenter believed

    proposed Sec. 23.451 represented an indispensable element of the

    business conduct standards and should be strengthened to prohibit a

    swap dealer from making a political contribution after the completion

    of a transaction, another believed the proposed rule should be deleted

    as unduly burdensome for those swap dealers that are part of financial

    institutions that are not, or will not be, subject to the rules of the

    MSRB.\889\ Alternatively, it was suggested by the latter commenter that

    any final rule parallel in certain respects the MSRB regulations on

    political contributions made in connection with municipal securities

    business and, in so doing, limit the final rule's scope to swap dealers

    and major swap participants already covered by the relevant MSRB

    regulations.\890\ In another alternative, this commenter requested that

    the Commission consider replacing as the triggering occasion for the

    application of the rule an ``offer to enter into or enter into a swap

    or a trading strategy involving a swap'' with the phrase ``engage in

    municipal swaps business.'' \891\ The commenter suggested that

    ``municipal swap business'' be defined to mean ``the execution of a

    swap with a municipal entity.'' \892\

    ---------------------------------------------------------------------------

    \889\ Cf. CFA/AFR Feb. 22 Letter, at 18, with SIFMA/ISDA Feb. 17

    Letter, at 39-40.

    \890\ SIFMA/ISDA Feb. 17 Letter, at 40.

    \891\ Id.

    \892\ Id.

    ---------------------------------------------------------------------------

    Regarding proposed Sec. 23.451(a)(3)'s definition of municipal

    entity,\893\ one commenter requested the Commission clarify differences

    with the definition of a State and municipal Special Entity under

    Section 4s(h)(1)(C)(2)(ii) \894\ and proposed Sec. 23.401, which

    limits the definition of Special Entity to ``a State, State agency,

    city, county, municipality, or other political subdivision of a

    State.'' \895\ Another commenter recommended excluding certain state-

    established plans that are run by third-party investment advisers, such

    as 529 college savings plans, from the definition of ``municipal

    entity'' or, at a minimum, creating a safe harbor from the pay-to-play

    provision where a Special Entity is represented by a qualified

    financial advisor and that advisor affirmatively selects the swap

    dealer.\896\

    ---------------------------------------------------------------------------

    \893\ See supra fn. 60 for a definition of the term ``municipal

    entity.''

    \894\ See Section IV.A. of this adopting release for a

    discussion of municipal entities and Special Entities.

    \895\ APGA Feb. 22 Letter, at 2.

    \896\ AMG-SIFMA Feb. 22 Letter, at 13.

    ---------------------------------------------------------------------------

    Regarding the proposed rule's definition of ``solicit,'' one

    commenter stated that the term could implicate communication by

    employees of a financial institution that do not have a role in the

    swaps business and who are already regulated by the MSRB.\897\ This

    commenter advocated that the Commission narrow the definition of

    ``solicit'' to include only ``direct communication by any person with a

    municipal entity for the purpose of obtaining or retaining municipal

    swaps business.'' In so doing, the commenter stated that the proposed

    rule does not include an analogous provision of MSRB Rule G-37 (and

    MSRB Proposed Rule G-42, Political Contributions and Prohibitions on

    Municipal Advisory Activities) limiting the scope of the rule to

    municipal financial professionals ``primarily engaged in municipal

    financial representative activities * * *.'' \898\ The same commenter

    urged the Commission to include a provision, parallel to the relevant

    MSRB rules, which specifies an operative date for the rule, such that

    it only applies to contributions made on or after its effective

    date.\899\

    ---------------------------------------------------------------------------

    \897\ SIFMA/ISDA Feb. 17 Letter, at 40.

    \898\ Id.

    \899\ Id.

    ---------------------------------------------------------------------------

    Another commenter stated that it is unclear how regulated entities

    will monitor for compliance with the proposed rule and suggested a re-

    writing of the rule in a more targeted fashion prohibiting ``political

    contributions with the intent to solicit swaps business.'' \900\ This

    commenter also stated that the term ``offer'' should be defined in a

    manner that is consistent with its traditional legal definition.\901\

    ---------------------------------------------------------------------------

    \900\ CEF Feb. 22 Letter, at 24.

    \901\ Id.

    ---------------------------------------------------------------------------

    3. Final Sec. 23.451

    The Commission has determined to adopt proposed Sec. 23.451 with

    changes to reflect certain of the comments and to harmonize its rule

    with the SEC's proposed pay-to-play prohibition.\902\ The SEC's

    proposed prohibition on certain political contributions by security-

    based swap dealers, proposed Rule 15Fh-6, would bar an SBS Dealer from

    entering into a security-based swap agreement with a ``municipal

    entity'' after they make contributions, with the aim of eliminating

    pay-to-play.\903\ Moreover, the Commission's approach to final Sec.

    23.451 is also consistent with MSRB Rules G-37 and G-38. Through such

    harmonization, the Commission achieves its goal of preventing quid pro

    quo arrangements while avoiding unnecessary burdens associated with

    disparities between the SEC's proposed rule and the Commission's final

    rule and guidance. In this way, the incremental cost of complying with

    the Commission's prohibition is expected to be minimal as many of the

    entities that will be subject to its restrictions should already have

    in place policies and procedures on political contributions by way of

    their compliance with existing requirements under SEC Advisers Act Rule

    206(4)-5 and MSRB Rules G-37 and G-38.

    ---------------------------------------------------------------------------

    \902\ In making this determination, the Commission concluded

    that final Sec. 23.451 is fully authorized by the discretionary

    rulemaking authority vested in the Commission by Section 731 of the

    Dodd-Frank Act, which amended the CEA by adding Section 4s(h). 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).

    \903\ SEC's proposed rules, 76 FR at 42432-33.

    ---------------------------------------------------------------------------

    There were two main changes made to proposed Sec. 23.451 in final

    Sec. 23.451. First, the Commission decided to exclude major swap

    participants from the pay-to-play prohibition because major swap

    participants, as defined, do not ``solicit'' swap transaction business

    within the meaning of the final rule and, as such, the Commission does

    not expect that major swap participants will assume a dealer-type role

    in the swap market.

    Second, in place of the term ``municipal entity'' in Sec.

    23.451(a), the Commission used the term ``governmental Special Entity''

    as defined in final Sec. 23.451(a)(3).\904\ This change clarifies that

    the pay-to-play

    [[Page 9801]]

    prohibition applies not just to municipalities, but to any

    contributions made for the purpose of obtaining state and/or local

    government business. It also addresses comments recommending that the

    Commission clarify that the prohibition only applies to certain Special

    Entities as defined in Section 4s(h) and final Sec. 23.401.

    ---------------------------------------------------------------------------

    \904\ Section 23.451(a)(3) defines ``governmental Special

    Entity'' as any Special Entity defined in Sec. 23.401(c)(2) (a

    State, State agency, city, county, municipality, other political

    subdivision of a State, or any instrumentality, department, or a

    corporation of or established by a State or political subdivision of

    a State) or Sec. 23.401(c)(4) (any governmental plan, as defined in

    Section 3 of the Employee Retirement Income Security Act of 1974 (29

    U.S.C. 1002)).

    ---------------------------------------------------------------------------

    The Commission declined to make changes to proposed Sec. 23.451

    based on comments recommending the prohibition on pay-to-play be

    deleted as unduly burdensome for those swap dealers that are part of

    financial institutions that are not, or will not be, subject to the

    rules of the MSRB. Rather, the Commission believes that a pay-to-play

    prohibition is integral to the business conduct standards framework for

    the protection of governmental Special Entities. The final rule is

    intended to protect the public by ensuring that swap dealers solicit

    and compete for governmental Special Entity business on the merits of

    their proposals rather than on the basis of their ability and

    willingness to make political contributions. Similarly, the Commission

    declines, as one commenter suggested, to limit the prohibition to the

    ``execution'' of swap business because the final rule is designed to

    protect the public in all phases of the transaction, including the

    solicitation or offering stage. At the same time, the Commission is

    taking steps to mitigate costs by harmonizing the final rule with both

    the SEC's and MSRB's prohibitions on certain political contributions.

    The Commission does not believe that a safe harbor from the final

    rule is appropriate merely because a governmental Special Entity is

    being represented by a qualified financial advisor who selects the swap

    dealer. By its nature, pay-to-play is covert because participants do

    not broadcast that contributions or payments are being made or accepted

    for the purpose of influencing the selection of a particular financial

    services provider. Given the covert and nefarious purpose behind such

    contributions or payments, the Commission believes any potential

    loophole, or Commission parsing of the word ``offer,'' would only breed

    mischief by would-be wrongdoers and unnecessarily expose the public to

    fraudulent dealings.

    As the rule text makes clear, the final rule is designed to prevent

    ``fraud.'' Given this fact, the Commission believes that it is

    unnecessary, as some commenters requested, to fashion the prohibition

    to reach only those ``political contributions made with the intent to

    solicit swaps business.'' Such an intent-based test in this context

    would again ignore the covert nature of such contributions or payments.

    Rather, the Commission believes that Sec. 23.451(b)(1)'s limiting

    principle (i.e., that it prohibits fraud), and the various exceptions

    to the prohibitions contained in Sec. 23.451(b)(2), should ameliorate

    any concerns that the prohibition may be unduly burdensome to monitor

    for compliance. Presumably, swap dealers already have in place policies

    and procedures designed to prevent their employees and agents from

    perpetrating fraud of this sort.

    As with the other business conduct standards being promulgated in

    this adopting release, Sec. 23.451 cannot be read in insolation. Of

    particular relevance here is the Commission's anti-evasion rule Sec.

    23.402(a) which, together with Sec. 23.451(c)'s provision that no swap

    dealer shall circumvent the prohibitions of the rule, will provide an

    effective safeguard against those who may be inclined to devise an end-

    run around final Sec. 23.451. Given these protections, the Commission

    does not find it necessary, as one commenter recommended, to change the

    rule text to make sure that improper contributions do not occur both

    before and after the solicitation and consummation of the transaction.

    Further, Sec. 23.451(d) provides a mechanism by which a swap dealer

    can apply for an exemption from the prohibitions of the final rule.

    Together, these rules ensure that Sec. 23.451 is balanced, flexible

    and capable of prohibiting multifarious forms of fraud while

    accommodating legitimate requests for relief based on various facts and

    circumstances. Similarly, Sec. 23.451(e) specifies where prohibitions

    are inapplicable, including where the contribution does not exceed the

    dollar thresholds or timing considerations provided in the rule.

    V. Implementation

    A. Effective Dates and Compliance Dates

    In the proposing release, the Commission requested comment on

    whether it should delay the effective date of any of the proposed

    requirements to allow additional time to comply and, if so, commenters

    were asked to identify the particular requirement and compliance burden

    that should merit a delay. Under Section 754 of the Dodd-Frank Act, the

    rules in subpart H of part 23 would be effective not less than 60 days

    after publication of the final rules implementing Section 731, which

    adds Section 4s(h) to the CEA.

    B. Comments

    The Commission received comments concerning implementation of the

    final external business conduct standards rules. The majority of the

    comments urged the Commission to implement the external business

    conduct standards after the implementation of the entity definitions

    and registration rules applicable to swap dealers and major swap

    participants and to allow sufficient time to implement appropriate

    policies and procedures and execute counterparty relationship

    documentation.\905\

    ---------------------------------------------------------------------------

    \905\ See MFA Mar. 24 Letter, at Annex A p. 3; EEI June 3

    Letter, at 7; NFA Aug. 31 Letter, at passim, NextEra Mar. 11 Letter,

    at 6; Comm. Cap. Mkts. June 24 Letter, at 2; Financial Assns. May 26

    Letter, at 3; Financial Assns. June 10 Letter, at 8-9 (The business

    conduct standards rulemaking should occur after the definitions

    rulemakings because, in most places, the Dodd-Frank Act refers to

    ``swap dealers'' instead of ``registered swap dealers,'' and the

    statutory definition of swap dealer is vague. Many persons could

    unwittingly violate the business conduct standards rules because

    they would not have known that they were subject to the rules.

    Certain terms such as ``Special Entity,'' ``best interests'' and

    ``acts as an advisor'' must be clarified by rule prior to the

    effectiveness of the business conduct standards rules.); see also

    ISDA June 3 Letter, at 2-4; WMBAA June 3 Letter, at 5; AGA June 3

    Letter, at 3.

    ---------------------------------------------------------------------------

    Other commenters suggested that the Commission's rules, including

    the business conduct standards rules, be implemented in a certain

    number of phases. The suggestions varied from as few as three to as

    many as sixteen phases. From among the commenters who believed that the

    rules should be implemented in phases, one commenter stated that the

    Commission should divide the rulemakings into three phases, with

    business conduct standards in the middle phase.\906\ Another commenter

    believed that the business conduct rules should be effective in the

    third of three phases.\907\

    ---------------------------------------------------------------------------

    \906\ CME June 3 Letter, at 3-4 and 7 (Rulemaking should occur

    in three phases--``early,'' ``middle'' and ``late.'' The early phase

    rules should deal solely with systemic risk. Business conduct

    standards, by contrast, should be in the middle phase.).

    \907\ BlackRock June 3 Medero, Prager and VedBrat Letter, at 2-3

    (The Commission should publish a proposed sequencing plan that

    details both the sequence and implementation for all rules.

    Implementation should be divided into three phases and business

    conduct rules would be effective in the final phase.); see also

    BlackRock June 3 Medero and Prager Letter, at 6.

    ---------------------------------------------------------------------------

    Among the commenters who believed that the rules should be

    implemented in four phases, one commenter stated that the external

    business conduct rules should be implemented during the second of four

    phases, following the implementation of the definitions rules.\908\

    Another commenter believed

    [[Page 9802]]

    the Commission should issue the business conduct standard rules in the

    second of four phases, but they recommended that the Commission should

    grant a ``one year blanket exemption'' for entities that engage in

    bilateral exempt commodity transactions.\909\ Another commenter

    suggested that the Commission should implement the business conduct

    standards during the last of four phases.\910\ One commenter suggested

    that the Commission's swap rules should be implemented in the fourth of

    eight phases,\911\ while another commenter opined that the rules should

    be divided into 16 phases with business conduct standards being

    implemented in phase number seven.\912\

    ---------------------------------------------------------------------------

    \908\ MFA Mar. 24 Letter, at Annex A p. 3 (Business conduct

    standards rules should be implemented during the second of four

    phases, following the implementation of definitions rules. The

    second phase should include implementation of clearing rules, swap-

    data reporting rules and internal/external business conduct

    standards for swap dealers and major swap participants. The third

    phase should prioritize SEF trading and segregation of uncleared

    swaps. The final phase should include real-time/public reporting and

    all other rulemaking, including antifraud and market manipulation

    rules.).

    \909\ NextEra Mar. 11 Letter, at 6 and 8 (The Commission should

    issue definitional rules first, then proceed to the core substantive

    rules, and then turn to non-core and ancillary rules. The second

    phase of rule implementation, which would follow the first phase of

    definitional rules, would implement business conduct standards,

    registration, governance, and capital and margin rules. The third

    phase would implement clearing requirements, the fourth phase would

    cover reporting and record-keeping standards, and the fifth phase

    would implement ancillary rules and necessary discretionary rules.).

    \910\ EEI June 3 Letter, at 7 (The Commission: (i) Should build

    its final rules in a common-sense manner (to start with basic

    definitions of ``swap,'' ``swap dealer,'' and ``major swap

    participant''); (ii) next build strong institutions such as SEFs,

    DCOs, and SDRs; (iii) then implement the mandatory clearing,

    exchange-trading, reporting, recordkeeping and other rules

    controlling those new markets; and (iv) then, finally, implement the

    obligations [e.g., business conduct standards] of swap dealers and

    major swap participants in a phased manner that is synchronized to

    the development of the new markets and the institutions that support

    them.).

    \911\ Comm. Cap. Mkts. June 24 Letter, at 2 (The first phase

    would include definitions and standards, and the second phase would

    include rules to reduce systemic risk, such as central clearing.

    Business conduct standards would occur in the fourth phase.).

    \912\ Financial Serv. Roundtable April 6 Letter, at 4-5.

    ---------------------------------------------------------------------------

    One commenter specifically mentioned the phases that were suggested

    by Commissioner O'Malia.\913\ The commenter stated that the Commission

    should adopt a schedule for implementation with each such phase. The

    commenter stated that if all the rules cited in Commissioner O'Malia's

    Phase 2 were adopted simultaneously, then it would be a burden on the

    commenter and, therefore, the rules should be implemented in a

    staggered schedule.\914\

    ---------------------------------------------------------------------------

    \913\ MGEX June 3 Letter, at 1-2; see also Extension of Comment

    Periods, 76 FR at 25276 Appendix 2.

    \914\ MGEX June 3 Letter, at 1-2.

    ---------------------------------------------------------------------------

    Some commenters did not suggest a specific number of phases, but

    had suggestions regarding the implementation of the rules. One

    commenter stressed the importance of the Commission providing a clear

    date for implementation and believed that market participants would

    work towards that date.\915\ The commenter also suggested that if

    documentation of customer relationships is a concern because of the

    large numbers of customers, some phasing in should be considered by the

    Commission.\916\

    ---------------------------------------------------------------------------

    \915\ Better Markets June 3 Letter, at 20.

    \916\ Id.

    ---------------------------------------------------------------------------

    Another commenter believed that the public should be given an

    opportunity to review the rule changes that resulted from public

    comments and have an opportunity to comment on the changes prior to the

    final rules being promulgated.\917\

    ---------------------------------------------------------------------------

    \917\ Noble July 7 Letter, at 2. The Commission declines to

    reopen the comment period on this rulemaking. If the Commission were

    to delay the final rulemaking to allow additional comments to

    address changes that were a result of comments that are already part

    of the public record, then it would only be fair to allow further

    comments to changes made as a result of those subsequent comments.

    The result would be the indefinite delay of the final rules for so

    long as someone is willing to comment on changes that were made.

    ---------------------------------------------------------------------------

    One commenter suggested that the Commission should sequence and

    implement the final rules by asset class.\918\ Another commenter opined

    that the Commission should require clearing, reporting and electronic

    execution for the ``better-prepared'' asset classes first (e.g.,

    certain commodity and interest rate products that are already quite

    liquid and standardized) and should provide ample time for the

    maturation of those asset classes and products that are not yet at that

    stage.\919\

    ---------------------------------------------------------------------------

    \918\ ETA May 4 Letter, at 2-5 (The rules should be implemented

    first for market infrastructure entities, then registration of

    market professionals, and finally registration of financial entities

    with new roles in each asset class.).

    \919\ Financial Assns. May 4 Letter, at 2-3 (Phased

    implementation by type of market participant will also allow the

    Commission and market participants to use lessons learned from

    larger market participants when developing rules applicable to end

    users. In addition, the Commission should, within each asset class

    and type of market participant, prioritize implementation of

    requirements that reduce systemic risk ahead of other requirements.

    Implementation of requirements designed to achieve other goals, such

    as trade execution, should be phased in only once clearing has been

    successfully implemented. This commenter also submitted charts that

    would sequence rules over nine separate stages. The Associations

    propose that the CFTC ``initiate'' business conduct standards in the

    sixth stage and ``finalize'' business conduct standards in the ninth

    and final stage.).

    ---------------------------------------------------------------------------

    The Commission received numerous comments on other portions of the

    business conduct standards rules that deal with Special Entities. \920\

    With regard to the implementation and phasing of the Commission's

    rules, one commenter stated that it is ``critical'' that, on or before

    finalization of the proposed rules, the Commission and DOL make a joint

    formal announcement that no action required by the business conduct

    standards will make a swap dealer or major swap participant an ERISA

    fiduciary.\921\

    ---------------------------------------------------------------------------

    \920\ Commenters submitted alternatives to the proposed rule

    regarding independent representatives for Special Entities (proposed

    Sec. 23.450). See, e.g., CalPERS Feb. 18 Letter, at 5-6; CEF Feb.

    22 Letter, at 23; Cityview Feb. 22 Submission; Riverside Feb. 22

    Letter, at 1-2; SFG Feb. 22 Letter, at 1; CFA/AFR Aug. 29 Letter, at

    23. CalPERS suggested a testing regime for independent

    representatives but noted that it would take time to create the

    testing framework. CalPERS recommended that, should their proposal

    advance, it may be necessary to delay the effective date of the

    independent representative provision of the regulations to permit

    implementation of their alternative approach. The Commission has

    modified proposed Sec. 23.450 to respond to commenters concerns,

    but has determined not to adopt a testing regime at this time.

    CalPERS Feb. 18 Letter, at 4-6. See Section IV.C.3. of this adopting

    release for a discussion of final Sec. 23.450.

    \921\ ABC/CIEBA Feb. 22 Letter, at 2-3 (The proposed rules

    should not be finalized when there is any uncertainty regarding

    whether the DOL regulations will be compatible with the CFTC's

    rules. If the DOL is not prepared to make the announcement when the

    CFTC is ready to finalize its proposed rules, the only workable

    solution is to delay the finalization of the business conduct

    standards with respect to ERISA plans until the DOL is prepared to

    act. Any other course of action would elevate timing issues over the

    retirement security of millions of Americans.). The Commission has

    harmonized the rulemaking with DOL requirements. See Section II of

    this adopting release for a discussion of ``Regulatory

    Intersections.''

    ---------------------------------------------------------------------------

    Two commenters believed that the rules should be phased in with the

    mandatory rulemaking being implemented first, followed by the

    implementation of rules issued using the Commission's discretionary

    authority.\922\

    ---------------------------------------------------------------------------

    \922\ BlackRock Feb. 22 Letter, at 2 (The Commission should

    adopt only mandatory rules, and after the Commission has gained more

    familiarity with the swaps marketplace, it may consider changing

    those standards.); Encana Feb. 22 Letter, at 2 (Some of the business

    conduct standards rules were not mandated by Congress and, in light

    of the compressed timeline for the implementation of the Dodd-Frank

    Act and current budgetary constraints, the Commission should

    reconsider its decision to impose non-mandatory requirements on swap

    dealers and major swap participants at this time. Encana suggests

    that, for swap dealers and major swap participants whose

    counterparties are normally end-users, the Commission should limit

    the rules to the requirements mandated by the Dodd-Frank Act. If,

    after a few years of experience, the Commission believes that

    additional business conduct standards are necessary, then the

    Commission could explore imposing additional requirements on swap

    dealers and major swap participants at that time.). The Commission

    has determined to adopt both mandatory and discretionary rules. See

    Section III.A.1. of this adopting release for a discussion of Sec.

    23.400-Scope.

    ---------------------------------------------------------------------------

    [[Page 9803]]

    One commenter stated that the Commission should continue to apply

    the exclusion for swaps available under pre-Dodd-Frank Act Section 2(h)

    of the CEA to allow firms such as its members to facilitate an orderly

    transition to the new rules. The commenter suggested that the

    Commission's rules be applicable first to bank holding companies, then

    later to other swaps participants.\923\

    ---------------------------------------------------------------------------

    \923\ CEF June 3 Letter, at 2.

    ---------------------------------------------------------------------------

    One commenter stated that, although Section 721 of the Dodd-Frank

    Act limits the Commission's exemptive authority with regard to certain

    provisions of the CEA, the Commission still retains authority to exempt

    persons from its own implementing rules.\924\ This commenter asked that

    the Commission use its authority to exempt persons from its

    implementing regulations to address instances where such an exemption

    would be in the public interest.

    ---------------------------------------------------------------------------

    \924\ NY City Bar June 13 Letter, at 3.

    ---------------------------------------------------------------------------

    Another commenter suggested that the Commission should adopt

    implementing regulations deferring the effective date of the provisions

    of Title VII to be in line with the ongoing international effort to

    implement reforms of the OTC derivatives market by December 31, 2012,

    following the September 2009 meeting of the G20 in Pittsburgh.\925\

    ---------------------------------------------------------------------------

    \925\ Bank of Tokyo May 6 Letter, at 4.

    ---------------------------------------------------------------------------

    C. Commission Determination

    After considering the comments, the Commission has determined that

    the effective date of the rules in subpart H of part 23 will be 60 days

    after publication of the final rules in the Federal Register. 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.\926\

    ---------------------------------------------------------------------------

    \926\ Under Sec. 23.450(b)(1)(vii), any swap dealer or major

    swap participant that offers to enter or enters into a swap with a

    Special Entity, other than a Special Entity defined in Sec.

    23.401(c)(3), shall have a reasonable basis to believe that the

    Special Entity has a representative that, in the case of a Special

    Entity as defined in Sec. 23.401(c)(2) or (4), is subject to

    restrictions on certain political contributions imposed by the

    Commission, the SEC, or an SRO subject to the jurisdiction of the

    Commission or the SEC; provided however, that Sec.

    23.450(b)(1)(vii) shall not apply if the representative is an

    employee of the Special Entity. Because neither the Commission nor

    an SRO registered with the Commission has established restrictions

    on certain political contributions as provided in Sec.

    23.450(b)(1)(vii), swap dealers and major swap participants will not

    have to have a reasonable basis to believe that a qualified

    independent representative of a Special Entity is subject to such

    restrictions on political contributions until the later of 180 days

    after the effective date of the final subpart H rules or the

    effective date of any rules promulgated by the Commission or an SRO

    registered with the Commission imposing such restrictions on

    political contributions that would apply to such qualified

    independent representative.

    ---------------------------------------------------------------------------

    The compliance schedule established by the Commission for the

    subpart H rules will allow swap dealers and major swap participants to,

    among other things, implement appropriate policies and procedures,

    train relevant personnel, execute any necessary amendments to

    counterparty relationship documentation, receive any representations

    from counterparties and enable Special Entities to ensure that they

    have qualified independent representatives as provided in Sec.

    23.450.\927\ While the schedule does not distinguish among swap

    dealers, asset classes or counterparties as suggested by various

    commenters, the schedule does provide a time certain for compliance and

    a substantial lead time of a minimum of eight months to accommodate the

    tasks that must be completed by affected market participants. The

    Commission was not persuaded that the distinctions among swap dealers,

    asset classes, counterparties or mandatory versus discretionary rules

    provide a compelling basis for the Commission to phase-in the

    implementation of the bulk of the external business conduct standards

    rules. Rather, the Commission believes that swap dealers and major swap

    participants will be able to develop and implement the required

    compliance mechanisms efficiently by considering their affected

    business processes across the board. Within the time frame provided,

    swap dealers and major swap participants will be able to phase-in their

    compliance according to their own priorities, provided that the

    requirements are implemented by the applicable compliance date.

    ---------------------------------------------------------------------------

    \927\ The compliance dates in this adopting release are subject

    to any superseding order of the Commission providing exemptive

    relief from certain requirements under the CEA pending completion of

    certain other rulemakings, including the entity and product

    definitions rulemakings. See, e.g. Effective Date for Swap

    Regulation, 76 FR 42508, Jul. 19, 2011; Amendment to July 14, 2011

    Order for Swap Regulation, 76 FR 80233, Dec. 23, 2011.

    ---------------------------------------------------------------------------

    VI. Related Matters

    A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') requires Federal agencies

    to consider the impact of its rules on ``small entities.'' \928\ A

    regulatory flexibility analysis or certification typically is required

    for ``any rule for which the agency publishes a general notice of

    proposed rulemaking pursuant to'' the notice-and-comment provisions of

    the Administrative Procedure Act, 5 U.S.C. 553(b).\929\ As the

    Commission stated in the proposing release, it previously has

    established that certain entities subject to its jurisdiction are not

    small entities for purposes of complying with the RFA.\930\ However, as

    the Commission also noted in the proposing release, swap dealers and

    major swap participants are new categories of registrant for which the

    Commission had not previously addressed the question of whether such

    persons are small entities.\931\

    ---------------------------------------------------------------------------

    \928\ 5 U.S.C. 601 et seq.

    \929\ 5 U.S.C. 601(2), 603, 604 and 605.

    \930\ Proposing release, 75 FR at 80655-56.

    \931\ See id.

    ---------------------------------------------------------------------------

    In this regard, the Commission explained in the proposing release

    that it previously had determined that FCMs should not be considered

    small entities for purposes of the RFA, based, in part, upon FCMs'

    obligation to meet the minimum financial requirements established by

    the Commission to enhance the protection of customers' segregated funds

    and protect the financial condition of FCMs generally.\932\ Like FCMs,

    swap dealers will be subject to minimum capital and margin requirements

    and are expected to comprise the largest global financial firms, and

    the Commission is required to exempt from designation as a swap dealer

    entities that engage in a de minimis quantity of swap dealing in

    connection with transactions with or on behalf of customers.\933\

    Accordingly, for purposes of the RFA for the proposing release and

    future rulemakings, the Commission proposed that swap dealers should

    not be considered small entities for essentially the same reasons that

    it had previously determined FCMs not to be small entities.\934\

    ---------------------------------------------------------------------------

    \932\ Policy Statement and Establishment of Definitions of

    ``Small Entities'' for Purposes of the Regulatory Flexibility Act,

    47 FR 18618, Apr. 30, 1982.

    \933\ See Section 1a(49)(D) of the CEA.

    \934\ Proposed Rules for Registration of Swap Dealers and Major

    Swap Participants, 75 FR at 71385.

    ---------------------------------------------------------------------------

    The Commission further explained that it also had previously

    determined that large traders are not small entities for RFA purposes,

    with the Commission considering the size of a trader's position to be

    the only appropriate test for the purpose of large trader reporting.

    The Commission then noted that a

    [[Page 9804]]

    person will be obligated to register as a major swap participant based

    upon its maintenance of substantial positions in swaps, creating

    substantial counterparty exposure that could have serious adverse

    effects on the financial stability of the United States banking system

    or financial markets. Accordingly, for purposes of the RFA for the

    proposing release and future rulemakings, the Commission also proposed

    that major swap participants should not be considered to be small

    entities for essentially the same reasons that it previously had

    determined large traders not to be small entities.\935\

    ---------------------------------------------------------------------------

    \935\ Id., at 71385-86.

    ---------------------------------------------------------------------------

    In response to the proposing release, one commenter, representing a

    number of market participants, submitted a comment related to the RFA,

    stating that ``[e]ach of the complex and interrelated regulations

    currently being proposed by the Commission has both an individual, and

    a cumulative, effect on [certain] small entities,'' and that the Small

    Business Administration had determined some of its members to be small

    entities.\936\ These members, as the Commission understands, have been

    determined to be small entities by the SBA because they are ``primarily

    engaged in the generation, transmission, and/or distribution of

    electric energy for sale and [their] total electric output for the

    preceding fiscal year did not exceed 4 million megawatt hours.'' \937\

    Thus, the commenter concluded that the Commission should conduct a

    regulatory flexibility analysis for each of its rulemakings under the

    Dodd-Frank Act, including this rulemaking applicable to Business

    Conduct Standards for Swap Dealers and Major Swap Participants with

    Counterparties.\938\

    ---------------------------------------------------------------------------

    \936\ ETA June 3 Letter, at 20-21.

    \937\ Small Business Administration, Table of Small Business

    Size Standards, (Nov. 5, 2010).

    \938\ ETA June 3 Letter, at 20-21.

    ---------------------------------------------------------------------------

    This commenter did not provide any information on how the proposing

    release may have a significant economic effect on a substantial number

    of small entities. Nonetheless, the Commission has reevaluated this

    rulemaking in light of the statements made to it by this commenter.

    After further consideration of those statements, the Commission has

    again determined that this final rulemaking, which is applicable to

    swap dealers and major swap participants, will not have a significant

    economic effect on a substantial number of small entities.

    In terms of affecting a substantial number of small entities, the

    Commission is statutorily required to exempt from registration as a

    swap dealer those entities that engage in a de minimis quantity of swap

    dealing. Thus, it is expected that most small entities will not be

    required to register with the Commission as a swap dealer.\939\

    Additionally, the Commission does not expect that the small entities

    identified by the commenter will be subject to registration with the

    Commission as a major swap participant, as most entities with total

    electric output not exceeding 4 million megawatt hours are not expected

    to maintain ``a substantial position in swaps'' or swap positions that

    will ``create substantial counterparty exposure that could have serious

    adverse effects on the financial stability of the United States banking

    system or financial markets.'' \940\

    Accordingly, for the reasons stated in the proposing release, the

    Commission continues to believe that the Business Conduct Standards for

    Swap Dealers and Major Swap Participants with Counterparties rulemaking

    will not have a significant economic impact on a substantial number of

    small entities. Therefore, the Chairman, on behalf of the Commission,

    hereby certifies, pursuant to 5 U.S.C. 605(b), that these regulations

    being published today by this Federal Register release will not have a

    significant economic impact on a substantial number of small entities.

    ---------------------------------------------------------------------------

    \939\ Section 1a(49)(D) of the CEA (7 U.S.C. 1a(49)(D)).

    \940\ Section 1a(33)(A)(ii) of the CEA (7 U.S.C. 1a(33)(A)(ii)).

    See also Section 1a(33)(B) (7 U.S.C. 1a(33)(B)) (requiring the

    application of a threshold for ``substantial position,'' below which

    an entity will not be required to register as an MSP).

    ---------------------------------------------------------------------------

    B. Paperwork Reduction Act

    The Paperwork Reduction Act (``PRA'') \941\ imposes certain

    requirements on Federal agencies in connection with their conducting or

    sponsoring any collection of information as defined by the PRA. Certain

    provisions of these regulations will result in new collection of

    information requirements within the meaning of the PRA. An agency may

    not conduct or sponsor, and a person is not required to respond to, a

    collection of information unless it displays a currently valid control

    number.

    ---------------------------------------------------------------------------

    \941\ 44 U.S.C. 3501 et seq.

    ---------------------------------------------------------------------------

    In the proposing release, the Commission informed the public that,

    while the proposed rules did contain collections of information, these

    collections would overlap with collections proposed by the Commission

    in the Business Conduct Standards--Internal rulemakings \942\ and with

    collections under the proposed rules adapting the recordkeeping,

    reporting and daily trading records requirements under Sec. 1.31 to

    account for swap transactions.\943\ Thus, the Commission did not submit

    the proposing release to OMB for approval or for assignment of an OMB

    control number.

    ---------------------------------------------------------------------------

    \942\ See proposing release, 75 FR at 80656. The Business

    Conduct Standards--Internal rulemakings referenced in the proposing

    release and their proposing release citations are: Governing the

    Duties of Swap Dealers, 75 FR 71397; CCO proposed rules, 75 FR

    70881; and Conflict-of-Interest Standards by Swap Dealers, 75 FR

    71391. The Commission submitted these proposing releases to the

    Office of Management and Budget (OMB) for review in accordance with

    44 U.S.C. 3507(d) and 5 CFR 1320.11. The Commission requested that

    OMB approve, and assign a new control number for, the collections of

    information covered by the proposing releases.

    \943\ See Adaptation of Regulations to Incorporate Swaps, 76 FR

    33066, Jun. 7, 2011. The Commission requested that OMB approve

    amendments to existing collections of information in connection with

    this proposal.

    ---------------------------------------------------------------------------

    The Commission invited comment on the accuracy of its estimate that

    no additional recordkeeping or information collection requirements or

    changes to existing collection requirements, other than those in the

    overlapping rulemakings, would result from the proposed rules. The

    Commission received no comments directly addressing this request, but

    it did receive one comment indirectly responsive to its

    invitation.\944\ In it, the commenter asserted that, for electric

    utilities that are governmental entities, the proposed rules require

    swap dealers and major swap participants to provide valuation and

    scenario analysis, as well as advice and disclaimers that are not

    currently requested or required by these electrical utilities.\945\

    According to this commenter, these requirements will create new

    ``paperwork'' for the swap dealer or major swap participant, thereby

    creating new costs for the end-user.

    ---------------------------------------------------------------------------

    \944\ ETA May 4 Letter.

    \945\ Id., at 8.

    ---------------------------------------------------------------------------

    The Commission has accounted for the information collection costs

    attributable to the swap dealer and major swap participant as required

    by the PRA in the information collections prepared for the rulemakings

    noted above, and understands that the only costs that may be created

    for end-users is any costs for which the Commission has accounted that

    may be passed on to the end-user in the form of transaction fees, if at

    all, which would not require an increase in the Commission's burden

    estimates in the information collections. Moreover, as the Commission

    noted in the proposing release, not only were the proposed disclosure

    rules aligned with current industry best practices, but several large

    swap dealers had told the

    [[Page 9805]]

    Commission staff during consultations that they were already providing

    counterparties with scenario analysis, at no extra charge.\946\

    Therefore, considering what swap dealers have represented the current

    landscape to be, any ``paperwork'' associated with scenario analysis

    should already be passed along to today's end-user. Moreover, to

    address counterparty concerns about costs and delay, the final rules

    will require scenario analysis only when requested by the counterparty

    for any swap not available for trading on a DCM or SEF and only from

    swap dealers, not major swap participants. In other circumstances, a

    swap dealer will have to notify its counterparty of the right to

    receive a scenario analysis. Thus, any pass-through costs for scenario

    analysis will be borne by those end-users that elect to receive it.

    ---------------------------------------------------------------------------

    \946\ See proposing release, 75 FR at 80645.

    ---------------------------------------------------------------------------

    Regardless, for purposes of this PRA analysis, these collections

    are part of the overall (1) supervision, compliance and recordkeeping

    requirements imposed by the Commission in the Business Conduct

    Standards--Internal rulemakings \947\ and (2) recordkeeping, reporting

    and daily trading records requirements under Sec. Sec. 1.31 and 1.35

    of the Commission Regulations (17 CFR 1.31 and 1.35).\948\ By their

    terms, these rules are part of the supervision, compliance and

    recordkeeping requirements that are provided for under the Business

    Conduct Standards-Internal rulemaking and the rulemaking adapting

    Sec. Sec. 1.31 and 1.35 to swap transactions, and those rulemakings

    are compliant with PRA.

    ---------------------------------------------------------------------------

    \947\ The Business Conduct Standards--Internal rulemakings

    referenced in the proposing release and their proposing release

    citations are: Governing the Duties of Swap Dealers, 75 FR 71397;

    CCO proposed rules, 75 FR 70881; and Conflict-of-Interest Standards

    by Swap Dealers, 75 FR 71391. The Commission submitted these

    proposing releases to the Office of Management and Budget (OMB) for

    review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The

    Commission requested that OMB approve, and assign a new control

    number for, the collections of information covered by the proposing

    releases.

    \948\ See Adaptation of Regulations to Incorporate Swaps, 76 FR

    33066, Jun. 7, 2011. The Commission requested that OMB approve

    amendments to existing collections of information in connection with

    this proposal.

    ---------------------------------------------------------------------------

    C. Cost-Benefit Considerations

    Section 15(a) of the CEA requires the Commission to consider the

    costs and benefits of its action before promulgating a regulation under

    the CEA.\949\ In particular, the costs and benefits of the proposed

    Commission action shall be evaluated in light of the following five

    considerations: (1) Protection of market participants and the public;

    (2) efficiency, competitiveness and financial integrity of futures

    markets; (3) price discovery; (4) sound risk management practices; and

    (5) other public interest considerations. The Commission has considered

    the costs and benefits of its business conduct standards rulemaking as

    part of the deliberative rulemaking process and discussed them below

    and throughout the preamble.

    ---------------------------------------------------------------------------

    \949\ 7 U.S.C. 19(a).

    ---------------------------------------------------------------------------

    The final rules in this adopting release implement Section 4s(h) of

    the CEA, which provides the Commission, subject to certain statutory

    requirements, with both mandatory and discretionary rulemaking

    authority to impose business conduct standards requirements on swap

    dealers and major swap participants in their dealings with

    counterparties, including Special Entities. Many of the final rules in

    this adopting release are mandated by Section 731 of the Dodd-Frank

    Act, leaving the Commission with little or no discretion to consider

    any alternatives where the statute prescribes particular requirements.

    Therefore, in many cases, the Commission's final regulations adhere

    closely to the enabling language of the statute. For example, the

    statute directs the Commission to adopt rules requiring swap dealers

    and major swap participants to verify that counterparties meet

    eligibility criteria, disclose material information about contemplated

    swaps to counterparties, including the material risks and

    characteristics of the swap, and incentives and conflicts of interest

    that the swap dealer or major swap participant may have in connection

    with the swap. The Commission also must adopt rules that require swap

    dealers and major swap participants to provide counterparties with a

    daily mark for swaps and establish a duty for swap dealers and major

    swap participants to communicate in a fair and balanced manner based on

    principles of fair dealing and good faith. In formulating the final

    mandatory rules, the Commission adopted approaches that mitigate the

    potential costs while maintaining fidelity to the congressional intent

    behind Section 731 the Dodd-Frank Act.

    In adopting rules using its discretionary authority, 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.\950\ The discretionary rules include confidential treatment of

    counterparty information, institutional suitability, ``know your

    counterparty,'' scenario analysis and pay-to-play restrictions. The

    discretionary rules reflect the Commission's expertise in establishing

    and overseeing an effective regulatory scheme for derivatives market

    professionals and appropriate harmonization with existing business

    conduct standards across market sectors. The final rules strike an

    appropriate balance between protecting the public interest and

    providing a workable compliance framework for market participants.

    ---------------------------------------------------------------------------

    \950\ In exercising its broad discretionary authority under

    Section 4s(h), the Commission was guided by the purposes of the CEA

    contained in Section 3. Section 3 explicitly includes among the

    purposes of the CEA ``to protect all market participants from

    fraudulent or other abusive sales practices * * *'' and ``to promote

    * * * fair competition * * * among * * * market participants.'' The

    final business conduct standards accomplish that by holding swap

    dealers and major swap participants to fair dealing standards and by

    providing counterparties with tools necessary to negotiate

    effectively with swap dealers and major swap participants and make

    informed trading decisions. See also Sections 4s(h)(1)(D),

    4s(h)(5)(B) and 4s(h)(6) of the CEA.

    ---------------------------------------------------------------------------

    Section 731 of the Dodd-Frank Act, which added new Section 4s(h) to

    the CEA, gave the Commission broad new authority to set business

    conduct standards rules for swap dealers and major swap participants in

    response to abuses in the unregulated derivatives markets. Among the

    abuses were those that targeted Special Entities, such as

    municipalities and school districts, which led to the heightened

    protections for Special Entities in Sections 4s(h)(4) and (5). These

    abuses have been the subject of congressional hearings, regulatory

    enforcement actions and private litigation. Section 4s(h) is aimed at

    reversing a caveat emptor trading environment and providing

    transparency in dealings between swap dealers or major swap

    participants and their counterparties. Transparency is enhanced

    through: Mandatory pre-trade disclosures of material information and a

    daily mark; communications based on principles of fair dealing and good

    faith; and Special Entity provisions to ensure that swap transactions

    are in the ``best interests'' of the Special Entity. Congress also

    included a robust anti-fraud provision that applies to swap dealers and

    major swap participants in their dealings with counterparties.

    As contemplated by Congress through its grant of broad

    discretionary authority, the Commission supplemented the mandatory

    provisions in Section 4s(h) to limit the ability of

    [[Page 9806]]

    dealers to employ abusive practices that could disadvantage market

    participants that are less sophisticated or have less market power. The

    final rules endeavor to protect market participants and the public

    without unduly restricting access to the important risk management

    tools and investment opportunities provided by swap markets. The final

    rules are informed by extensive consultations with relevant federal and

    foreign regulators and stakeholders. Where possible, the rules are

    harmonized with requirements in related market sectors, industry best

    practice recommendations and SRO rules.

    The Commission received comments regarding the potential costs and

    benefits of the proposed rules, which are discussed in detail above in

    each section of the preamble relating to the rules. The Commission

    considered these comments in adopting the final rules. The benefits of

    the final rules identified by commenters and the Commission include:

    (1) Enhanced transparency and reduced information asymmetries among

    market participants resulting from required disclosures and

    communications standards; (2) principles based duties that are

    sufficiently flexible to address emerging compliance issues; (3)

    Special Entity provisions to protect taxpayers, pensioners and

    charitable institutions from abusive practices; (4) a compliance

    framework and mechanisms, including safe harbors, that facilitate

    information flow and market access, mitigate costs and enhance legal

    certainty, while raising business conduct standards consistent with

    legislative intent; and (5) regulatory harmonization of existing

    business conduct standards and best practices in related market sectors

    and among dealers, including consideration of SRO guidance for

    comparable principles based rules.

    The costs identified by commenters include assertions that: (1)

    Required disclosures are costly both in resources and possible delays,

    and could create potential liability unless disclosure can be

    standardized with appropriate safe harbors; (2) requiring swap dealers

    and major swap participants to make suitability evaluations of

    counterparties for specific trades will increase transaction costs and

    may create execution delays (both when a counterparty with an

    established relationship with a given swap dealer elects to begin

    trading a product outside of that relationship and a counterparty with

    no such relationship looks to begin trading with a given dealer); (3)

    principles based rules may expose swap dealers and major swap

    participants to potential compliance risk in both enforcement and

    private rights of actions; as a result, swap dealers and major swap

    participants will pass the costs of added risk to their counterparties

    or there will be fewer possible swap dealer trading relationships,

    which could reduce liquidity; (4) execution delay and the chilling of

    trading activity may result as the rules will interfere with the flow

    of information between swap dealers or major swap participants and

    counterparties and impose barriers to efficient execution of

    transactions and possibly create moral hazard; and (5) the cost and

    risks to Special Entities may increase if dealers avoid such

    counterparties, and sophisticated Special Entities may not need the

    protections provided by the rules.

    The Commission considered the comments it received and, as

    discussed in detail in the various sections of the preamble above, and

    as highlighted below, has taken steps to mitigate the costs and lower

    the burdens to the extent possible while also achieving the regulatory

    objectives of the Dodd-Frank Act. For example, the final rules in this

    adopting release allow compliance on a relationship basis rather than a

    transaction basis, when appropriate, to meet disclosure and due

    diligence duties. In addition, whenever possible, the Commission

    provides guidance in complying with the principles based statutory

    disclosure duties, which should reduce the burdens of complying with

    such obligations. The Commission also confirmed that certain business

    conduct standards rules will not apply to swaps executed on a SEF or

    DCM where the swap dealer or major swap participant does not know the

    identity of the counterparty prior to execution, including verification

    of eligibility, disclosures and Special Entity requirements. Finally,

    the Commission created safe harbors where appropriate, including an

    affirmative defense for swap dealers and major swap participants to a

    non-scienter fraud claim, and, for non-scienter violations of the other

    rules, the Commission will consider good faith compliance with policies

    and procedures in exercising its prosecutorial discretion if such

    policies and procedures are reasonably designed to comply with the

    requirements of any particular rule.

    The Commission has considered the costs and benefits of the final

    rules in this adopting release pursuant to Section 15(a) of the CEA,

    including the comments it received relating to potential costs and

    benefits of each rule, where applicable. A discussion of the final

    rules in light of the Section 15(a) considerations is included below.

    In some cases, the Section 15(a) discussions apply to clusters of rules

    where the rules have a common purpose and shared costs and benefits.

    For example, the rules requiring disclosure of material information

    (risks, characteristics, incentives and conflicts of interest) have the

    common purpose of providing information to counterparties in a manner

    sufficient to enable counterparties to assess transactions before

    assuming the associated risks. The costs and benefits of providing such

    disclosures are similarly shared and, therefore, are addressed together

    to fully appreciate their cumulative effects. The Commission has

    indicated with respect to each rule how it has analyzed the five

    considerations in Section 15(a) of the CEA.

    With respect to quantification of the costs and benefits of the

    final business conduct standards rules, the Commission notes that,

    because the Dodd-Frank Act establishes a new regulatory regime for the

    swaps market, there is little or no reliable quantitative data upon

    which the Commission can evaluate, in verifiable numeric terms, the

    economic effects of the final business conduct standards rules. No

    commenters presented the Commission with verifiable data pertinent to

    any of the proposed rules, stated whether such verifiable data exists,

    or explained how such cost data or any empirical analysis of that data

    would inform the choice of implementation pursuant to a specific

    provision of the Dodd-Frank Act or whether such data and resultant

    empirical analysis is ascertainable with a degree of certainty that

    could inform Commission deliberations.\951\

    [[Page 9807]]

    Commenters did not provide any verifiable cost estimates.\952\

    ---------------------------------------------------------------------------

    \951\ For example, with respect to potential costs associated

    with restrictions on information flows from dealers to their

    counterparties and increased reliance by counterparties on dealers,

    there is no clear means of quantification because of the difficulty

    in designing metrics for these potential costs. In addition, because

    there is no historical period in which similar rules were in effect,

    there remains the formidable (and costly) challenge of comparing the

    current environment to the post-rule environment. This challenge is

    compounded by the likelihood that the effect of the rule will differ

    across dealers and across counterparties. Quantification of the

    potential delays in swap execution and higher associated fees faces

    similar challenges, including lack of available data over which to

    measure the effect (if any) of such delays. The combination of these

    factors makes it impractical to determine reliable estimates of

    these types of costs. Moreover, no commenters provided verifiable

    estimates. As a consequence, the discussion of these potential costs

    is undertaken in qualitative terms.

    The Commission recognizes that the business conduct standards

    rules impose certain compliance costs, most of which are the result

    of statutory mandates. Generally, the costs are anticipated to be

    incremental, because they are associated with existing, highly

    complementary compliance burdens imposed by the SEC or prudential

    regulators. These existing regulations, however, are not uniformly

    applied across the entire dealer community. As a consequence,

    certain dealers are expected to face higher compliance costs than

    others. The lack of dealer-specific information (e.g., on current

    staffing levels and those levels envisioned as being necessary for

    compliance with the rule) prevents reliable estimation of these

    costs, and no such information was provided to the Commission during

    the comment period.

    \952\ One late-filing commenter recently provided the Commission

    with a report to support its position that cost-benefit

    considerations compel excluding entities ``engaged in production,

    physical distribution or marketing of natural gas, power, or oil

    that also engage in active trading of energy derivatives''--termed

    ``nonfinancial energy companies'' in the report--from regulation as

    swap dealers, including this final rulemaking. See NERA Dec. 20

    letter, at 1. Based on responses to an anonymous survey of an

    unspecified number of firms identified only in the aggregate as

    nonfinancial energy companies that ``could be captured'' under the

    swap dealer definition, the report estimates that nonfinancial

    energy companies would incur certain initial and recurring

    regulatory compliance costs relevant to this rulemaking. As

    indicated in fn. 951, the Commission recognizes the potential for

    compliance costs associated with this rule to fall

    disproportionately across all swap dealers. The final rule attempts

    to minimize these burdens overall while remaining consistent with

    statutory intent.

    ---------------------------------------------------------------------------

    1. Section 23.402(a)--Policies and Procedures To Ensure Compliance and

    Prevent Evasion and Section 23.402(g)--Record Retention

    a. Benefits

    Section 23.402(a) requires that swap dealers and major swap

    participants (1) have written policies and procedures to ensure

    compliance with subpart H of part 23 and to prevent evasion of any

    provision of the CEA or Commission Regulations, and (2) implement and

    monitor compliance with such policies and procedures as part of their

    supervision and risk management requirements as specified in subpart J

    of part 23. Section 23.402(g) requires that swap dealers and major swap

    participants create a record of their compliance with subpart H and

    retain records in accordance with subpart F and Sec. 1.31. As a

    result, the requirements of Sec. 23.402(a) and (g) are part of the

    overall supervision, compliance and recordkeeping regime established in

    Section 4s of the CEA and as implemented in the relevant internal

    business conduct standards rulemakings. As such, the costs and benefits

    of Sec. 23.402(a) and (g) discussed herein are part of the overall

    costs and benefits of the related internal business conduct standards

    requirements as discussed in connection with those rulemakings \953\

    and are a function of the requirements in the other rules that comprise

    subpart H. In this way, Sec. 23.402(a) and (g) facilitates compliance

    with all of the subpart H business conduct standards rules.

    ---------------------------------------------------------------------------

    \953\ Because the firm-wide supervision, compliance, and

    recordkeeping functions are all accounted for in the Business

    Conduct Standards--Internal Rulemakings (see Governing the Duties of

    Swap Dealers, 75 FR 71397; CCO proposed rules, 75 FR 70881; and

    Conflict-of-Interest Standards by Swap Dealers, 75 FR 71391) and

    Sec. 1.31 (see Adaptation of Regulations to Incorporate Swaps, 76

    FR 33066, Jun. 7, 2011), and these policies and procedures and

    record retention provisions are subsets of the overall supervision,

    compliance and recordkeeping functions of the swap dealer or major

    swap participant, the Commission also has considered the costs and

    benefits of these rules in connection with those other rulemakings.

    ---------------------------------------------------------------------------

    Although difficult to quantify, robust policies and procedures and

    documentation requirements will benefit all market participants.\954\

    Swap dealers and major swap participants will benefit because, 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.\955\ In

    addition, swap dealers and major swap participants will be able to rely

    on their policies and procedures to demonstrate compliance with subpart

    H in connection with their registration applications.\956\ The

    requirement to document compliance with the business conduct standards

    rules will reduce misunderstandings and complaints between swap dealers

    or major swap participants and counterparties. Robust compliance

    procedures will also benefit counterparties by encouraging a culture of

    compliance that will help to ensure that swap dealers and major swap

    participants deliver the protections intended by Section 4s(h). Section

    23.402(a) also requires swap dealers and major swap participants to

    have policies and procedures to prevent evasion of the CEA and

    Commission Regulations. Such policies and procedures will assist

    regulators in ensuring that the intent of Congress, particularly

    through the Dodd-Frank Act amendments, is abided and that the

    Commission's jurisdictional markets are not used to circumvent

    regulatory requirements, including by engaging in fraud or other

    abuses.\957\ Implementing anti-evasion policies and procedures as part

    of the supervision, risk management and compliance regimes of swap

    dealers and major swap participants should benefit swap markets by

    enhancing transparency and encouraging participation.

    ---------------------------------------------------------------------------

    \954\ This benefit is enhanced by the Commission requirement

    that recordkeeping policies and procedures ensure that records are

    sufficiently detailed to allow compliance officers and regulators to

    determine compliance.

    \955\ In particular, in connection with allegations of fraud

    under Sec. 23.410(a)(2) and (3) (for violations of the fraud

    provisions under subpart H), final Sec. 23.410(b) provides that a

    swap dealer or major swap participant may establish an affirmative

    defense against allegations of violations of final Sec.

    23.410(a)(2) and (3) by demonstrating that it did not act

    intentionally or recklessly and complied in good faith with written

    policies and procedures reasonably designed to meet the particular

    requirement that is the basis for the alleged violation.

    \956\ 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 Sec. 3.10(a)(1)(v)(A), Proposed

    Rules for Registration of Swap Dealers and Major Swap Participants,

    75 FR 71379.

    \957\ See Section 747 of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    b. Costs

    While there will be costs associated with establishing,

    implementing, testing, reviewing and auditing compliance with policies

    and procedures, the Commission expects these costs to be incremental.

    Many swap dealers and major swap participants are already subject to

    comprehensive supervision, compliance and recordkeeping requirements

    imposed in related regulated market sectors, including futures, banking

    and securities. Therefore, the additional costs will be limited to

    adapting existing policies and procedures to accommodate these new

    requirements. Regardless, the costs will be an incremental part of a

    swap dealer's or major swap participant's overall risk management

    program as required under subpart J and may be tailored to the swap

    related business conducted by a particular swap dealer or major swap

    participant.

    Similarly, there will be costs associated with record retention,

    including the costs of creating a record of compliance and storing it.

    To mitigate these costs, the Commission has confirmed 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

    [[Page 9808]]

    use internet based applications to provide disclosures and daily

    marks.\958\

    ---------------------------------------------------------------------------

    \958\ 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.

    ---------------------------------------------------------------------------

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of final Sec. 23.402(a) and (g) pursuant to the five

    considerations identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    The Commission believes that the Sec. 23.402(a) policies and

    procedures and record retention requirements, which are part of the

    overall supervision, risk management and compliance systems of swap

    dealers and major swap participants included in subparts F and J of

    part 23, reinforce subpart H's protections for swap market participants

    and the public by promoting compliance with subpart H and discouraging

    evasion of regulatory requirements. The costs of compliance are

    incremental and do not diminish the intended benefits of the business

    conduct standards rules for market participants.

    ii. Efficiency, Competitiveness and Financial Integrity

    The Commission believes that effective internal risk management and

    oversight protects the financial integrity of the critical market

    participants--individual swap dealers and major swap participants.

    Their financial integrity, in turn, promotes the financial integrity of

    derivatives markets as a whole by fostering confidence in financial

    system stability. Additionally, the Commission believes that Sec.

    23.402(a) will enhance the efficiency and competitiveness of markets to

    the extent that swap dealers and major swap participants have sound

    risk management programs.

    Accurate recordkeeping is foundational to sound risk management and

    the financial integrity of swap dealers and major swap participants.

    The recordkeeping rules, including Sec. 23.402(g), will enhance

    confidence in the financial integrity of the market and encourage

    participation by avoiding misunderstandings and reducing the potential

    for disputes between counterparties and evasion of regulatory

    requirements. Documentation will facilitate compliance reviews and

    Commission enforcement actions for failure to comply with disclosure,

    due diligence and fair dealing requirements.

    iii. Price Discovery

    The Commission does not believe that Sec. 23.402(a) and (g) will

    have a material impact on price discovery.

    iv. Sound Risk Management Practices

    The policies and procedures and record retention provisions in

    Sec. 23.402(a) and (g) which apply principally to counterparty

    relationships of swap dealers and major swap participants are subsets

    of the overall supervision, compliance, recordkeeping and risk

    management functions of the swap dealer or major swap participant (as

    accounted for in the Business Conduct Standards--Internal

    rulemakings).\959\ The Commission believes that proper recordkeeping is

    essential to risk management because it facilitates an entity's

    awareness of its swap business. Such awareness supports sound internal

    risk management policies and procedures by ensuring that decision-

    makers within swap dealers and major swap participants are fully

    informed about the entity's activities, including its dealings with

    counterparties, and can take steps to mitigate and address significant

    risks faced by the entity. When individual market participants engage

    in sound risk management practices, the entire market benefits. On the

    other hand, compliance with these policies and procedures and

    recordkeeping requirements is likely to require investment in

    recordkeeping, as well as front office and back office systems. The

    costs associated with this investment might otherwise be used to

    enhance other aspects of a firm's risk management program.

    ---------------------------------------------------------------------------

    \959\ See Governing the Duties of Swap Dealers, 75 FR 71397; CCO

    proposed rules, 75 FR 70881; Conflict-of-Interest Standards by Swap

    Dealers, 75 FR 71391; and Sec. 1.31 (see Adaptation of Regulations

    to Incorporate Swaps, 76 FR 33066).

    ---------------------------------------------------------------------------

    v. Other Public Interest Considerations

    The Commission has not identified any other public interest

    considerations in connection with Sec. 23.402(a) or (g).

    2. Section 23.402(b)--Know Your Counterparty; Section 23.402(c)--True

    Name and Owner; and Section 23.434--Recommendations to Counterparties--

    Institutional Suitability

    a. Benefits

    The Commission is promulgating certain due diligence rules for swap

    dealers pursuant to its discretionary authority under Section 4s(h)

    that further the purposes of the Dodd-Frank Act business conduct

    standards provisions. These final rules are Sec. Sec. 23.402(b)--Know

    your counterparty, 23.402(c)--True name and owner, and 23.434--

    Institutional suitability (collectively, the ``due diligence rules'').

    Sections 23.402(b) and 23.402(c) require a swap dealer to use

    reasonable due diligence to obtain and retain a record of the essential

    facts concerning each counterparty whose identity is known to the swap

    dealer prior to the execution of the transaction and the authority of

    any person acting for such counterparty. Final Sec. 23.434 requires

    swap dealers making recommendations to undertake reasonable diligence

    to understand the potential risks and rewards of the swap or trading

    strategy and to have a reasonable basis to believe that the swap is

    suitable for the counterparty.

    All of the due diligence rules confer similar benefits in that they

    protect the public and market participants by requiring swap dealers to

    have essential information about their counterparties prior to entering

    into transactions and, to the extent they are making a recommendation,

    understand the trading objectives and characteristics of the

    counterparty. While not readily amenable to quantification, the

    benefits of the rules are significant. The rules are designed to

    prevent the potentially considerable costs for the counterparty (and

    incidentally the swap dealer when a counterparty is unable or unwilling

    to cover losses) of entering into unsuitable transactions. Such costs

    include losses associated with the position, generally, and the costs

    (at times considerable) of both exiting the position and establishing a

    new position, recognizing that the discovery of an ``unsuitable'' trade

    is more likely to occur during a period of market stress, which may

    magnify these costs. In this way, the due diligence rules are an

    integral component of the business conduct standards that are, in large

    part, designed to ensure that the counterparties and dealers understand

    the swap or trading strategy and place the dealer and counterparty on

    equal footing with respect to the risks and rewards of a particular

    swap or trading strategy.

    The Commission believes that the due diligence rules will

    secondarily benefit dealers and regulators by requiring that a dealer

    be able to document essential information about its counterparties and

    any swaps or trading strategies that it recommends. While not a

    quantifiable benefit, documentation will facilitate effective review of

    a recommendation's suitability and render such recommendations less

    susceptible to ``second-guessing,'' as well as review of the authority

    of its counterparty to enter into transactions. The due diligence

    [[Page 9809]]

    rules relate to the risk management systems of the swap dealer making

    explicit the requirement that the swap dealer obtain facts required to

    implement the swap dealer's credit and operational risk management

    policies in connection with transactions entered into with the

    counterparty. The due diligence rules also harmonize the requirements

    for market professionals in related market sectors, including futures,

    securities and banking. An ancillary public interest benefit of such

    rules in those related markets has been their deterrence of

    counterparty misconduct, including, for example, unauthorized trading

    and money laundering.

    b. Costs

    The primary costs of final Sec. Sec. 23.402(b), (c) and 23.434 are

    associated with obtaining information necessary to identify the

    counterparty, conducting any required due diligence before making a

    recommendation and maintaining records of essential customer

    information and suitability determinations. The Commission believes

    these costs are mitigated by at least five factors. First, as stated

    above, many of the dealers subject to these rules have long been

    subject to similar obligations under either NFA rules or the mandates

    of regulatory authorities in other markets, including banking and

    securities.\960\ As such, the incremental costs of complying with the

    Commission's final rules are likely to be insignificant. Indeed, the

    Commission confirmed that it would consider SRO interpretations of

    analogous provisions, as appropriate, when assessing compliance with

    the due diligence rules by swap dealers.\961\ Second, in response to

    the comments it received, the Commission elected to promulgate several

    cost-mitigating alternatives to the proposed due diligence rules. For

    example, the Commission made clear that a dealer could fulfill its

    counterparty-specific suitability obligations through certain

    representations from the counterparty. Third, the Commission provided

    additional guidance, including a detailed explanation of what is likely

    and, as importantly, unlikely to constitute a ``recommendation'' within

    the meaning of final Sec. 23.434. The guidance is included in the

    preamble to the final rules as well as in Appendix A to subpart H of

    part 23 of the Commission's Regulations. Fourth, the Commission made

    clear that a determination of whether a dealer acted in compliance with

    the rules is an objective inquiry based on a consideration of all the

    relevant facts and circumstances surrounding a particular

    recommendation. Fifth, the Commission set forth various safe harbors

    from which a dealer could demonstrate compliance. In these and other

    ways, the Commission believes that it has taken meaningful steps to

    minimize the risks and costs of compliance and any ancillary costs

    associated with, for example, vexatious litigation by a counterparty

    experiencing buyer's remorse.

    ---------------------------------------------------------------------------

    \960\ See, e.g., Section III.A.3.b. at fn. 179 discussing SRO

    know your customer rules; see also Section III.G.3. at fn. 536

    discussing suitability requirements under the banking and federal

    securities laws.

    \961\ See Section III.A.3.b. of this release at fn. 188

    discussing final Sec. 23.402(b) (know your counterparty), Section

    III.F.3. of this release at fn. 500 discussing final Sec. 23.433

    (communications-fair dealing), and Section III.G.3. of this release

    at fn. 542 discussing final Sec. 23.434 (recommendations to

    counterparties-institutional suitability).

    ---------------------------------------------------------------------------

    Commenters expressed concerns about potential costs of the due

    diligence rules. They claimed that the proposed due diligence

    requirements would interfere with efficient execution of transactions

    if required on a transaction-by-transaction basis. The proposed rules

    also may have disadvantaged counterparties by requiring them to provide

    confidential information to swap dealers that could be used against

    them in negotiations or misappropriated by swap dealers. The Commission

    has made a number of changes in the final rules to mitigate those

    costs. For example, the Commission clarified that the due diligence

    requirements can be satisfied on a relationship basis, where

    appropriate, in accordance with final Sec. 23.402(d), through

    representations from the counterparty that can be contained in

    counterparty relationship documentation. The Commission also amended

    the requirements in the ``know your counterparty'' rule to align with

    the arm's length nature of the relationship between swap dealers and

    counterparties. In addition, the Commission adopted a confidential

    treatment rule, Sec. 23.410(c), that protects confidential

    counterparty information from disclosure and use that would be

    materially adverse to the interests of the counterparty.

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of the final due diligence rules pursuant to the five

    considerations identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    The final due diligence rules, although discretionary, are

    important components of the business conduct standards regime that

    Congress mandated to add to the integrity of the swaps market. By

    codifying and, in some cases, enhancing current market practices, the

    final rules provide protections for counterparties. More specifically,

    the rules protect market participants and the public from the risks

    attendant to swap dealers subrogating customers' interests to increase

    the dealer's own profit maximizing interests by selling unsuitable

    swaps or trading strategies. The requirement that dealers make suitable

    recommendations, together with the requirement that swap dealers know

    their counterparty, should help to ameliorate the risks associated with

    unfair dealing. Taken together, these practices should also help

    regulators perform their functions in an effective manner. The

    informational and diligence costs associated with this rulemaking are

    incremental and do not diminish these benefits.

    ii. Efficiency, Competitiveness and Financial Integrity

    A frequent criticism of the swaps market leading up to the 2008

    financial crisis was that dealers engaged in self-dealing to the

    detriment of customers and counterparties, such as by offering swaps

    and trading strategies that the dealers knew were unsuitable for the

    specific counterparty.\962\ Recommending products that have no

    beneficial purpose other than to enrich the dealer erodes confidence in

    markets, which, in turn, casts doubt on the efficiency, competitiveness

    and financial integrity of the markets subject to the jurisdiction of

    the Commission.

    ---------------------------------------------------------------------------

    \962\ See, e.g., CFA/AFR Feb. 22 Letter, at 1-4; Better Markets

    Feb. 22 Letter, 1-2; Sen. Levin Aug. 29 Letter, at 2-5 and 8-10;

    Senate Report, at 382, 397-98 and 619-24.

    ---------------------------------------------------------------------------

    The Commission designed these rules to achieve the intended

    statutory benefits set forth in the Dodd-Frank Act and concludes that

    any incremental costs above the statutory-baseline will not be of such

    magnitude so as to impede swap market efficiency, competitiveness or

    financial integrity of the markets.

    iii. Price Discovery

    To the extent the final due diligence rules, which are part of a

    larger business conduct standards regulatory framework, prevent the

    aforementioned erosion of confidence in the markets,

    [[Page 9810]]

    they also facilitate price discovery albeit indirectly.

    iv. Sound Risk Management Practices

    Verification and recording of counterparty identities, and

    carefully considered and well-documented recommendations, improve the

    risk management practices of a swap dealer and have concomitant

    benefits in that actual compliance with the final rules will help to

    insulate the dealer from later accusations by a disgruntled

    counterparty seeking to exit an unprofitable swap position by alleging,

    for example, that the dealer engaged in malfeasance or recklessness in

    recommending a swap or trading strategy. The above-acknowledged

    informational and diligence costs do not directly diminish these

    benefits.

    v. Other Public Interest Considerations

    The due diligence rules have the ancillary benefit of dissuading

    market participants from using Commission regulated derivatives markets

    to engage in illegal conduct in violation of other criminal laws,

    including money laundering and tax evasion. Swap dealers will be

    required to obtain certain essential information from counterparties to

    know their identity, their authority to trade and who controls their

    trading. This type of information has been helpful in related market

    sectors, like futures, securities and banking, in detecting and

    deterring such misconduct.

    3. Section 23.402(d)--Reasonable Reliance on Representations

    a. Benefits

    Section 23.402(d) does not impose any affirmative duties on swap

    dealers or major swap dealers, but rather provides them with an

    alternative means of compliance with certain other rules under subpart

    H of part 23 that require due diligence.\963\ In this way, the rule

    benefits market participants by facilitating compliance with certain of

    the business conduct standards rules without undermining the

    protections intended by the rules.

    ---------------------------------------------------------------------------

    \963\ 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 due

    diligence rules, respectively: Sec. 23.402(b)--Know your

    counterparty; Sec. 23.430--Verification of counterparty

    eligibility; Sec. 23.434--Institutional suitability; Sec. 23.440--

    Requirements for swap dealers acting as advisors to Special

    Entities; and Sec. 23.450--Requirements for swap dealers and major

    swap participants acting as counterparties to Special Entities.

    ---------------------------------------------------------------------------

    The rule allows swap dealers and major swap participants to rely on

    written representations from counterparties and their representatives

    to satisfy certain due diligence obligations unless the swap dealer or

    major swap participant has information that would cause a reasonable

    person to question the accuracy of the representation. Furthermore,

    representations can be made on a relationship basis in counterparty

    relationship documentation and need not be made on a transaction-by-

    transaction basis, provided that the counterparty undertakes to timely

    update such representations in connection with new swaps.

    Swap dealers and major swap participants requested clarity about

    the type of information that would satisfy their due diligence

    obligations, and counterparties were concerned that they would be

    required to provide confidential financial and position information

    that would give swap dealers and major swap participants an unfair

    advantage in their swap related negotiations. Section 23.402(d),

    coupled with the safe harbors and guidance provided to address

    compliance with the due diligence rules in subpart H, will benefit all

    parties by streamlining the means of compliance to enable efficient

    execution of transactions without materially diminishing the

    protections intended by the Dodd-Frank Act business conduct standards.

    b. Costs

    Section 23.402(d) does not, by itself, impose any direct costs on

    market participants. The costs of this rule, if any, are indirect since

    the rule is only applicable where swap dealers, major swap participants

    and counterparties choose to rely on counterparty representations to

    satisfy due diligence requirements imposed by other business conduct

    standards rules. As such, any costs of the rule are accounted for in

    the analysis of the related rules. One other cost that could arise is

    if the swap dealer or major swap participant had information that would

    cause a reasonable person to question the accuracy of a representation.

    In that situation, the swap dealer or major swap participant could not

    rely on the representation without undertaking appropriate due

    diligence and incurring any costs associated with further inquiry.

    However, swap dealers and major swap participants benefit from such

    inquiry if it keeps them from entering into a swap under false

    pretenses. Moreover, if the Commission determined not to adopt the

    rule, the cost to swap dealers and major swap participants would be

    significant. Under that alternative, as one commenter asserted in

    connection with Sec. 23.450--Acting as a counterparty to a Special

    Entity, swap dealers and major swap participants might stop entering

    into swaps altogether or, at the very least, pass increased costs onto

    their counterparties.\964\

    ---------------------------------------------------------------------------

    \964\ See SWIB Feb. 22 Letter, at 5. The costs and benefits

    associated with the ability of swap dealers and major swap

    participants to reasonably rely on a counterparty's representations

    are discussed in greater detail under the cost-benefit

    considerations for the particular requirements to which it applies:

    Sec. 23.402(c) (True Name and Owner), Sec. 23.430 (Verification of

    Counterparty Eligibility), Sec. 23.434 (Recommendations to

    Counterparties--Institutional Suitability), Sec. 23.440

    (Requirements for Swap Dealers Acting as Advisors to Special

    Entities), and Sec. 23.450 (Requirements for Swap Dealers and Major

    Swap Participants Acting as Counterparties to Special Entities).

    ---------------------------------------------------------------------------

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of final Sec. 23.402(d) pursuant to the five

    considerations identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    The purpose of the business conduct standards rules is to protect

    market participants and the general public. Final Sec. 23.402(d)

    furthers that intent by providing clear instruction on how market

    participants can comply with certain of those rules. The proviso that a

    swap dealer and major swap participant can only rely on a

    counterparty's representation in the absence of information that would

    cause them to question the accuracy of the representation protects swap

    dealers and major swap participants from the potentially negative

    consequences of entering into a swap in reliance on false information.

    This rule also protects counterparties by providing counterparties with

    control over the amount and type of information provided to a swap

    dealer or major swap participant.

    ii. Efficiency, Competitiveness and Financial Integrity

    This rule gives swap dealers and major swap participants a timely

    and cost-effective way to comply with their duties to counterparties.

    This increases the efficiency, competitiveness and financial integrity

    of the swaps market relative to an alternative that retains a due

    diligence requirement without an explicit means of compliance.

    Moreover, the Commission believes that the protection of proprietary

    information, which also is achieved through this rule, is essential for

    the competitiveness and integrity of derivatives markets.

    [[Page 9811]]

    iii. Price Discovery

    The Commission does not believe that Sec. 23.402(d) will have a

    material impact on price discovery.

    iv. Sound Risk Management Practices

    The Commission does not believe that Sec. 23.402(d) will adversely

    impact sound risk management practices. While the principles based

    nature of the rules may introduce some uncertainty into the process of

    complying with the due diligence business conduct standards rules, the

    compliance roadmap in this particular rule decreases that risk by

    providing an efficient means for swap dealers and major swap

    participants to comply with several of their pre-transactional duties.

    v. Other Public Interest Considerations

    The Commission has not identified any other public interest

    considerations in connection with Sec. 23.402(d).

    4. Section 23.402(e)--Manner of Disclosure; Section 23.402(f)--

    Disclosures in a Standard Format; Section 23.431--Disclosure of

    Material Risks, Characteristics, Material Incentives and Conflicts of

    Interest Regarding a Swap; Section 23.432--Clearing Disclosures; and

    Section 23.433--Communications--Fair Dealing

    a. Benefits

    Final Sec. 23.431, which requires disclosures of material

    information, and the associated disclosure rules in subpart H of part

    23 (the ``disclosure rules'') \965\ contain the disclosure regime for

    swap dealers and major swap participants. These rules are fundamental

    to the transparency objectives of Section 4s(h) of the Dodd-Frank Act.

    The disclosure rules primarily benefit counterparties by requiring that

    swap dealers and major swap participants disclose material information

    regarding potential swap transactions, including material risks,

    characteristics, incentives, conflicts of interest, daily marks and

    rights relating to clearing of the swap. They also benefit

    counterparties by providing flexible and reliable means of compliance

    to take account of the nature of the swaps being offered and to avoid

    undue interference with the execution process.

    ---------------------------------------------------------------------------

    \965\ Consistent with Section 4s(h)(3)(B) of the CEA, Sec.

    23.431--Disclosures of material information, requires disclosure of

    material risks, characteristics, material incentives, conflicts of

    interest and daily mark relating to a swap. Associated rules

    include: Sec. 23.402(e)--Manner of disclosure; Sec. 23.402(f)--

    Disclosures in a standard format; and Sec. 23.432--Clearing.

    ---------------------------------------------------------------------------

    In addition, the communications-fair dealing rule in final Sec.

    23.433 adopts the statutory language in Section 4s(h)(3)(C) and

    requires swap dealers and major swap participant ``to communicate in a

    fair and balanced manner based on principles of fair dealing and good

    faith.'' The fair dealing rule works in concert with the disclosure

    rules and the anti-fraud rules in Sec. 23.410 (the ``abusive practices

    rules'') to provide transparency to market participants in dealing with

    swap dealers and major swap participants.\966\

    ---------------------------------------------------------------------------

    \966\ See Section III.F. of this adopting release for a

    discussion of Sec. 23.433--Communications--Fair Dealing.

    ---------------------------------------------------------------------------

    While not readily amenable to quantification, the benefits of the

    disclosure and fair dealing rules are significant for counterparties.

    The disclosure rules will allow counterparties to better assess the

    risks and rewards of a swap and avoid swaps that are inconsistent with

    their trading objectives. The fair dealing rule ensures that swap

    dealers' and major swap participants' communications to counterparties

    are not exaggerated and discussions or presentations of profits or

    other benefits are balanced with the associated risks. The disclosure

    and fair dealing regime imposed by Section 4s(h) reverses the caveat

    emptor environment that permeated the unregulated derivatives

    marketplace prior to enactment of the Dodd-Frank Act and afforded

    little transparency or protection for either sophisticated

    counterparties or Special Entities. Legislative history indicates that

    the business conduct standards in Section 4s(h) were the result of

    widespread concerns about sharp practices and significant information

    asymmetries between swap dealers and their counterparties that created

    significant imbalances in their respective bargaining power and the

    assumption of unanticipated risks by counterparties. The disclosure and

    fair dealing rules implement the statutory objective of transparency

    for all swap transactions.

    With respect to disclosures of the daily mark for uncleared swaps,

    the rules will provide counterparties, on a daily basis, the mid-market

    mark for the swap.\967\ This information will provide an objective

    reference mark for counterparties to assist them in valuing open

    positions on their books for a variety of purposes, including risk

    management. The standard in the rule is intended to achieve a degree of

    consistency in the calculation of the daily mark across swap dealers

    and major swap participants. Such consistency will provide added

    transparency in pricing transactions and enhance the ability of

    counterparties to consider daily marks for their own valuation

    purposes. Counterparties will also receive from the swap dealer or

    major swap participant a mid-market mark along with the price of any

    swap prior to entering into the swap. Again, receiving the mid-market

    mark prior to execution of a swap will assist counterparties in

    assessing the price of a swap and negotiating swap terms, generally,

    with swap dealers and major swap participants.

    ---------------------------------------------------------------------------

    \967\ The mid-market mark will not include amounts for profit,

    credit reserve, hedging, funding, liquidity or any other costs of

    adjustments.

    ---------------------------------------------------------------------------

    The Commission believes that the disclosure rules will secondarily

    benefit swap dealers, major swap participants and regulators by

    requiring documentation of swap-related disclosures. While not a

    quantifiable benefit, documentation will facilitate effective

    supervision and compliance with required disclosures, which should

    reduce potential complaints, investigations and litigation. The fair

    dealing rule also benefits swap dealers and major swap participants by

    harmonizing the statutory requirements with similar protections that

    currently apply to registrants in the futures and securities

    markets.\968\

    ---------------------------------------------------------------------------

    \968\ See NFA Interpretive Notice 9041-Obligations to Customers

    and other Market Participants (``Communications with the Public--

    Under NFA Compliance Rules 2-4 and 2-29(a)(1), all communications

    with the public regarding security futures products must be based on

    principles of fair dealing and good faith * * *.''); see also NASD

    Rule 2210(d). Final Sec. 23.433 is also harmonized with the SEC's

    proposed Fair and Balanced Communications rule for SBS Entities. See

    proposed 17 CFR 240.15Fh-3(g), SEC's proposed rules, 76 FR at 42455;

    and SEC's proposed rules Correction, 76 FR 46668, Aug. 3, 2011.

    ---------------------------------------------------------------------------

    b. Costs

    The primary costs of the disclosure rules are associated with

    implementing policies and procedures to achieve compliance with the

    principles based disclosure requirements, preparing and disseminating

    the disclosures, and maintaining records of the disclosures. The

    Commission expects that expenses will vary depending on the regulatory

    status of the swap dealer or major swap participant with financial

    firms regulated by prudential or securities authorities having

    relatively less additional costs because of existing regulatory

    requirements. Costs will also vary depending on the nature of the

    business conducted by the swap dealer considering that the process of

    making disclosures may be more streamlined for standardized swaps than,

    for example, complex bespoke swaps.

    Regardless, the Commission believes that any costs associated with

    the disclosure rules will be incremental for

    [[Page 9812]]

    the following reasons. First, as stated above in Section III.D. of this

    adopting release, many swap dealers and major swap participants subject

    to this scheme have long been subject to similar disclosure obligations

    based on informal OTC derivatives industry practice and under the

    mandates of regulatory authorities in related market sectors, including

    banking, securities and insurance. As such, the incremental cost of

    complying with the Commission's final rules is likely to be small

    relative to the overall costs of operating as a swap dealer or major

    swap participant.

    Second, in response to comments, the Commission elected to

    promulgate several cost-mitigating alternatives in the final disclosure

    rules. For example, the Commission made clear that a swap dealer or

    major swap participant could fulfill its disclosure obligations by any

    reliable means agreed to in writing by the counterparty. In addition,

    disclosures applicable to multiple swaps may be made in counterparty

    relationship documentation or other written agreements rather than on a

    transaction-by-transaction basis. The scenario analysis rule was

    revised from mandatory to elective and limited to swaps that are not

    made available for trading on a DCM or SEF. Further, anonymous

    transactions initiated on a SEF or DCM are exempt from the pre-

    transaction disclosure requirements.

    Third, the Commission provided additional guidance in response to

    comments regarding many aspects of the disclosure scheme, including

    manner of disclosure, disclosures in a standard format, material risks,

    scenario analysis, material characteristics, material incentives,

    conflicts of interest, daily mark and clearing issues. Fourth, the

    Commission made clear that in exercising its prosecutorial discretion

    for disclosure violations, it would consider whether the swap dealer or

    major swap participant had complied in good faith with policies and

    procedures reasonably designed to comply with the particular disclosure

    requirement. In these and other ways, the Commission believes that it

    has taken meaningful steps to minimize the risks and costs of

    compliance and any ancillary costs associated with, for example,

    private rights of action by counterparties unhappy with a particular

    swap transaction.

    The Commission is allowing swap dealers and major swap participants

    to satisfy their disclosure obligations, where appropriate, on a

    relationship basis, as opposed to a transaction-by-transaction basis as

    a way of avoiding trading delays and the associated costs. However, in

    certain instances, consistent with the statutory requirement that swap

    dealers and major swap participants disclose information about the

    material risks and characteristics of the swap, the disclosure

    obligation will require supplements to standardized disclosures that

    are, to a degree, tailored to the individual transaction under

    consideration. The costs and benefits of these types of transaction-

    specific disclosures are considered relative to a case where material

    risk disclosure, as required under the statute, is accomplished at a

    level less granular than that which tailors such disclosure to a

    particular swap type. In addition, since the requirement for scenario

    analysis, through its value for illustrating material risk, is made at

    the discretion of the Commission, its associated costs and benefits are

    discussed relative to the absence of such a requirement.

    Commenters also identified costs associated with the fair dealing

    rule. One commenter asserted that the principles based nature of the

    proposed fair dealing rule had the potential to impose costs on swap

    dealers and major swap participants including costs resulting from

    compliance risk.\969\ As discussed in the introduction to this Section

    VI.C. of this adopting release, such costs are not readily subject to

    quantification. Another commenter requested that the Commission clarify

    the standards for communication by reference to existing SRO standards

    applicable in related market sectors.\970\

    ---------------------------------------------------------------------------

    \969\ NY City Bar Feb. 22 Letter, at 3.

    \970\ FHLBanks Feb. 22 Letter, at 6.

    ---------------------------------------------------------------------------

    In response to commenters, the Commission clarifies in this

    adopting release that it will consider NFA guidance when interpreting

    Sec. 23.433.\971\ The Commission believes harmonizing with existing

    SRO rules and precedents in the futures and securities markets

    diminishes the potential costs associated with legal uncertainty.

    Furthermore, the Commission clarifies in this adopting release that, in

    the absence of fraud, the Commission will consider good faith

    compliance with policies and procedures reasonably designed to comply

    with the fair dealing rule as a mitigating factor when exercising its

    prosecutorial discretion in connection with a violation of Sec.

    23.433.

    ---------------------------------------------------------------------------

    \971\ See Section III.F.3. of this adopting release for a

    discussion of final Sec. 23.433 and NFA guidance.

    ---------------------------------------------------------------------------

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of the final disclosure rules and the fair dealing rule

    pursuant to the five considerations identified in Section 15(a) of the

    CEA as follows:

    i. Protection of Market Participants and the Public

    The principal purpose of the disclosure rules is to protect market

    participants and the public by making swaps more transparent to enable

    counterparties to better assess the risks and rewards of entering into

    a particular transaction. The disclosure rules are a core component of

    the overall business conduct standards regime imposed in Section 4s(h)

    of the Dodd-Frank Act.

    In determining how to implement the statutory disclosure

    requirements, the Commission considered certain negative externalities

    that may be created by requiring swap dealers and major swap

    participants to provide transaction specific disclosures. One risk is

    that requiring such disclosures by swap dealers and major swap

    participants could create disincentives to counterparties for

    performing their own independent assessments of a transaction under

    consideration. As a result, there is an increased likelihood that any

    insufficiencies in the information provided by swap dealers and major

    swap participants that are not easily discernible at the time the

    disclosure is made could impact an expanded class of market

    participants in a similar way. For instance, the model risk borne by

    swap dealers and major swap participants may be transferred onto a

    broader set of market participants.

    In addition, transaction-specific disclosures, generally, and

    specifically those based on model outputs (e.g., certain scenario

    analyses) require ongoing validation to ensure their sufficiency,

    accuracy and relevance. To the extent that the level of these

    validation efforts varies across swap dealers and major swap

    participants, the risk of relative insufficiencies or omissions in

    disclosure borne by the counterparties reliant on this information will

    vary correspondingly.

    Because the disclosure rules are principles based, the quality of

    policies and procedures adopted by swap dealers and major swap

    participants will play a significant role in determining the

    sufficiency, accuracy and relevance of the disclosures made to

    counterparties. Moreover, some of the disclosures are models-based,

    whether through disclosures of a given product's sensitivity to certain

    market risk factors or the performance of the product during different

    scenario events or episodes. Policies and procedures, generally, and

    especially those governing models require ongoing

    [[Page 9813]]

    validation to ensure their sufficiency, accuracy and relevance. The

    consequences of varying levels of supervision, to the extent that these

    levels vary in their ability to preserve the sufficiency, accuracy and

    relevance of the disclosures, will be borne by counterparties. Any such

    differences in supervisory efforts, to the extent they are allowed to

    persist, lessen the degree to which counterparties can rely on the

    information being provided to them. To mitigate these concerns, the

    Dodd-Frank Act imposes robust supervision and compliance requirements

    on swap dealers and major swap participants, which are implemented in

    subpart J of part 23. In subpart H, and in guidance in this adopting

    release, the Commission has endeavored to clarify the relationship

    between swap dealers and major swap participants, on the one hand, and

    counterparties on the other to discourage undue reliance and to

    incentivize counterparties to engage in appropriate due diligence

    before entering into swaps.

    Transaction-specific information is certainly valuable to the

    counterparty to assess the relative merits of a prospective

    transaction. Through economies of scale, swap dealers and major swap

    participants may be better positioned to provide these disclosures (as

    opposed to the counterparty discovering the information itself). In

    other words, swap dealers and major swap participants may be the

    lowest-cost provider of this information. As a result, efficiency gains

    may be realized by requiring swap dealers and major swap participants

    to disseminate this information. The fact that commenters point to

    significant information advantages enjoyed by swap dealers and major

    swap participants over their counterparties supports this lowest-cost

    solution.

    Additionally, the fair dealing rule protects market participants

    and the public by requiring that communications between swap dealers or

    major swap participants and their counterparties are conducted based on

    principles of fair dealing and good faith. The rule raises the standard

    for communications in the previously unregulated swaps market and

    encourages confidence in the swap market by market participants and the

    public. The fair dealing rule, particularly in conjunction with the

    disclosure rules, ensures that market participants have information

    necessary to assess the risks and rewards of a swap when dealing with

    swap dealers and major swap participants, which have had informational

    advantages over their counterparties by virtue of their roles in the

    marketplace.

    ii. Efficiency, Competitiveness and Financial Integrity

    Commenters raised concerns that requiring material information

    disclosure prior to execution may delay execution, increase market risk

    and adversely affect efficiency. Further, the required disclosures may

    result in proceedings or litigation, which could test the financial

    integrity of certain swap market participants.

    The Commission has designed the disclosure rules to minimize

    potential inefficiencies and anti-competitive results, and to bolster

    financial integrity. For example, the rules allow disclosures to be

    made by any reliable means agreed to by the counterparty. In addition,

    risk disclosures in a standard format may be included in counterparty

    relationship documentation or other written agreements between the

    parties. Scenario analysis is elective rather than mandatory. Moreover,

    because the disclosure rules are principles based, the Commission will

    take into account whether reasonably designed policies and procedures

    are in place prior to exercising its prosecutorial discretion when

    considering violations of the disclosure rules.

    The fair dealing rule principally protects counterparties; however,

    there are additional benefits for markets. The fair dealing rule,

    particularly when considered with the abusive practices rules and the

    disclosure rules, improves transparency and discourages abusive

    practices, and thereby encourages participation in the market, which

    contributes to liquidity, efficiency and competitiveness in the

    marketplace. Furthermore, the fair dealing rule assists market

    participants to assess potential risk in connection with a swap and

    make more informed decisions consistent with their trading objectives.

    iii. Price Discovery

    Transaction specific disclosures may, to a degree, cause delays in

    execution. These delays may occur either when a counterparty with an

    established relationship with a given swap dealer or major swap

    participant elects to begin trading a product outside of that

    relationship or a counterparty with no such relationship looks to begin

    trading with a given swap dealer or major swap participant. These

    delays may have negative consequences on liquidity, potentially

    subjecting counterparties to heightened transaction costs. Moreover,

    these delays may be pro-cyclical, meaning that they increase during

    times of heightened market volatility. In recognition of the potential

    for these delays, the Commission adopted several procedural provisions

    to mitigate adverse consequences, including (1) allowing, where

    appropriate, disclosures to be made at the relationship level as

    opposed to the transaction level, (2) allowing certain oral disclosures

    if agreed to by the counterparty and confirmed in writing, (3) making

    Web site-based disclosures (password-protected if for the daily mark)

    available, and (4) allowing swap dealers and major swap participants to

    partner with DCMs, SEFs, and/or third-party vendors to make certain

    disclosures.

    To the extent that delays in execution foster a more complete

    assessment of the merits of a particular transaction, the likelihood of

    after-the-fact realizations of ill-conceived positions may be reduced

    as well as any trading activity these realizations encourage. To the

    extent that this trading activity impacts market volatility, its

    reduction has positive implications for price discovery. Moreover,

    since these realizations are more likely to occur during periods of

    market stress, the corresponding benefit of their reduction may be

    elevated during such periods.

    As stated in the price discovery consideration of final Sec.

    23.410, the fair dealing rule benefits counterparties but also provides

    added benefits for markets.\972\ The fair dealing rule requires swap

    dealer and major swap participant communications to be fair and

    balanced and restricts misleading or other potentially abusive

    communications that could undermine the price discovery function of the

    swap market.

    ---------------------------------------------------------------------------

    \972\ See Section VI.C.5.c.iii. of this adopting release for a

    discussion of price discovery considerations of final Sec. 23.410--

    Prohibition on fraud, manipulation and other abusive practices.

    ---------------------------------------------------------------------------

    iv. Sound Risk Management Practices

    Presumably, exercising the opt-in feature for scenario analysis

    will impart some cost to the counterparty. This cost will depend on the

    specificity of the analysis being requested and will be paid through

    some combination of delayed execution and/or higher fees. The rule

    attempts to mitigate these costs by making scenario analysis optional

    on the part of the counterparty as it is under current industry

    practice. Moreover, exercising this feature signals that the

    counterparty values the information provided by the analysis and,

    therefore, is willing to bear the associated costs. In contrast, a

    policy of mandatory scenario analysis forces this cost to be borne, to

    varying degrees, by

    [[Page 9814]]

    all market participants, even though the corresponding benefit to a

    subset of those participants may be at or near zero. As a result, the

    final scenario analysis provision furthers a primary objective of the

    Dodd-Frank Act by encouraging sound risk management practices among

    market participants without unduly imposing costs.

    Consistent with the statutory framework in Section 4s(h), whether

    standard form or particularized disclosures are sufficient in any given

    case will depend on the facts and circumstances of the subject

    transaction. Principles based disclosure rules take into account the

    various types of swap transactions that are subject to the rules (from

    highly standardized agreements to complex bespoke swaps), as well as

    the varied scope of swap related business undertaken by swap dealers

    and major swap participants. Compliance with principles based rules,

    like the disclosure rules, is by nature a matter of interpretation by

    swap dealers or major swap participants in the design of their policies

    and procedures, as well as by regulators and counterparties in their

    after-the-fact review of such disclosures, prompted, for example, by

    performance results that are claimed to be inconsistent with such

    disclosures. Subjective criteria introduce uncertainty into the

    compliance process and, in so doing, contribute to heightened risk

    costs that, at least in part, may be passed on to counterparties.

    Depending on how this uncertainty distributes across all swaps

    products, certain market participants may bear a disproportionate share

    of the resulting costs. The Commission attempts to dampen these costs,

    generally, by considering good faith compliance with policies and

    procedures reasonably designed to comply with the requirements of any

    particular rule. The rules also supply guidance for complying with

    these duties as a means for mitigating any uncertainty in regulatory

    compliance.

    To the extent that the disclosure rules contribute to execution

    delays, for the duration of these delays, market participants will

    either need to bear certain market risks or be prevented from taking on

    those risks.\973\

    ---------------------------------------------------------------------------

    \973\ See the discussions of price discovery above for a

    description of the provisions designed to mitigate these delays.

    ---------------------------------------------------------------------------

    The fair dealing rule does not undermine sound risk management

    practices for swap dealers or major swap participants and has the

    potential to enhance risk management practices for counterparties.

    Counterparties will be able to manage their swap related risks based on

    more complete and reliable information from swap dealers and major swap

    participants. Swap dealers and major swap participants will be

    incentivized to implement policies and procedures reasonably designed

    to ensure that they make fair and balanced communications that provide

    their counterparties with a sound basis for evaluating the facts with

    respect to any swap. Similar to the discussion of the cost-benefit

    considerations of the anti-fraud rules, such practices will reduce

    counterparties' risk that they may otherwise enter into a swap that is

    inconsistent with their trading objectives based on unbalanced or

    misleading communications.

    v. Other Public Interest Considerations

    The disclosure rules are designed to address historical information

    asymmetry between counterparties and swap dealers or major swap

    participants and should enable counterparties to better protect their

    own interests before assuming the risk of any particular swap

    transaction. In addition, requiring both the disclosure of material

    information and fair dealing will enhance transparency and promote

    counterparty confidence in the previously unregulated swap market,

    which better enables counterparties to use swaps to assume and manage

    risk.

    5. Section 23.410--Prohibition on Fraud, Manipulation and Other Abusive

    Practices

    a. Benefits

    Final Sec. 23.410 prohibits fraud, manipulation and other abusive

    practices and is applicable to swap dealers and major swap

    participants. Section 23.410(a) mirrors the language of Section

    4s(h)(4)(a) of the CEA. Section 23.410(b) provides an affirmative

    defense for swap dealers and major swap participants to alleged non-

    scienter violations of Sec. 23.410(a)(2) and (3). Final Sec.

    23.410(c) prohibits swap dealers and major swap participants from

    disclosing confidential counterparty information or using such

    confidential information in a manner that would tend to be adverse to

    the counterparty.

    The rule primarily benefits counterparties, including Special

    Entities, in that it prohibits fraudulent, deceptive and manipulative

    practices by swap dealers and major swap participants and misuse of

    confidential information to the detriment of the counterparty. While

    not readily amenable to quantification, the benefits of the rule are

    significant. The rule is designed to mitigate the potentially

    considerable costs associated with a counterparty entering into a swap

    having been induced by fraudulent, deceptive or manipulative conduct.

    The rule also reduces the possibility that counterparties will be

    disadvantaged by manipulative conduct or misuse of confidential

    information by, among other things, improper disclosure of the

    counterparty's trading positions, intentions to trade or financial

    status.\974\ In these ways, the rule is an integral component of the

    business conduct standards, which are, in large part, designed to

    ensure that counterparties and swap dealers are on equal footing with

    respect to understanding the risks and rewards of a particular swap or

    trading strategy.

    ---------------------------------------------------------------------------

    \974\ The protections in final Sec. 23.410 also address

    historical imbalances in negotiating power between swap dealers and

    counterparties related to sophistication and financial wherewithal.

    The treatment of confidential counterparty information by swap

    dealers depended on the relative ability of the parties to negotiate

    terms in their interest.

    ---------------------------------------------------------------------------

    The rule also enhances the authority of the Commission to ensure

    fair and equitable markets. Market participants and the public will

    benefit substantially from such enhanced prevention and deterrence of

    fraud and manipulation. Rules protecting the confidential treatment of

    counterparty information and prohibiting fraud and manipulation

    encourage market participation, with the ensuing positive implications

    such participation has on market efficiency and price discovery.

    b. Costs

    The Commission does not believe that there will be significant

    costs in connection with final Sec. 23.410. First, Sec. 23.410(a)

    merely codifies Section 4s(h)(4)(A) of the CEA.\975\ To the extent

    there were any costs to be considered, Congress made that determination

    in promulgating Section 4s(h)(4)(A). Further, final Sec. 23.410(b) has

    added an affirmative defense, which mitigates any costs that may have

    been imposed by the application of non-scienter fraud provisions in

    final Sec. Sec. 23.410(a)(2) and (3) to swap dealers and major swap

    participants. The Commission believes that swap dealers and major swap

    participants already have in place policies and procedures, and provide

    training to ensure that their traders and staff do not engage in fraud

    and manipulation. To the extent there are any costs with respect to

    final Sec. 23.410(a), such costs will be related to training staff and

    ensuring that existing compliance procedures are up-to-date. In

    addition, such policies and procedures are already accounted for by

    virtue of the Commission's

    [[Page 9815]]

    promulgation of final Sec. Sec. 180.1 and 180.2, which similarly

    prohibit manipulative or deceptive conduct, as well as the other

    applicable anti-fraud and manipulation prohibitions in the CEA.

    ---------------------------------------------------------------------------

    \975\ See Section 731 of Dodd-Frank Act.

    ---------------------------------------------------------------------------

    To the extent there are costs with respect to the protection of

    confidential counterparty information, the primary costs of this rule

    are associated with implementing policies and procedures designed to

    protect such information. The design of the final rule, and the

    Commission guidance in this adopting release, address concerns by

    commenters that the proposed confidential treatment and trading ahead

    provisions would have unduly affected the ability of swap dealers and

    major swap participants to enter into transactions with other

    counterparties or manage their own risks. The Commission believes that

    the actual costs to swap dealers and major swap participants will be

    insubstantial and have been mitigated by the final rules.

    First, as stated above, swap dealers and major swap participants

    subject to final Sec. 23.410(a) are already subject to Section

    4s(h)(4)(A) of the CEA, which was added by the Dodd-Frank Act. In

    addition, as stated above, the Commission believes that swap dealers

    and major swap participants already have policies and procedures and a

    compliance regime in place to prevent fraud and manipulation by traders

    and staff. Further, swap dealers and major swap participants have long

    been subject to either self-imposed internal business conduct rules or

    to contractual requirements of confidentiality contained in negotiated

    swap agreements for individual swaps or in counterparty relationship

    documentation with counterparties.\976\

    ---------------------------------------------------------------------------

    \976\ See SIFMA/ISDA Feb. 17 Letter, at 11.

    ---------------------------------------------------------------------------

    The Commission understands that there will be incremental costs

    associated with adapting existing policies and procedures to the new

    rules, but believes that these costs would be materially the same

    regardless of the rules' substance. Final Sec. 23.410(a) imposes no

    affirmative duties, and it is unlikely that it will impose any

    additional costs beyond the existing costs associated with ensuring

    that behavior and statements are not fraudulent, deceptive or

    manipulative.\977\ In this regard, the Commission believes it will not

    be necessary for firms that currently have adequate compliance programs

    to hire additional staff or significantly upgrade their systems to

    comply with the new rules, although firms may incur some compliance

    costs such as the cost associated with training traders and staff about

    the new rules.

    ---------------------------------------------------------------------------

    \977\ See Prohibition on Manipulative and Deceptive Devices, 76

    FR at 41408-41409, for a discussion of the costs and benefits of

    final Sec. Sec. 180.1 and 180.2.

    ---------------------------------------------------------------------------

    Finally, in response to comments regarding proposed Sec.

    23.410(a), the Commission elected to revise the proposed rule by adding

    a cost-mitigating section. Final Sec. 23.410(b) provides that a swap

    dealer or major swap participant may establish an affirmative defense

    against allegations of violations of final Sec. 23.410(a)(2) and (3)

    by demonstrating that it did not act intentionally or recklessly and

    complied in good faith with written policies and procedures reasonably

    designed to meet the particular requirement that is the basis for the

    alleged violation. With respect to the confidential treatment of

    counterparty information, the Commission provided that such

    confidential information may be disclosed or used for effective

    execution of the swap with the counterparty, to hedge or mitigate

    exposure created by the swap, or to comply with requests from

    regulators or as required by law, or as agreed by the counterparty. In

    these and other ways, the Commission believes that it has taken

    appropriate steps to minimize the risks and costs of compliance and any

    ancillary costs associated with final Sec. 23.410 (e.g., vexatious

    litigation by a counterparty experiencing buyer's remorse).

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of final Sec. 23.410 pursuant to the five considerations

    identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    The purpose of final Sec. 23.410 is to protect market participants

    and the public by prohibiting fraud, manipulation and other abusive

    practices. Final Sec. 23.410(a) codifies Section 4s(h)(4)(A) of the

    CEA and appropriately extends the protections intended under the Dodd-

    Frank Act. Final Sec. 23.410(c) provides protection for counterparties

    by prohibiting disclosure and misuse of their confidential information.

    As such, Sec. 23.410(c), although discretionary, is a central element

    in the business conduct standards regime that Congress mandated the

    Commission implement by imposing standards on swap dealers and major

    swap participants in their dealings with counterparties. The rule is

    also guided by Section 3(b) of the CEA, which explicitly includes among

    the purposes of the CEA ``* * * to protect all market participants from

    fraudulent or other abusive sales practices * * *.'' In addition, the

    rule implements the discretionary authority provided by Congress in

    Section 4s(h)(1)(A) of the CEA, which authorizes the Commission to

    prescribe rules that relate to ``fraud, manipulation, and other abusive

    practices involving swaps (including swaps that are offered but not

    entered into * * *).'' As provided by Sections 3 and 4s(h)(1)(A) of the

    CEA, the rule protects market participants, generally, and Special

    Entities, particularly (which, when victims of fraud, manipulation or

    abuse, can have significant negative implications for taxpayers,

    pensioners and charitable institutions).

    In addition, the requirements that dealers disclose counterparty

    information only on a ``need to know'' basis and establish policies and

    procedures to protect confidential counterparty information, together

    with the other important requirements set forth in this rulemaking,

    ameliorate the risks associated with disclosure of confidential

    information to a swap dealer or major swap participant. The above-

    acknowledged diligence costs do not diminish these benefits.

    ii. Efficiency, Competitiveness and Financial Integrity

    While final Sec. 23.410 is aimed at protecting counterparties,

    there are ancillary benefits for markets. Markets that are free of

    fraud, manipulation and other abusive practices encourage

    participation, which adds to liquidity, efficiency and competitiveness.

    The final rule enhances these benefits by appropriately restricting

    abusive conduct by swap dealers and major swap participants. In

    addition, protections against fraud, manipulation and misuse of

    counterparty information promote the financial integrity of

    counterparties by reducing the likelihood of (1) their being victims of

    fraud (and needing to bear the costs associated with such fraud) or

    manipulation in the value of their positions, and (2) their

    confidential information being used in ways that are adverse to their

    investment objectives. These protections look to reduce the level of

    risk to which counterparties are exposed when conducting business in

    the swaps markets.

    iii. Price Discovery

    As stated in the previous section, while final Sec. 23.410 is

    aimed at protecting counterparties from abusive conduct by swap dealers

    and major swap participants, there are ancillary

    [[Page 9816]]

    benefits for markets. These benefits are key to providing ``a means for

    managing and assuming price risks, discovering prices, or disseminating

    pricing information through trading in liquid, fair and financially

    secure trading facilities.'' \978\ Indeed, it is an explicit purpose of

    the CEA ``to deter and prevent price manipulation or any other

    disruptions to market integrity.'' \979\ The final rule appropriately

    restricts abusive conduct by swap dealers and major swap participants

    without unduly chilling legitimate trading that could undermine the

    price discovery function of the market.

    ---------------------------------------------------------------------------

    \978\ Section 3(a) of the CEA (7 U.S.C. 5(a)).

    \979\ Section 3(b) of the CEA (7 U.S.C. 5(b)).

    ---------------------------------------------------------------------------

    iv. Sound Risk Management Practices

    Final Sec. 23.410 supports sound risk management practices for

    swap dealers and major swap participants by incentivizing them to

    expand their policies and procedures to avoid misuse of confidential

    counterparty information. This will reduce the risks faced by

    counterparties that their proprietary information will be

    misappropriated, while concomitantly mitigating litigation risks for

    swap dealers and major swap participants. The above-acknowledged

    diligence costs do not diminish these benefits.

    v. Other Public Interest Considerations

    Final Sec. 23.410 is consistent with prohibitions against

    fraudulent and manipulative practices in other market sectors,

    including futures, securities and banking. It is also consistent with

    market abuse prohibitions that are generally in effect in foreign

    markets. Harmonization reduces compliance costs and enhances

    protections for market participants whose trading strategies cross

    market sectors and international borders.

    6. Section 23.430--Verification of Counterparty Eligibility

    a. Benefits

    Final Sec. 23.430--Verification of counterparty eligibility, is a

    due diligence business conduct requirement for swap dealers and major

    swap participants that is mandated by Section 4s(h) of the CEA. The

    final rule implements congressional intent that only ECPs have access

    to swaps that are traded bilaterally or on a SEF (where the swap dealer

    or major swap participant knows the identity of the counterparty). The

    final rule also ensures that swap dealers and major swap participants

    determine prior to offering to enter into or entering into a swap

    whether its counterparty is a Special Entity, which would trigger

    additional protections under Sections 4s(h) and subpart H of part

    23.\980\ To avoid interfering with the efficient execution of

    transactions, the rule provides a safe harbor that allows swap dealers

    and major swap participants to rely on counterparty representations,

    which can be contained in counterparty relationship documentation. The

    rule specifies the content of the written representations on which the

    swap dealer or major swap participant can reasonably rely.

    ---------------------------------------------------------------------------

    \980\ See Section 4s(h)(4) and (5) of the CEA and Sec. Sec.

    23.440 and 23.450.

    ---------------------------------------------------------------------------

    While not readily amenable to quantification, the benefits of the

    verification rule are material. The principal benefit is the

    implementation of congressional intent that certain swaps be available

    only to ECPs and that retail customers be limited to swaps trading only

    on a DCM. The rule also fosters compliance with the Special Entity

    rules by verifying Special Entity status early in the relationship

    between the swap dealer or major swap participant and the Special

    Entity counterparty. Swap dealers and major swap participants benefit

    from the rule to the extent that verification of eligibility will

    assist them in avoiding non-ECP counterparties that would seek to avoid

    liability for unprofitable swaps based on ineligibility. The

    requirement to verify the Special Entity status of a counterparty is

    implicit in the provisions that afford heightened protections for

    Special Entities.\981\

    ---------------------------------------------------------------------------

    \981\ Id.

    ---------------------------------------------------------------------------

    b. Costs

    As discussed above, Congress required the Commission to implement a

    counterparty eligibility verification rule. The Commission is not

    required to consider the costs and benefits of Congress' mandate;

    rather Section 15(a) of the CEA requires the Commission to consider the

    costs and benefits of its regulatory actions. In this case, the primary

    costs of final Sec. 23.430 are associated with obtaining information

    necessary to verify that a counterparty is an ECP, and where relevant a

    Special Entity or counterparty able to elect Special Entity protections

    as provided in Sec. 23.401(c)(6), and maintaining records regarding

    the verification. The Commission believes that its implementing

    regulation mitigates these costs by closely adhering to the existing

    industry best practices, which provide that professional

    intermediaries, prior to entering into any transaction, evaluate

    counterparty legal capacity, transactional authority and credit. In

    addition, the Commission's regulation is similar to swap counterparty

    restrictions under the Commodity Futures Modernization Act amendments

    to the CEA.\982\ Given existing OTC derivatives market practice and

    historical restrictions on market access, the Commission expects the

    cost of complying with final Sec. 23.430 will be insignificant. In

    addition, the final rule specifically allows swap dealers and major

    swap participants to rely on written representations by the

    counterparty to satisfy the verification rule for both ECP and Special

    Entity status and such representations can be made in counterparty

    relationship documentation. The rule also specifies the content of

    representations that would provide a reasonable basis for reliance, and

    the Commission confirmed that a change in a counterparty's ECP status

    during the term of a swap will not affect the enforceability of the

    swap. Based on the foregoing, the Commission believes that it has taken

    meaningful and appropriate steps to minimize the risks and costs of

    compliance with Congress' directive to implement a counterparty

    eligibility verification rule as mandated in Section 4s(h) of the CEA.

    ---------------------------------------------------------------------------

    \982\ See Sections 2(g) and 2(h) of the CEA prior to the Dodd-

    Frank Act amendments.

    ---------------------------------------------------------------------------

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of final Sec. 23.430 pursuant to the five considerations

    identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    Congress has determined that swap market participation, except on a

    DCM, should be limited to ECPs, and final Sec. 23.430 furthers that

    determination by establishing a procedure for restricting access by

    unqualified persons. In this way, the rule provides protection for

    market participants and the public by limiting access to qualified

    persons. The due diligence costs associated with this rulemaking are

    incremental and do not diminish the benefits.

    ii. Efficiency, Competitiveness and Financial Integrity

    The final verification rule mitigates negative effects on

    efficiency, competitiveness and financial integrity by addressing costs

    associated with execution delays. In addition, the financial integrity

    of the market may be enhanced by requiring due diligence by swap

    dealers and major swap participants to restrict participation by non-

    ECPs that generally have limited

    [[Page 9817]]

    ability to evaluate and assume the risk of complex bilateral swaps.

    iii. Price Discovery

    By virtue of the compliance mechanisms built into the rule, the

    Commission believes that it will not unduly interfere with the price

    discovery function of the market that could result from execution

    delays. Section 4s(h) limits market participation to ECPs, which could

    negatively affect liquidity and price discovery, but the final rule

    does not exacerbate such potential consequences by limiting market

    access. Indeed, by ensuring that only ECPs (the CEA proxy for

    sophistication and financial wherewithal) can participate, other ECPs

    may be encouraged to participate, thereby enhancing liquidity and price

    discovery.

    iv. Sound Risk Management Practices

    The final rule addresses counterparty risk, which is one of the

    primary risks in the swaps market. As indicated above, the final rule

    codifies OTC derivatives industry best practice by requiring swap

    dealers and major swap participants to verify that the potential

    counterparty is an ECP and, where relevant, a Special Entity. This

    verification supplements the industry best practice requirement

    advising that, prior to trading, market professionals should check a

    counterparty's legal capacity, transactional authority and credit.

    Therefore, the rule complements existing market practice and sound risk

    management practices.

    v. Other Public Interest Considerations

    The Commission has not identified any other public interest

    considerations.

    7. Section 23.440--Requirements for Swap Dealers Acting as Advisors to

    Special Entities; Section 23.450--Requirements for Swap Dealers and

    Major Swap Participants Acting as Counterparties to Special Entities;

    and Section 23.451--Political Contributions by Certain Swap Dealers

    a. Benefits

    Final Sec. Sec. 23.401(c), 23.440, 23.450 and 23.451 (the

    ``Special Entity rules'') provide heightened protections to a

    particular class of swap market participant when dealing with swap

    dealers and major swap participants. Special Entities play an important

    public interest role by virtue of their responsibility for managing

    taxpayer funds, the assets of public and private employee pension plans

    and endowments of charitable institutions. The Special Entity rules

    implement the congressional mandate to establish a higher standard of

    care for swap dealers that act as advisors to Special Entities and to

    ensure that Special Entities are represented by knowledgeable,

    independent advisors when dealing with swap dealers and major swap

    participants.

    The Special Entity rules also prohibit swap dealers from entering

    into swaps with a governmental Special Entity \983\ if the swap dealer

    makes certain political contributions to officials of that governmental

    Special Entity to prevent what is known as ``pay-to-play.'' The

    Commission believes that the pay-to-play rule in Sec. 23.451 is a

    necessary and appropriate prohibition to prevent swap dealers and

    others from engaging in fraudulent practices. Given the competitive

    nature of the swaps market, the incentives to engage in pay-to-play may

    be significant. The rule also harmonizes with existing pay-to-play

    restrictions applicable to certain swap dealers who are also subject to

    pay-to-play rules in the securities sector to promote regulatory

    consistency across related market sectors.

    ---------------------------------------------------------------------------

    \983\ Final Sec. 23.451(a)(3) defines ``governmental Special

    Entity'' as State and municipal Special Entities defined in Sec.

    23.402(c)(2) and governmental plans as defined in Sec.

    23.402(c)(4); see also Section IV.D. of this adopting release at fn.

    904.

    ---------------------------------------------------------------------------

    The Special Entity rules provide substantial benefits to Special

    Entities and the general public. Swaps may have complex terms or employ

    leverage that can expose counterparties to significant financial risks,

    and unanticipated losses from a swap transaction can be financially

    devastating. Because financial losses in connection with a swap depend

    on the facts and circumstances regarding the particular swap and the

    particular Special Entity, the costs of such losses are not reliably

    quantifiable and, therefore, the benefits of preventing such losses are

    also not reliably quantifiable.

    Although the costs of the Special Entity rules are not readily

    quantifiable, the benefits to Special Entities are significant.

    Ensuring that Special Entities are represented by independent advisors

    that have sufficient knowledge to evaluate the transaction and risks of

    a swap is a vitally important protection for Special Entities.

    Independent and knowledgeable advice will benefit Special Entities, and

    those whose interests they represent, by creating a more level playing

    field when negotiating with swap dealers and major swap participants.

    Final Sec. 23.450 mitigates the likelihood that a Special Entity will

    assume risks and any consequent losses based on (1) inadequate advice

    due to a lack of understanding of the risks, or (2) biased advice that

    is not in the best interests of the Special Entity.

    Final Sec. 23.440 benefits Special Entities by restricting swap

    dealers from providing advice that is not in the Special Entity's best

    interests. A swap dealer that markets a swap to counterparties has an

    inherent conflict of interest, but is often in the best position to

    know the risks and characteristics of a complex swap, and the

    incentives for a swap dealer to provide conflicted advice that is not

    in the best interests of the Special Entity are substantial. The

    Commission believes that Sec. 23.440 will provide important

    protections to make sure that a swap dealer's communications that are

    the most susceptible to being misleading or abusive are subject to the

    statutory ``best interests'' standard.

    Commenters were in general agreement that pay-to-play is a serious

    issue that should be addressed by the Commission. As discussed in this

    adopting release, the Commission expects that final Sec. 23.451 will

    yield several important, if unquantifiable, benefits. Overall, the rule

    is intended to address pay-to-play relationships that interfere with

    the legitimate process by which a governmental Special Entity decides

    to enter into swaps with a particular swap dealer. Such a process

    should be determined on the merits rather than on contributions to

    political officials. The potential for fraud to invade the various,

    intertwined relationships created by pay-to-play arrangements has been

    documented in notorious cases of abuse. The Commission believes that

    the prohibition will reduce the occurrence of fraudulent conduct

    resulting from pay-to-play and, as a result, will achieve its goals of

    protecting market participants and the public from the resulting harms.

    By addressing pay-to-play practices, Sec. 23.451 helps to ensure

    that governmental Special Entities consider the merits of any

    particular transaction with a swap dealer and not the size of a swap

    dealer's political contributions. These benefits, although difficult to

    quantify, could result in substantial savings to government

    institutions, public pension plans and their beneficiaries, resulting

    in better performance for taxpayers. Efficiencies are enhanced when

    government counterparties competitively award business based on price,

    performance and service and not the influence of pay-to-play, which in

    turn enables firms to compete on merit, rather than their

    [[Page 9818]]

    ability or willingness to make contributions.\984\

    ---------------------------------------------------------------------------

    \984\ In addition to Sec. 23.451, which prohibits swap dealers

    from engaging in pay-to-play practices with governmental Special

    Entities, Sec. 23.450(b)(1)(vii) similarly requires a swap dealer

    or major swap participant to have a reasonable basis to believe that

    a governmental Special Entity's representative (other than an

    employee) is subject to pay-to-play prohibitions imposed by the

    Commission, SEC or an SRO subject to the jurisdiction of the

    Commission or the SEC. The Commission believes that Sec.

    23.450(b)(1)(vii) will create substantially similar benefits to

    those described regarding Sec. 23.451. Therefore, the Commission

    believes governmental Special Entities and their beneficiaries will

    benefit from advisers that are selected based on the quality of

    their advisory services and not the size of their political

    contributions. See Section IV.C.3.d.viii. of this adopting release

    for a discussion of final Sec. 23.450(b)(1)(vii).

    ---------------------------------------------------------------------------

    Finally, the Special Entity rules protect U.S. taxpayers, the

    retirement savings of U.S. private and public employees and pensioners,

    and beneficiaries of charitable endowments (``Special Entity

    beneficiaries''). Losses to a company that assumes significant risk

    through swaps are typically limited to its investors and creditors.

    However, Special Entities that assume risk through the use of swaps

    also expose Special Entity beneficiaries to such risks. When a Special

    Entity suffers losses in connection with a swap, the Special Entity

    beneficiaries ultimately bear such losses. Certain swaps can create

    significant risk exposure that may result in substantial losses. And in

    the wake of the 2008 financial crisis, significant or even catastrophic

    losses have been proven not to be merely theoretical. In the case of

    Special Entities, such losses could result in taxpayer bailouts of

    public institutions or devastating losses to vulnerable members of the

    public including pensioners and beneficiaries of charitable endowments.

    Additionally, taxpayers and public employees and pensioners may benefit

    from Sec. 23.451 because they might otherwise bear the financial

    burden of bailing out a public institution or governmental pension plan

    that has ended up with a shortfall due to poor performance or excessive

    fees that might result from pay-to-play. Therefore, the Special Entity

    rules provide significant protections for Special Entity beneficiaries

    and the public at large by ensuring that Special Entities have

    independent and knowledgeable representatives, are afforded a higher

    standard of care from swap dealers that act as advisors and, in the

    case of governmental Special Entities, are not unduly influenced by

    political contributors. The Commission has considered a number of

    regulatory alternatives proposed by commenters and has revised some of

    the proposed rules in response to commenters' suggestions.\985\

    ---------------------------------------------------------------------------

    \985\ See, e.g., Section IV.B.3.b. and d. of this adopting

    release for a discussion of commenters' alternative approaches to

    Sec. 23.440 and Section IV.C.3 of this adopting release for a

    discussion of alternative approaches to Sec. 23.450.

    ---------------------------------------------------------------------------

    b. Costs

    As identified by commenters,\986\ the proposed Special Entity rules

    had the potential to impose costs including: (1) Reduced access to swap

    markets for Special Entities if swap dealers and major swap

    participants decline to act as their counterparties, (2) limited flow

    of information from swap dealers to Special Entities, (3) litigation

    risk for swap dealers and major swap participants, (4) compliance

    obligations on swap dealers and major swap participants, (5) and delays

    in swap execution.\987\ As discussed in the introduction to this

    Section IV.C. of this adopting release, such costs are difficult and

    costly to quantify and, in some cases, are not subject to reliable

    quantification. Additionally, some commenters asserted that conflicting

    federal regulatory regimes could impose costs, such as penalties for

    violating ERISA's prohibited transaction provisions.\988\ Any penalty

    for violation of another federal law in connection with a swap will

    depend on the facts and circumstances regarding the particular swap and

    the particular Special Entity; therefore, the costs of such penalties

    are not reliably quantifiable.

    ---------------------------------------------------------------------------

    \986\ The Commission requested comment on the costs and benefits

    of the proposed Special Entity rules and invited commenters to

    provide data or other information to support their views on the

    proposal's costs and benefits. The Commission received general

    comments on costs and benefits but no verifiable data. See proposing

    release, 75 FR at 80657.

    \987\ See, e.g., Section IV.C.2.g. of this adopting release for

    a summary of comments regarding transaction costs and risks related

    to the Special Entity rules.

    \988\ See Section II of this adopting release for a discussion

    of regulatory intersections with the Commission's business conduct

    standards rules.

    ---------------------------------------------------------------------------

    One commenter provided an example to quantify potential costs to

    the sponsor of a fully-funded ERISA plan that could not hedge its

    interest rate risk in the swap markets.\989\ The commenter stated that

    an ERISA plan with $15 billion in assets and liabilities ``whose

    interest rate sensitivity is somewhat higher than average,'' would be

    exposed to a 13% increase in liabilities with a 1% decrease in interest

    rates.\990\ According to the commenter, the 1% decrease in interest

    rates would result in a $1.46 billion shortfall in plan assets to

    liabilities, amortized over seven years, and the ERISA plan sponsor

    would owe approximately $248 million in annual contributions to cover

    the shortfall.\991\ The commenter's example, however, illustrates that

    the costs to a Special Entity that cannot access the swap markets will

    depend on the particular facts and circumstances of the particular

    Special Entity. Therefore, quantification of such costs to Special

    Entities as a class is not feasible.

    ---------------------------------------------------------------------------

    \989\ ABC/CIEBA Feb. 22 Letter, at 4.

    \990\ Id.

    \991\ Id.

    ---------------------------------------------------------------------------

    The heightened standard of care for swap dealers that act as

    advisors to Special Entities, which Sec. 23.440 implements, may, to a

    degree, reduce the level of information swap dealers are willing to

    share with Special Entities regarding swaps products and strategies out

    of a concern over triggering advisory status and the best interests

    duty attached to that status. Final Sec. 23.440 attempts to mitigate

    these costs by providing safe harbors that effectively exclude from the

    swap dealer's best interests duty (1) communications between swap

    dealers and ERISA plans and (2) communications to a Special Entity

    where the swap dealer does not express an opinion as to whether the

    Special Entity should enter into a recommended swap or swap trading

    strategy that is tailored to the particular needs or characteristics of

    the Special Entity.

    The safe harbor for a swap dealer dealing with any Special Entity

    in Sec. 23.440(b)(2) preserves the ability of the swap dealer to

    communicate a wide range of information about swaps, including

    communications where a swap dealer provides trading ideas for swaps or

    swap trading strategies that are tailored to the needs or

    characteristics of a Special Entity, without being subject to the best

    interests duty. Moreover, to provide additional clarity on the types of

    communications that would not cause a swap dealer to ``act as an

    advisor,'' the Commission offers in Appendix A to subpart H a non-

    exclusive list of communications not subject to the best interests duty

    as guidance for swap dealers that elect to operate within the safe

    harbor. Additionally, the types of communications and information not

    subject to the best interests duty under the safe harbor in Sec.

    23.440(b)(2) are the types information that many commenters found to be

    most valuable.\992\ The types of communications and information

    included in the scope of the safe harbor also facilitates swap dealers'

    ability to engage in normal course of business

    [[Page 9819]]

    communications, including sales, marketing and trading ideas, with

    Special Entities without being subject to the best interests duty and

    potential litigation risks attendant to such a duty.

    ---------------------------------------------------------------------------

    \992\ See Section IV.B.2.a. of this adopting release at fn. 624

    and accompanying text.

    ---------------------------------------------------------------------------

    Final Sec. 23.450 also establishes a safe harbor for a swap dealer

    or major swap participant to satisfy its duty to have a reasonable

    basis to believe that a Special Entity has a qualified independent

    representative. The safe harbor under Sec. 23.450(d)(2) harmonizes the

    independent representative requirements for ERISA plans. A swap dealer

    or major swap participant will have a reasonable basis to believe that

    an ERISA plan has a qualified independent representative whenever the

    ERISA plan represents in writing that it has an ERISA fiduciary. This

    safe harbor alleviates concerns raised by some commenters that

    compliance with the proposed rule could cause a swap dealer or major

    swap participant to become an ERISA fiduciary that would impose costs,

    including private litigation liabilities, costs associated with

    violations of ERISA's prohibited transaction rules or costs to ERISA

    plans that may be unable to find swap dealers or major swap

    participants willing to enter into swaps with them.

    With respect to all Special Entities other than ERISA plans, the

    safe harbor under Sec. 23.450(d)(1) permits a swap dealer or major

    swap participant to rely on written representations from the Special

    Entity and its representative that each, respectively, has complied in

    good faith with written policies and procedures reasonably designed to

    ensure that the representative satisfies the applicable requirements in

    Section 4s(h)(5) and Sec. 23.450. Additionally, the Commission revised

    Sec. 23.450 to address commenters' concerns regarding the proposed

    ``material business relationship'' prong of the independence test.\993\

    ---------------------------------------------------------------------------

    \993\ See Section IV.C.3.d.iv. of this adopting release for a

    discussion of the final independence standard in Sec. 23.450.

    ---------------------------------------------------------------------------

    Many commenters expressed concern that the proposed independence

    test would create costly and burdensome compliance requirements and

    that the proposed material relationship prong was duplicative of or not

    harmonized with other independence standards.\994\ The revised

    independence test mitigates commenters' concerns that the ``material

    business relationship'' was unadministrable by deleting the requirement

    to identify and disclose all compensation that a swap dealer or major

    swap participant paid to the Special Entity's representative within the

    previous 12 months.\995\ The revised standard under which a

    representative will be deemed independent replaced the ``material

    business relationship'' prong with three requirements: (1) The

    representative discloses material conflicts of interest to the Special

    Entity and complies with policies and procedures designed to manage and

    mitigate such conflicts; (2) the representative is not controlled by,

    in control of or under common control with the swap dealer or major

    swap participant; and (3) the swap dealer or major swap participant did

    not refer, recommend or introduce the representative to the Special

    Entity. Any costs that arise due to a representative disclosing,

    managing and mitigating conflicts of interest will be incremental

    because third-party advisors, generally, will be regulated entities

    such as CTAs, investment advisers or municipal advisors, and will be

    subject to similar requirements. In addition, representatives that are

    in-house employees will likely be subject to conflict of interest

    restrictions by virtue of their employment agreement.

    ---------------------------------------------------------------------------

    \994\ See Section IV.C.2.c.ii. of this adopting release for a

    summary of comments regarding the independence tests under proposed

    Sec. 23.450 at fn. 779.

    \995\ See proposing release, 75 FR at 80660.

    ---------------------------------------------------------------------------

    The safe harbor under Sec. 23.450(d) reduces litigation risk

    concerns raised by some commenters asserting that a swap dealer or

    major swap participant may be held liable to a Special Entity for

    ``approving'' an unqualified representative or may be liable to a

    representative that was found to be unqualified.\996\ Under the safe

    harbor, a swap dealer or major swap participant may rely on written

    representations that the representative is qualified thereby relieving

    the swap dealer or major swap participant of engaging in extensive due

    diligence to make its own determination.

    ---------------------------------------------------------------------------

    \996\ See, e.g., ABC/CIEBA Feb. 22 Letter, at 9-10; HOOPP Feb.

    22 Letter, at 2; ABC Aug. 29 Letter, at 7.

    ---------------------------------------------------------------------------

    Special Entities may incur additional costs to retain the services

    of a representative and to develop policies and procedures to ensure

    that the representative is qualified and independent. The Commission

    believes that any additional costs will be incremental and relatively

    minimal because, according to commenters, many Special Entities already

    employ in-house or third-party expert advisors.\997\ Furthermore, the

    independent representative rules implement the statutory requirement

    that Special Entities have qualified independent representatives.

    Therefore, Congress made the determination that the additional costs

    are justified by the benefits that such a protection provides to

    Special Entities and Special Entity beneficiaries. However, the final

    rules implement the statutory requirements in such a way as to minimize

    any additional costs associated with the concerns expressed by

    commenters.

    ---------------------------------------------------------------------------

    \997\ See, e.g., ERIC Feb. 22 Letter, at 12; VRS Feb. 22 Letter,

    at 2 and fn. 3; U. Tex. System Feb. 22 Letter, at 4.

    ---------------------------------------------------------------------------

    To mitigate and reduce any due diligence costs imposed under

    Sections 4s(h)(4) and (5), both Sec. Sec. 23.440 and 23.450 permit

    reliance on representations to satisfy such due diligence obligations.

    Furthermore, such representations may be made on a relationship basis

    to reduce or eliminate execution delays that could otherwise result

    from transaction-by-transaction compliance. Commission staff has also

    extensively consulted with the SEC and DOL staffs to ensure that the

    final rules are appropriately harmonized and so that compliance with

    the Special Entity rules will not result in violation of other federal

    laws.\998\

    ---------------------------------------------------------------------------

    \998\ See Section II of this adopting release for a discussion

    of regulatory intersections and harmonization with the SEC and DOL.

    ---------------------------------------------------------------------------

    The Commission has clarified, in response to commenters, that the

    definition of Special Entity under Sec. 23.402(c) does not include

    collective investment vehicles in which a Special Entity invests.\999\

    Some commenters asserted that adopting a look-through test for the

    Special Entity definition would create unnecessary and duplicative

    compliance costs and execution delays for collective investment

    vehicles and their investors.\1000\ This adopting release clarifies

    that the Commission will not look-through a collective investment

    vehicle to its investors to determine whether an entity is a Special

    Entity and thereby eliminates these cost concerns.

    ---------------------------------------------------------------------------

    \999\ See Section IV.A.3.e. of this adopting release for a

    discussion of the Commission's determination regarding collective

    investment vehicles and the definition of Special Entity.

    \1000\ See, e.g., AMG-SIFMA Feb. 22 Letter, at 12-13.

    ---------------------------------------------------------------------------

    The pay-to-play prohibition in Sec. 23.451 is designed to prevent

    fraud. A prohibition on fraud should not, in the Commission's judgment,

    impose significant costs. Nevertheless, the Commission is cognizant

    that its pay-to-pay prohibition will involve some compliance costs. At

    the same time, such costs are expected to be incremental and minimal

    because the Commission anticipates that many of the persons subject to

    Sec. 23.451 will already be subject to similar prohibitions imposed by

    the MSRB or

    [[Page 9820]]

    SEC.\1001\ In an effort to mitigate these costs, the Commission has

    adopted a practical, cost-effective means to comply with the rule

    without requiring a swap dealer to impose a blanket ban on all

    political contributions by its covered associates. Further, based on

    comments received, the Commission modified its proposed rule to achieve

    the goal of discouraging swap dealer participation in pay-to-play

    practices while seeking to limit the burdens imposed by the rule. In

    this regard, the Commission highlights its efforts to harmonize its

    rule with the prohibition proposed by the SEC,\1002\ the exceptions for

    certain de minimis contributions, automatic exemptions and safe

    harbors.\1003\

    ---------------------------------------------------------------------------

    \1001\ The Commission also believes that Sec. 23.450(b)(1)(vii)

    may impose similar costs, including compliance costs. See supra fn.

    984for a discussion of Sec. 23.450(b)(1)(vii)'s benefits. However,

    the Commission also believes that the cost mitigating features of

    Sec. 23.450 and the incremental nature of the requirements also

    limit any burdens or costs imposed by the rule. The costs are

    incremental because some independent representatives to governmental

    Special Entities may be SEC-registered investment advisers subject

    to SEC Advisers Act Rule 206(4)-5 on pay-to-play or registered

    municipal advisors subject to the MSRB's pay-to-play prohibitions.

    See Section II.C. of this adopting release for a discussion of

    Special Entity representatives that are also municipal advisors; see

    also supra fn. 880 and accompanying text.

    \1002\ See proposed 17 CFR 240.15Fh-6, SEC's proposed rules, 76

    FR at 42457-58.

    \1003\ See Section IV.D.3. of this adopting release for a

    discussion of the pay-to-play prohibitions under final Sec. 23.451.

    ---------------------------------------------------------------------------

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of the final Special Entity rules pursuant to the five

    considerations identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    At the core of the Special Entity rules is the protection of a

    specific class of market participants that are central to the public

    interest. Final Sec. 23.440 ensures that swap dealers that act as

    advisors to Special Entities are subject to a best interests duty.

    Conversely, where the swap dealer elects to operate within the safe

    harbor, the rule facilitates open communications with Special Entities

    to afford them the benefits of the swap dealer's access to valuable

    swap related information.

    Final Sec. 23.450 seeks to ensure that any Special Entity that

    enters into swaps with swap dealers or major swap participants has a

    sufficiently knowledgeable representative to evaluate the risks

    inherent in the transaction and to provide unbiased, independent advice

    that is in the best interests of the Special Entity. The pay-to-play

    prohibition protects market participants and the public from fraud.

    Government business allocated on the basis of political contributions

    exposes the public to several hazards, including noncompetitive pricing

    and unnecessary assumption of risk.

    The Commission believes that the Special Entity rules protect the

    public from, among other things, taxpayer bailouts and unnecessary

    losses to U.S. retirement savings and charitable endowments. To the

    extent the rules impose increased costs on swap dealers or major swap

    participants that may be passed on to Special Entities or may serve as

    an incentive for swap dealers or major swap participants to decline to

    transact with Special Entities, the Commission believes it has provided

    for reasonable and practicable means of compliance that mitigate any

    such costs.

    ii. Efficiency, Competitiveness and Financial Integrity of Futures

    Markets

    The Special Entity rules do impose costs that impact efficiency.

    However, the rules have been designed to mitigate the impact. For

    example, the rules allow for reliance on representations on a

    relationship basis to mitigate due diligence costs or transaction-by-

    transaction compliance that may delay execution. In addition, Congress

    made the determination that Special Entities need additional

    protections by enacting Section 4s(h), and the Commission has furthered

    congressional intent by mitigating the attendant costs of such

    protections without materially diminishing their benefits. Furthermore,

    the public interest is served and markets function more efficiently

    when swap dealers compete for governmental Special Entity business

    based on price and the overall utility of the swap to the Special

    Entity and not on the swap dealers' willingness to make political

    contributions.

    iii. Price Discovery

    In the event that advisory status is triggered, compliance with the

    best interests duty by the affected swap dealer may lead to execution

    delays. The cumulative effect of these delays may, to a degree,

    adversely impact liquidity resulting in higher transaction costs for

    counterparties that trade swaps. In recognition of this potential

    impact, the best interests duty is limited to certain recommendations

    of swaps that are tailored to the particular needs or characteristics

    of the Special Entity, and the swap dealer may rely on representations

    from the Special Entity to satisfy the ``reasonable efforts'' duty for

    determining whether a recommended swap or swap trading strategy is in

    the best interests of that Special Entity.

    Final rule Sec. 23.450 provides several means to mitigate the

    costs of satisfying the ``reasonable basis'' requirement. First, if the

    representative to an ERISA plan is an ERISA fiduciary, then the

    reasonable basis is established. Second, certain representations made

    by the Special Entity will be deemed to provide such a reasonable

    basis, and these representations, where appropriate, are allowable at

    the relationship level as opposed to the transaction level. Third, in

    the absence of such representations, the Commission has provided a list

    of factors as guidance for establishing this reasonable basis.\1004\

    ---------------------------------------------------------------------------

    \1004\ See Section IV.C.3.d. of this adopting release for a

    discussion of the factors used as guidance for the requirements of

    Sec. 23.450(b).

    ---------------------------------------------------------------------------

    iv. Sound Risk Management Practices

    The Special Entity rules foster sound risk management practices by

    ensuring that Special Entities have representatives and advisors that

    are capable of evaluating the risks and rewards of swap transactions

    and that they evaluate each transaction considering the best interests

    of the Special Entity. The independent representative provisions,

    coupled with the disclosure rules, provide important tools for Special

    Entities to enhance their risk management practices to avoid

    unnecessary and inappropriate risk.

    Nevertheless, execution delays, to the extent that they may result

    from the Special Entity rules, force market participants to either bear

    certain market risks or be prevented from earning the premiums

    associated with bearing those risks over the duration of the delay. The

    design of the Special Entity rules permit reliance on representations

    on a relationship basis to mitigate these delays.

    Any uncertainty over the triggers for advisory status, through an

    increase in the risk exposure of the swap dealer, may translate into

    higher fees charged to counterparties as compensation for that

    increased exposure. Guidance provided by the Commission clarifying the

    instances and communications that are exempt from this status mitigates

    this uncertainty.

    v. Other Public Interest Considerations

    The Special Entity rules promote public trust in swap markets by

    striving to ensure that Special Entities are adequately represented and

    treated

    [[Page 9821]]

    fairly. When a Special Entity incurs substantial losses due to

    inadequate advice, biased advice or unfair access such as through pay-

    to-play schemes, the public loses confidence in the markets.

    Additionally, the pay-to-play prohibition fosters public confidence in

    the integrity of the means and manner in which its elected officials

    handle government finances.

    8. Section 4.6--Exclusion for Certain Otherwise Regulated Persons From

    the Definition of the Term ``Commodity Trading Advisor''

    a. Benefits

    Final Sec. 4.6(a)(3) is an exclusion from the definition of CTA

    for swap dealers and, correspondingly, from the application of the CTA

    registration requirement, any relevant duties under part 4 of the

    Commission's Regulations and Section 4o of the CEA, the anti-fraud

    provision for CTAs. The Commission believes the exclusion furthers the

    regulatory approach that underlies the Dodd-Frank Act by facilitating

    the flow of market-related information between swap dealers and

    counterparties without undermining the robust protections provided by

    the business conduct standards provisions. The exclusion benefits both

    swap dealers and counterparties that claimed that their communications

    could be chilled, and trading stifled, if swap dealers were deemed to

    be CTAs and subject to a higher standard of care when providing

    services that are ``solely incidental'' to their business as a swap

    dealer. The exclusion clarifies the role of swap dealers and reduces

    ambiguity in the trading relationship between swap dealers and

    counterparties.

    While not readily amenable to quantification, the benefits of the

    rule are significant. The rule is designed to avoid the potential costs

    associated with a swap dealer being deemed a CTA. In addition to CTA

    registration fees for a swap dealer and its associated persons, CTAs

    are generally held to a fiduciary standard under case law,\1005\ a

    standard that was rejected by Congress for swap dealers when it adopted

    Section 4s(h).\1006\ Therefore, excluding swap dealers from the

    definition of CTA when engaging in certain swap dealing activities that

    overlap with CTA activities is consistent with congressional intent.

    ---------------------------------------------------------------------------

    \1005\ See, e.g., Savage v. CFTC, 548 F.2d 192 at 197.

    \1006\ See Section IV.B.3.c. at fn. 706 and accompanying text

    for a discussion of the legislative history of fiduciary duties for

    swap dealers; see also Sections II.D. and IV.B. of this adopting

    release for a discussion of Regulatory Intersections--Commodity

    Trading Advisor Status for Swap Dealers and Sec. 23.440--Final

    Rules for Swap Dealers and Major Swap Participants Dealing with

    Special Entities--Requirements for Swap Dealers Acting as Advisors

    to Special Entities, respectively.

    ---------------------------------------------------------------------------

    Commenters raised concerns that if a swap dealer were deemed to be

    a CTA then it would increase the potential that they also would be

    deemed an ERISA fiduciary when dealing with ERISA plans. That would

    subject the swap dealer to a principal transaction prohibition and to

    substantial penalties under ERISA. Such risks could dissuade swap

    dealers from engaging in swaps with pension plans that are subject to

    ERISA.\1007\ Similar risks could potentially adversely affect other

    counterparties that are regulated under similar state regulatory

    regimes. These counterparties could face increased costs because swap

    dealers could charge more to assume the higher duties, fewer swap

    dealers would be willing to do business with them or swap dealers would

    offer a narrower range of services.

    ---------------------------------------------------------------------------

    \1007\ See Section II.B. of this adopting release for a

    discussion of Regulatory Intersections--Department of Labor ERISA

    Fiduciary Regulations.

    ---------------------------------------------------------------------------

    The rule benefits counterparties by reducing burdens on

    communications and broadening the range of services available from swap

    dealers, as well as increasing the number of swap dealers with which a

    Special Entity may enter into swaps. While not a quantifiable benefit,

    a greater number of swap dealers should encourage competition and

    reduce prices for counterparties. Having access to a wider range of

    services will allow counterparties to more effectively hedge their

    exposure to market risks and to take advantage of investment

    opportunities using swaps.

    b. Costs

    As a result of final Sec. 4.6(a)(3) relieving a burden rather than

    imposing one, the Commission does not believe that there are any costs

    associated with the exclusion from the definition of CTA for swap

    dealers whose advice is solely incidental to its swap dealing

    activities. This is particularly true because the business conduct

    standards viewed as a whole provide important protections for

    counterparties that are not diminished by clarifying the status of swap

    dealers that make recommendations to counterparties.

    c. Section 15(a) of the CEA

    In light of the foregoing, the Commission has evaluated the costs

    and benefits of final Sec. 4.6(a)(3) pursuant to the five

    considerations identified in Section 15(a) of the CEA as follows:

    i. Protection of Market Participants and the Public

    The objective of Sec. 4.6(a)(3) is to allow a freer flow of

    information and ideas between a swap dealer and its counterparties,

    albeit subject to the disclosure and due diligence requirements of

    subpart H, among other provisions. Allowing swap dealers to provide

    limited advice necessary to design bespoke instruments will benefit

    market participants by offering them a broader range of products to

    meet their particular hedging requirements and trading objectives. The

    exclusion will reduce the potential for vexatious litigation by

    providing certainty regarding the applicable standard of care to be

    applied to these transactions.

    The exclusion is consistent with the goal of protecting market

    participants and the public when considered together with the business

    conduct standards in Section 4s(h) and subpart H of part 23. The

    exclusion does not diminish protections for market participants and the

    public in those rules, but rather furthers the intent of Congress that

    swap dealers not be held to a fiduciary standard.\1008\ Moreover, the

    exclusion for swap dealers from the CTA definition does not apply to

    all advisory activities, but only the swap dealer's advisory activities

    that are solely incidental to its business as a swap dealer. As such,

    the Commission has designed these rules to be as targeted as possible

    to achieve the intended statutory benefits, namely to enable the flow

    of accurate and timely information between swap dealers and their

    counterparties, and to continue to allow the marketplace to develop and

    provide opportunities for swap dealers and counterparties to transact.

    However, swap dealers will be CTAs if they provide advisory services

    beyond those that are solely incidental to their swap dealing

    activities, thereby preserving counterparty protections afforded by the

    rules that apply to CTAs.

    ---------------------------------------------------------------------------

    \1008\ See Section II.D. of this adopting release for a

    discussion of Regulatory Intersections--Commodity Trading Advisor

    Status for Swap Dealers.

    ---------------------------------------------------------------------------

    Accordingly, in the Commission's judgment, this rule alleviates a

    burden, which reduces rather than imposes costs, in such a way that the

    final rule will achieve the intended benefits of protecting market

    participants and the public.

    ii. Efficiency, Competitiveness and Financial Integrity of Futures

    Markets

    Because swap dealers may not be willing to perform certain

    functions, like custom tailoring a swap to meet a

    [[Page 9822]]

    counterparty's needs if such activities would cause the swap dealer to

    be deemed to be a CTA, excluding them from the CTA definition for

    certain activities could broaden the range of services that a swap

    dealer may offer a counterparty. It could also increase the number of

    swap dealers that are willing to perform such functions. While not a

    quantifiable benefit, a greater number of swap dealers and available

    products should enhance efficiency and competition and reduce prices

    for counterparties. Because the rule alleviates a burden, rather than

    imposing costs, the Commission concludes that Sec. 4.6(a)(3) will not

    impede swap market efficiency, competitiveness or financial integrity.

    iii. Price Discovery

    Relative to not applying this exclusion to swap dealers, the final

    rule encourages more swap dealers to offer a wider range of products to

    counterparties, which promotes competition and facilitates price

    discovery. Accordingly, the exclusion does not adversely affect price

    discovery and potentially enhances it.

    iv. Sound Risk Management Practices

    While not creating material incentives for swap dealers to alter

    how they manage risk, the exclusion from the CTA definition will assist

    swap dealers in reducing the level of risk associated with their

    counterparty interactions. The exclusion clarifies the duties owed to

    counterparties and reduces the potential for litigation. Because the

    standard of care for swap dealers acting as CTAs is higher than the

    standard of care when they act as counterparties in principal to

    principal transactions, disagreements could arise based on

    misunderstandings concerning the respective roles of the parties. By

    acting within the scope of the exclusion in compliance with the final

    rule, swap dealers will reduce the risk of undue reliance by

    counterparties and any resulting litigation.

    v. Other Public Interest Considerations

    The Commission has not identified any other public interest

    considerations.

    List of Subjects 17 CFR Part 4

    Advertising, Brokers, Commodity futures, Commodity pool operators,

    Commodity trading advisors, Customer protection, Reporting and

    recordkeeping requirements, Swaps.

    List of Subjects 17 CFR Part 23

    Antitrust, Commodity futures, Business conduct standards, Conflict

    of interests, Counterparties, Information, Major swap participants,

    Registration, Reporting and recordkeeping, Special Entities, Swap

    dealers, Swaps.

    For the reasons presented above, the Commission hereby amends part

    4 and part 23 (as added on January 19, 2012 (77 FR 2613), of Title 17

    of the Code of Federal Regulations as follows:

    PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS

    0

    1. The authority citation for part 4 shall be revised to read as

    follows:

    Authority: 7 U.S.C 1a, 2, 4, 6(c), 6b, 6c, 6l, 6m, 6n, 6o, 12a

    and 23, as amended by the Dodd-Frank Wall Street Reform and Consumer

    Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

    0

    2. In Sec. 4.6, add new paragraph (a)(3) to read as follows:

    Sec. 4.6 Exclusion for certain otherwise regulated persons from the

    definition of the term ``commodity trading advisor.''

    (a) * * *

    (3) A swap dealer registered with the Commission as such pursuant

    to the Act or excluded or exempt from registration under the Act or the

    Commission's regulations; Provided, however, That the commodity

    interest and swap advisory activities of the swap dealer are solely

    incidental to the conduct of its business as a swap dealer.

    * * * * *

    PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS

    Authority and Issuance

    0

    3. The authority citation for part 23 shall be revised to read as

    follows:

    Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6c, 6p, 6s, 9, 9a, 12a,

    13b, 13c, 16a, 18, 19, 21 as amended by Title VII of the Dodd-Frank

    Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,

    124 Stat. 1376 (Jul. 21, 2010).

    0

    4. Add subpart H to read as follows:

    Subpart H--Business Conduct Standards for Swap Dealers and Major Swap

    Participants Dealing With Counterparties, Including Special Entities

    Sec.

    23.400 Scope.

    23.401 Definitions.

    23.402 General provisions.

    23.403-23.409 [Reserved]

    23.410 Prohibition on fraud, manipulation and other abusive

    practices.

    23.411-23.429 [Reserved]

    23.430 Verification of counterparty eligibility.

    23.431 Disclosures of material information.

    23.432 Clearing disclosures.

    23.433 Communications--fair dealing.

    23.434 Recommendations to counterparties--institutional suitability.

    23.435-23.439 [Reserved]

    23.440 Requirements for swap dealers acting as advisors to Special

    Entities.

    23.441-23.449 [Reserved]

    23.450 Requirements for swap dealers and major swap participants

    acting as counterparties to Special Entities.

    23.451 Political contributions by certain swap dealers.

    Appendix A--Guidance on the application of Sec. Sec. 23.434 and

    23.440 for swap dealers that make recommendations to counterparties

    or Special Entities

    Subpart H--Business Conduct Standards for Swap Dealers and Major

    Swap Participants Dealing With Counterparties, Including Special

    Entities

    Sec. 23.400 Scope.

    The sections of this subpart shall apply to swap dealers and,

    unless otherwise indicated, major swap participants. These rules are

    not intended to limit or restrict the applicability of other provisions

    of the Act and rules and regulations thereunder, or other applicable

    laws, rules and regulations. The provisions of this subpart shall apply

    in connection with transactions in swaps as well as in connection with

    swaps that are offered but not entered into.

    Sec. 23.401 Definitions.

    (a) Counterparty. The term ``counterparty,'' as appropriate in this

    subpart, includes any person who is a prospective counterparty to a

    swap.

    (b) Major swap participant. The term ``major swap participant''

    means any person defined in Section 1a(33) of the Act and Sec. 1.3 of

    this chapter and, as appropriate in this subpart, any person acting for

    or on behalf of a major swap participant, including an associated

    person defined in Section 1a(4) of the Act.

    (c) Special Entity. The term ``Special Entity'' means:

    (1) A Federal agency;

    (2) A State, State agency, city, county, municipality, other

    political subdivision of a State, or any instrumentality, department,

    or a corporation of or established by a State or political subdivision

    of a State;

    (3) Any employee benefit plan subject to Title I of the Employee

    Retirement Income Security Act of 1974 (29 U.S.C. 1002);

    (4) Any governmental plan, as defined in Section 3 of the Employee

    Retirement

    [[Page 9823]]

    Income Security Act of 1974 (29 U.S.C. 1002);

    (5) Any endowment, including an endowment that is an organization

    described in Section 501(c)(3) of the Internal Revenue Code of 1986 (26

    U.S.C. 501(c)(3)); or

    (6) Any employee benefit plan defined in Section 3 of the Employee

    Retirement Income Security Act of 1974 (29 U.S.C. 1002), not otherwise

    defined as a Special Entity, that elects to be a Special Entity by

    notifying a swap dealer or major swap participant of its election prior

    to entering into a swap with the particular swap dealer or major swap

    participant.

    (d) Swap dealer. The term ``swap dealer'' means any person defined

    in Section 1a(49) of the Act and Sec. 1.3 of this chapter and, as

    appropriate in this subpart, any person acting for or on behalf of a

    swap dealer, including an associated person defined in Section 1a(4) of

    the Act.

    Sec. 23.402 General provisions.

    (a) Policies and procedures to ensure compliance and prevent

    evasion.

    (1) Swap dealers and major swap participants shall have written

    policies and procedures reasonably designed to:

    (i) Ensure compliance with the requirements of this subpart; and

    (ii) Prevent a swap dealer or major swap participant from evading

    or participating in or facilitating an evasion of any provision of the

    Act or any regulation promulgated thereunder.

    (2) Swap dealers and major swap participants shall implement and

    monitor compliance with such policies and procedures as part of their

    supervision and risk management requirements specified in subpart J of

    this part.

    (b) Know your counterparty. 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 prior to the execution of the

    transaction that are necessary for conducting business with such

    counterparty. For purposes of this section, 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.

    (c) True name and owner. Each swap dealer or major swap participant

    shall obtain and retain a record which shall show the true name and

    address of each counterparty whose identity is known to the swap dealer

    or major swap participant prior to the execution of the transaction,

    the principal occupation or business of such 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.

    (d) Reasonable reliance on representations. A swap dealer or major

    swap participant may rely on the written representations of a

    counterparty to satisfy its due diligence requirements under this

    subpart, unless it has information that would cause a reasonable person

    to question the accuracy of the representation. If agreed to by the

    counterparties, such representations may be contained in counterparty

    relationship documentation and may satisfy the relevant requirements of

    this subpart for subsequent swaps offered to or entered into with a

    counterparty, provided however, that such counterparty undertakes to

    timely update any material changes to the representations.

    (e) Manner of disclosure. A swap dealer or major swap participant

    may provide the information required by this subpart by any reliable

    means agreed to in writing by the counterparty; provided however, for

    transactions initiated on a designated contract market or swap

    execution facility, written agreement by the counterparty regarding the

    reliable means of disclosure is not required.

    (f) Disclosures in a standard format. If agreed to by a

    counterparty, the disclosure of material information that is applicable

    to multiple swaps between a swap dealer or major swap participant and a

    counterparty may be made in counterparty relationship documentation or

    other written agreement between the counterparties.

    (g) Record retention. Swap dealers and major swap participants

    shall create a record of their compliance with the requirements of this

    subpart and shall retain records in accordance with subpart F of this

    part and Sec. 1.31 of this chapter and make them available to

    applicable prudential regulators upon request.

    Sec. Sec. 23.403-23.409 [Reserved]

    Sec. 23.410 Prohibition on fraud, manipulation, and other abusive

    practices.

    (a) It shall be unlawful for a swap dealer or major swap

    participant--

    (1) To employ any device, scheme, or artifice to defraud any

    Special Entity or prospective customer who is a Special Entity;

    (2) To engage in any transaction, practice, or course of business

    that operates as a fraud or deceit on any Special Entity or prospective

    customer who is a Special Entity; or

    (3) To engage in any act, practice, or course of business that is

    fraudulent, deceptive, or manipulative.

    (b) Affirmative defense. It shall be an affirmative defense to an

    alleged violation of paragraph (a)(2) or (3) of this section for

    failure to comply with any requirement in this subpart if a swap dealer

    or major swap participant establishes that the swap dealer or major

    swap participant:

    (1) Did not act intentionally or recklessly in connection with such

    alleged violation; and

    (2) Complied in good faith with written policies and procedures

    reasonably designed to meet the particular requirement that is the

    basis for the alleged violation.

    (c) Confidential treatment of counterparty information. (1) It

    shall be unlawful for any swap dealer or major swap participant to:

    (i) Disclose to any other person any material confidential

    information provided by or on behalf of a counterparty to the swap

    dealer or major swap participant; or

    (ii) Use for its own purposes in any way that would tend to be

    materially adverse to the interests of a counterparty, any material

    confidential information provided by or on behalf of a counterparty to

    the swap dealer or major swap participant.

    (2) Notwithstanding paragraph (c)(1) of this section, a swap dealer

    or major swap participant may disclose or use material confidential

    information provided by or on behalf of a counterparty to the swap

    dealer or major swap participant if such disclosure or use is

    authorized in writing by the counterparty, or is necessary:

    (i) For the effective execution of any swap for or with the

    counterparty;

    (ii) To hedge or mitigate any exposure created by such swap; or

    (iii) To comply with a request of the Commission, Department of

    Justice, any self-regulatory organization designated by the Commission,

    or an applicable prudential regulator, or is otherwise required by law.

    (3) Each swap dealer or major swap participant shall implement

    written policies and procedures reasonably designed to protect material

    confidential information provided by or on behalf of a counterparty

    from disclosure and use in violation of this section by any person

    acting for or on behalf of the swap dealer or major swap participant.

    [[Page 9824]]

    Sec. Sec. 23.411-23.429 [Reserved]

    Sec. 23.430 Verification of counterparty eligibility.

    (a) Eligibility. A swap dealer or major swap participant shall

    verify that a counterparty meets the eligibility standards for an

    eligible contract participant, as defined in Section 1a(18) of the Act

    and Sec. 1.3 of this chapter, before offering to enter into or

    entering into a swap with that counterparty.

    (b) Special Entity. In verifying the eligibility of a counterparty

    pursuant to paragraph (a) of this section, a swap dealer or major swap

    participant shall also verify whether the counterparty is a Special

    Entity.

    (c) Special Entity election. In verifying the eligibility of a

    counterparty pursuant to paragraph (a) of this section, a swap dealer

    or major swap participant shall verify whether a counterparty is

    eligible to elect to be a Special Entity under Sec. 23.401(c)(6) and,

    if so, notify such counterparty of its right to make such an election.

    (d) Safe harbor. A swap dealer or major swap participant may rely

    on written representations of a counterparty to satisfy the

    requirements of this section as provided in Sec. 23.402(d). A swap

    dealer or major swap participant will have a reasonable basis to rely

    on such written representations for purposes of the requirements in

    paragraphs (a) and (b) of this section if the counterparty specifies in

    such representations the provision(s) of Section 1a(18) of the Act or

    paragraph(s) of Sec. 1.3 of this chapter that describe its status as

    an eligible contract participant and, in the case of a Special Entity,

    the paragraph(s) of the Special Entity definition in Sec. 23.401(c)

    that define its status as a Special Entity.

    (e) This section shall not apply with respect to:

    (1) A transaction that is initiated on a designated contract

    market; or

    (2) A transaction initiated on a swap execution facility, if the

    swap dealer or major swap participant does not know the identity of the

    counterparty to the transaction prior to execution.

    Sec. 23.431 Disclosures of material information.

    (a) At a reasonably sufficient time prior to entering into a swap,

    a swap dealer or major swap participant shall disclose to any

    counterparty to the swap (other than a swap dealer, major swap

    participant, security-based swap dealer, or major security-based swap

    participant) material information concerning the swap in a manner

    reasonably designed to allow the counterparty to assess:

    (1) The material risks of the particular swap, which may include

    market, credit, liquidity, foreign currency, legal, operational, and

    any other applicable risks;

    (2) The material characteristics of the particular swap, which

    shall include the material economic terms of the swap, the terms

    relating to the operation of the swap, and the rights and obligations

    of the parties during the term of the swap; and

    (3) The material incentives and conflicts of interest that the swap

    dealer or major swap participant may have in connection with a

    particular swap, which shall include:

    (i) With respect to disclosure of the price of the swap, the price

    of the swap and the mid-market mark of the swap as set forth in

    paragraph (d)(2) of this section; and

    (ii) Any compensation or other incentive from any source other than

    the counterparty that the swap dealer or major swap participant may

    receive in connection with the swap.

    (b) Scenario Analysis. Prior to entering into a swap with a

    counterparty (other than a swap dealer, major swap participant,

    security-based swap dealer, or major security-based swap participant)

    that is not made available for trading, as provided in Section 2(h)(8)

    of the Act, on a designated contract market or swap execution facility,

    a swap dealer shall:

    (1) Notify the counterparty that it can request and consult on the

    design of a scenario analysis to allow the counterparty to assess its

    potential exposure in connection with the swap;

    (2) Upon request of the counterparty, provide a scenario analysis,

    which is designed in consultation with the counterparty and done over a

    range of assumptions, including severe downside stress scenarios that

    would result in a significant loss;

    (3) Disclose all material assumptions and explain the calculation

    methodologies used to perform any requested scenario analysis; provided

    however, that the swap dealer is not required to disclose confidential,

    proprietary information about any model it may use to prepare the

    scenario analysis; and

    (4) In designing any requested scenario analysis, consider any

    relevant analyses that the swap dealer undertakes for its own risk

    management purposes, including analyses performed as part of its ``New

    Product Policy'' specified in Sec. 23.600(c)(3).

    (c) Paragraphs (a) and (b) of this section shall not apply with

    respect to a transaction that is:

    (1) Initiated on a designated contract market or a swap execution

    facility; and

    (2) One in which the swap dealer or major swap participant does not

    know the identity of the counterparty to the transaction prior to

    execution.

    (d) Daily mark. A swap dealer or major swap participant shall:

    (1) For cleared swaps, notify a counterparty (other than a swap

    dealer, major swap participant, security-based swap dealer, or major

    security-based swap participant) of the counterparty's right to

    receive, upon request, the daily mark from the appropriate derivatives

    clearing organization.

    (2) For uncleared swaps, provide the counterparty (other than a

    swap dealer, major swap participant, security-based swap dealer, or

    major security-based swap participant) with a daily mark, which shall

    be the mid-market mark of the swap. The mid-market mark of the swap

    shall not include amounts for profit, credit reserve, hedging, funding,

    liquidity, or any other costs or adjustments. The daily mark shall be

    provided to the counterparty during the term of the swap as of the

    close of business or such other time as the parties agree in writing.

    (3) For uncleared swaps, disclose to the counterparty:

    (i) The methodology and assumptions used to prepare the daily mark

    and any material changes during the term of the swap; provided however,

    that the swap dealer or major swap participant is not required to

    disclose to the counterparty confidential, proprietary information

    about any model it may use to prepare the daily mark; and

    (ii) Additional information concerning the daily mark to ensure a

    fair and balanced communication, including, as appropriate, that:

    (A) The daily mark may not necessarily be a price at which either

    the counterparty or the swap dealer or major swap participant would

    agree to replace or terminate the swap;

    (B) Depending upon the agreement of the parties, calls for margin

    may be based on considerations other than the daily mark provided to

    the counterparty; and

    (C) The daily mark may not necessarily be the value of the swap

    that is marked on the books of the swap dealer or major swap

    participant.

    Sec. 23.432 Clearing disclosures.

    (a) For swaps required to be cleared--right to select derivatives

    clearing organization. A swap dealer or major swap participant shall

    notify any counterparty (other than a swap dealer, major swap

    participant, securities-based swap dealer, or major securities-based

    [[Page 9825]]

    swap participant) with which it entered into a swap that is subject to

    mandatory clearing under Section 2(h) of the Act, that the counterparty

    has the sole right to select the derivatives clearing organization at

    which the swap will be cleared.

    (b) For swaps not required to be cleared--right to clearing. A swap

    dealer or major swap participant shall notify any counterparty (other

    than a swap dealer, major swap participant, securities-based swap

    dealer, or major securities-based swap participant) with which it

    entered into a swap that is not subject to the mandatory clearing

    requirements under Section 2(h) of the Act that the counterparty:

    (1) May elect to require clearing of the swap; and

    (2) Shall have the sole right to select the derivatives clearing

    organization at which the swap will be cleared.

    Sec. 23.433 Communications--fair dealing.

    With respect to any communication between a swap dealer or major

    swap participant and any counterparty, the swap dealer or major swap

    participant shall communicate in a fair and balanced manner based on

    principles of fair dealing and good faith.

    Sec. 23.434 Recommendations to counterparties--institutional

    suitability.

    (a) A swap dealer that recommends a swap or trading strategy

    involving a swap to a counterparty, other than a swap dealer, major

    swap participant, security-based swap dealer, or major security-based

    swap participant, must:

    (1) Undertake reasonable diligence to understand the potential

    risks and rewards associated with the recommended swap or trading

    strategy involving a swap; and

    (2) Have a reasonable basis to believe that the recommended swap or

    trading strategy involving a swap is suitable for the counterparty. To

    establish a reasonable basis for a recommendation, a swap dealer must

    have or obtain information about the counterparty, including the

    counterparty's investment profile, trading objectives, and ability to

    absorb potential losses associated with the recommended swap or trading

    strategy involving a swap.

    (b) Safe Harbor. A swap dealer may fulfill its obligations under

    paragraph (a)(2) of this section with respect to a particular

    counterparty if:

    (1) The swap dealer reasonably determines that the counterparty, or

    an agent to which the counterparty has delegated decision-making

    authority, is capable of independently evaluating investment risks with

    regard to the relevant swap or trading strategy involving a swap;

    (2) The counterparty or its agent represents in writing that it is

    exercising independent judgment in evaluating the recommendations of

    the swap dealer with regard to the relevant swap or trading strategy

    involving a swap;

    (3) The swap dealer discloses in writing that it is acting in its

    capacity as a counterparty and is not undertaking to assess the

    suitability of the swap or trading strategy involving a swap for the

    counterparty; and

    (4) In the case of a counterparty that is a Special Entity, the

    swap dealer complies with Sec. 23.440 where the recommendation would

    cause the swap dealer to act as an advisor to a Special Entity within

    the meaning of Sec. 23.440(a).

    (c) A swap dealer will satisfy the requirements of paragraph (b)(1)

    of this section if it receives written representations, as provided in

    Sec. 23.402(d), that:

    (1) In the case of a counterparty that is not a Special Entity, the

    counterparty has complied in good faith with written policies and

    procedures that are reasonably designed to ensure that the persons

    responsible for evaluating the recommendation and making trading

    decisions on behalf of the counterparty are capable of doing so; or

    (2) In the case of a counterparty that is a Special Entity, satisfy

    the terms of the safe harbor in Sec. 23.450(d).

    Sec. Sec. 23.435-23.439 [Reserved]

    Sec. 23.440 Requirements for swap dealers acting as advisors to

    Special Entities.

    (a) Acts as an advisor to a Special Entity. For purposes of this

    section, a swap dealer ``acts as an advisor to a Special Entity'' when

    the swap dealer recommends a swap or trading strategy involving a swap

    that is tailored to the particular needs or characteristics of the

    Special Entity.

    (b) Safe harbors. A swap dealer will not ``act as an advisor to a

    Special Entity'' within the meaning of paragraph (a) of this section

    if:

    (1) With respect to a Special Entity that is an employee benefit

    plan as defined in Sec. 23.401(c)(3):

    (i) The Special Entity represents in writing that it has a

    fiduciary as defined in Section 3 of the Employee Retirement Income

    Security Act of 1974 (29 U.S.C. 1002) that is responsible for

    representing the Special Entity in connection with the swap

    transaction;

    (ii) The fiduciary represents in writing that it will not rely on

    recommendations provided by the swap dealer; and

    (iii) The Special Entity represents in writing:

    (A) That it will comply in good faith with written policies and

    procedures reasonably designed to ensure that any recommendation the

    Special Entity receives from the swap dealer materially affecting a

    swap transaction is evaluated by a fiduciary before the transaction

    occurs; or

    (B) That any recommendation the Special Entity receives from the

    swap dealer materially affecting a swap transaction will be evaluated

    by a fiduciary before that transaction occurs; or

    (2) With respect to any Special Entity:

    (i) The swap dealer 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 particular needs or

    characteristics of the Special Entity;

    (ii) The Special Entity represents in writing that:

    (A) The Special Entity will not rely on recommendations provided by

    the swap dealer; and

    (B) The Special Entity will rely on advice from a qualified

    independent representative within the meaning of Sec. 23.450; and

    (iii) The swap dealer discloses to the Special Entity that it is

    not undertaking to act in the best interests of the Special Entity as

    otherwise required by this section.

    (c) A swap dealer that acts as an advisor to a Special Entity shall

    comply with the following requirements:

    (1) Duty. Any swap dealer that acts as an advisor to a Special

    Entity shall have a duty to make a reasonable determination that any

    swap or trading strategy involving a swap recommended by the swap

    dealer is in the best interests of the Special Entity.

    (2) Reasonable efforts. Any swap dealer that acts as an advisor to

    a Special Entity shall make reasonable efforts to obtain such

    information as is necessary to make a reasonable determination that any

    swap or trading strategy involving a swap recommended by the swap

    dealer is in the best interests of the Special Entity, including

    information relating to:

    (i) The financial status of the Special Entity, as well as the

    Special Entity's future funding needs;

    (ii) The tax status of the Special Entity;

    (iii) The hedging, investment, financing, or other objectives of

    the Special Entity;

    (iv) The experience of the Special Entity with respect to entering

    into swaps, generally, and swaps of the type and complexity being

    recommended;

    (v) Whether the Special Entity has the financial capability to

    withstand

    [[Page 9826]]

    changes in market conditions during the term of the swap; and

    (vi) Such other information as is relevant to the particular facts

    and circumstances of the Special Entity, market conditions, and the

    type of swap or trading strategy involving a swap being recommended.

    (d) Reasonable reliance on representations of the Special Entity.

    As provided in Sec. 23.402(d), the swap dealer may rely on written

    representations of the Special Entity to satisfy its requirement in

    paragraph (c)(2) of this section to make ``reasonable efforts'' to

    obtain necessary information.

    Sec. Sec. 23.441-23.449 [Reserved]

    Sec. 23.450 Requirements for swap dealers and major swap participants

    acting as counterparties to Special Entities.

    (a) Definitions. For purposes of this section:

    (1) The term ``principal relationship'' means where a swap dealer

    or major swap participant is a principal of the representative of a

    Special Entity or the representative of a Special Entity is a principal

    of the swap dealer or major swap participant. The term ``principal''

    means any person listed in Sec. 3.1(a)(1) through(3) of this chapter.

    (2) The term ``statutory disqualification'' means grounds for

    refusal to register or to revoke, condition, or restrict the

    registration of any registrant or applicant for registration as set

    forth in Sections 8a(2) and 8a(3) of the Act.

    (b)(1) Any swap dealer or major swap participant that offers to

    enter or enters into a swap with a Special Entity, other than a Special

    Entity defined in Sec. 23.401(c)(3), shall have a reasonable basis to

    believe that the Special Entity has a representative that:

    (i) Has sufficient knowledge to evaluate the transaction and risks;

    (ii) Is not subject to a statutory disqualification;

    (iii) Is independent of the swap dealer or major swap participant;

    (iv) Undertakes a duty to act in the best interests of the Special

    Entity it represents;

    (v) Makes appropriate and timely disclosures to the Special Entity;

    (vi) Evaluates, consistent with any guidelines provided by the

    Special Entity, fair pricing and the appropriateness of the swap; and

    (vii) In the case of a Special Entity as defined in Sec.

    23.401(c)(2) or (4), is subject to restrictions on certain political

    contributions imposed by the Commission, the Securities and Exchange

    Commission, or a self-regulatory organization subject to the

    jurisdiction of the Commission or the Securities and Exchange

    Commission; provided however, that this paragraph (b)(1)(vii) of this

    section shall not apply if the representative is an employee of the

    Special Entity.

    (2) Any swap dealer or major swap participant that offers to enter

    or enters into a swap with a Special Entity as defined in Sec.

    23.401(c)(3) shall have a reasonable basis to believe that the Special

    Entity has a representative that is a fiduciary as defined in Section 3

    of the Employee Retirement Income Security Act of 1974 (29 U.S.C.

    1002).

    (c) Independent. For purposes of paragraph (b)(1)(iii) of this

    section, a representative of a Special Entity will be deemed to be

    independent of the swap dealer or major swap participant if:

    (1) The representative is not and, within one year of representing

    the Special Entity in connection with the swap, was not an associated

    person of the swap dealer or major swap participant within the meaning

    of Section 1a(4) of the Act;

    (2) There is no principal relationship between the representative

    of the Special Entity and the swap dealer or major swap participant;

    (3) The representative:

    (i) Provides timely and effective disclosures to the Special Entity

    of all material conflicts of interest that could reasonably affect the

    judgment or decision making of the representative with respect to its

    obligations to the Special Entity; and

    (ii) Complies with policies and procedures reasonably designed to

    manage and mitigate such material conflicts of interest;

    (4) The representative is not directly or indirectly, through one

    or more persons, controlled by, in control of, or under common control

    with the swap dealer or major swap participant; and

    (5) The swap dealer or major swap participant did not refer,

    recommend, or introduce the representative to the Special Entity within

    one year of the representative's representation of the Special Entity

    in connection with the swap.

    (d) Safe Harbor. (1) A swap dealer or major swap participant shall

    be deemed to have a reasonable basis to believe that the Special

    Entity, other than a Special Entity defined in Sec. 23.401(c)(3), has

    a representative that satisfies the applicable requirements of

    paragraph (b)(1) of this section, provided that:

    (i) The Special Entity represents in writing to the swap dealer or

    major swap participant that it has complied in good faith with written

    policies and procedures reasonably designed to ensure that it has

    selected a representative that satisfies the applicable requirements of

    paragraph (b) of this section, and that such policies and procedures

    provide for ongoing monitoring of the performance of such

    representative consistent with the requirements of paragraph (b) of

    this section; and

    (ii) The representative represents in writing to the Special Entity

    and swap dealer or major swap participant that the representative:

    (A) Has policies and procedures reasonably designed to ensure that

    it satisfies the applicable requirements of paragraph (b) of this

    section;

    (B) Meets the independence test in paragraph (c) of this section;

    and

    (C) Is legally obligated to comply with the applicable requirements

    of paragraph (b) of this section by agreement, condition of employment,

    law, rule, regulation, or other enforceable duty.

    (2) A swap dealer or major swap participant shall be deemed to have

    a reasonable basis to believe that a Special Entity defined in Sec.

    23.401(c)(3) has a representative that satisfies the applicable

    requirements in paragraph (b)(2) of this section, provided that the

    Special Entity provides in writing to the swap dealer or major swap

    participant the representative's name and contact information, and

    represents in writing that the representative is a fiduciary as defined

    in Section 3 of the Employee Retirement Income Security Act of 1974 (29

    U.S.C. 1002).

    (e) Reasonable reliance on representations of the Special Entity. A

    swap dealer or major swap participant may rely on written

    representations of a Special Entity and, as applicable under this

    section, the Special Entity's representative to satisfy any requirement

    of this section as provided in Sec. 23.402(d).

    (f) Chief compliance officer review. If a swap dealer or major swap

    participant initially determines that it does not have a reasonable

    basis to believe that the representative of a Special Entity meets the

    criteria established in this section, the swap dealer or major swap

    participant shall make a written record of the basis for such

    determination and submit such determination to its chief compliance

    officer for review to ensure that the swap dealer or major swap

    participant has a substantial, unbiased basis for the determination.

    (g) Before the initiation of a swap, a swap dealer or major swap

    participant shall disclose to the Special Entity in writing:

    (1) The capacity in which it is acting in connection with the swap;

    and

    [[Page 9827]]

    (2) If the swap dealer or major swap participant engages in

    business with the Special Entity in more than one capacity, the swap

    dealer or major swap participant shall disclose the material

    differences between such capacities.

    (h) This section shall not apply with respect to a transaction that

    is:

    (1) Initiated on a designated contract market or swap execution

    facility; and

    (2) One in which the swap dealer or major swap participant does not

    know the identity of the counterparty to the transaction prior to

    execution.

    Sec. 23.451 Political contributions by certain swap dealers.

    (a) Definitions. For the purposes of this section:

    (1) The term ``contribution'' means any gift, subscription, loan,

    advance, or deposit of money or anything of value made:

    (i) For the purpose of influencing any election for federal, state,

    or local office;

    (ii) For payment of debt incurred in connection with any such

    election; or

    (iii) For transition or inaugural expenses incurred by the

    successful candidate for federal, state, or local office.

    (2) The term ``covered associate'' means:

    (i) Any general partner, managing member, or executive officer, or

    other person with a similar status or function;

    (ii) Any employee who solicits a governmental Special Entity for

    the swap dealer and any person who supervises, directly or indirectly,

    such employee; and

    (iii) Any political action committee controlled by the swap dealer

    or by any person described in paragraphs (a)(2)(i) and (a)(2)(ii) of

    this section.

    (3) The term ``governmental Special Entity'' means any Special

    Entity defined in Sec. 23.401(c)(2) or (4).

    (4) The term ``official'' of a governmental Special Entity means

    any person (including any election committee for such person) who was,

    at the time of the contribution, an incumbent, candidate, or successful

    candidate for elective office of a governmental Special Entity, if the

    office:

    (i) Is directly or indirectly responsible for, or can influence the

    outcome of, the selection of a swap dealer by a governmental Special

    Entity; or

    (ii) Has authority to appoint any person who is directly or

    indirectly responsible for, or can influence the outcome of, the

    selection of a swap dealer by a governmental Special Entity.

    (5) The term ``payment'' means any gift, subscription, loan,

    advance, or deposit of money or anything of value.

    (6) The term ``regulated person'' means:

    (i) A person that is subject to restrictions on certain political

    contributions imposed by the Commission, the Securities and Exchange

    Commission, or a self-regulatory agency subject to the jurisdiction of

    the Commission or the Securities and Exchange Commission;

    (ii) A general partner, managing member, or executive officer of

    such person, or other individual with a similar status or function; or

    (iii) An employee of such person who solicits a governmental

    Special Entity for the swap dealer and any person who supervises,

    directly or indirectly, such employee.

    (7) The term ``solicit'' means a direct or indirect communication

    by any person with a governmental Special Entity for the purpose of

    obtaining or retaining an engagement related to a swap.

    (b) Prohibitions and exceptions. (1) As a means reasonably designed

    to prevent fraud, no swap dealer shall offer to enter into or enter

    into a swap or a trading strategy involving a swap with a governmental

    Special Entity within two years after any contribution to an official

    of such governmental Special Entity was made by the swap dealer or by

    any covered associate of the swap dealer; provided however, that:

    (2) This prohibition does not apply:

    (i) If the only contributions made by the swap dealer to an

    official of such governmental Special Entity were made by a covered

    associate:

    (A) To officials for whom the covered associate was entitled to

    vote at the time of the contributions, provided that the contributions

    in the aggregate do not exceed $350 to any one official per election;

    or

    (B) To officials for whom the covered associate was not entitled to

    vote at the time of the contributions, provided that the contributions

    in the aggregate do not exceed $150 to any one official per election;

    (ii) To a swap dealer as a result of a contribution made by a

    natural person more than six months prior to becoming a covered

    associate of the swap dealer, provided that this exclusion shall not

    apply if the natural person, after becoming a covered associate,

    solicits the governmental Special Entity on behalf of the swap dealer

    to offer to enter into or to enter into a swap or trading strategy

    involving a swap; or

    (iii) To a swap that is:

    (A) Initiated on a designated contract market or swap execution

    facility; and

    (B) One in which the swap dealer does not know the identity of the

    counterparty to the transaction prior to execution.

    (3) No swap dealer or any covered associate of the swap dealer

    shall:

    (i) Provide or agree to provide, directly or indirectly, payment to

    any person to solicit a governmental Special Entity to offer to enter

    into, or to enter into, a swap with that swap dealer unless such person

    is a regulated person; or

    (ii) Coordinate, or solicit any person or political action

    committee to make, any:

    (A) Contribution to an official of a governmental Special Entity

    with which the swap dealer is offering to enter into, or has entered

    into, a swap; or

    (B) Payment to a political party of a state or locality with which

    the swap dealer is offering to enter into or has entered into a swap or

    a trading strategy involving a swap.

    (c) Circumvention of rule. No swap dealer shall, directly or

    indirectly, through or by any other person or means, do any act that

    would result in a violation of paragraph (b) of this section.

    (d) Requests for exemption. The Commission, upon application, may

    conditionally or unconditionally exempt a swap dealer from the

    prohibition under paragraph (b) of this section. In determining whether

    to grant an exemption, the Commission will consider, among other

    factors:

    (1) Whether the exemption is necessary or appropriate in the public

    interest and consistent with the protection of investors and the

    purposes of the Act;

    (2) Whether the swap dealer:

    (i) Before the contribution resulting in the prohibition was made,

    implemented policies and procedures reasonably designed to prevent

    violations of this section;

    (ii) Prior to or at the time the contribution which resulted in

    such prohibition was made, had no actual knowledge of the contribution;

    and

    (iii) After learning of the contribution:

    (A) Has taken all available steps to cause the contributor involved

    in making the contribution which resulted in such prohibition to obtain

    a return of the contribution; and

    (B) Has taken such other remedial or preventive measures as may be

    appropriate under the circumstances;

    (3) Whether, at the time of the contribution, the contributor was a

    covered associate or otherwise an employee of the swap dealer, or was

    seeking such employment;

    (4) The timing and amount of the contribution which resulted in the

    prohibition;

    [[Page 9828]]

    (5) The nature of the election (e.g., federal, state or local); and

    (6) The contributor's apparent intent or motive in making the

    contribution that resulted in the prohibition, as evidenced by the

    facts and circumstances surrounding the contribution.

    (e) Prohibitions inapplicable. (1) The prohibitions under paragraph

    (b) of this section shall not apply to a contribution made by a covered

    associate of the swap dealer if:

    (i) The swap dealer discovered the contribution within 120 calendar

    days of the date of such contribution;

    (ii) The contribution did not exceed the amounts permitted by

    paragraphs (b)(2)(i)(A) or (B) of this section; and

    (iii) The covered associate obtained a return of the contribution

    within 60 calendar days of the date of discovery of the contribution by

    the swap dealer.

    (2) A swap dealer may not rely on paragraph (e)(1) of this section

    more than twice in any 12-month period.

    (3) A swap dealer may not rely on paragraph (e)(1) of this section

    more than once for any covered associate, regardless of the time

    between contributions.

    Appendix A--Guidance on the Application of Sec. Sec. 23.434 and 23.440

    for Swap Dealers That Make Recommendations to Counterparties or Special

    Entities

    The following provides guidance on the application of Sec. Sec.

    23.434 and 23.440 to swap dealers that make recommendations to

    counterparties or Special Entities.

    Section 23.434--Recommendations to Counterparties--Institutional

    Suitability

    A swap dealer that recommends a swap or trading strategy

    involving a swap to a counterparty, other than a swap dealer, major

    swap participant, security-based swap dealer or major security-based

    swap participant, must undertake reasonable diligence to understand

    the potential risks and rewards associated with the recommended swap

    or trading strategy involving a swap--general suitability (Sec.

    23.434(a)(1))--and have a reasonable basis to believe that the

    recommended swap or trading strategy involving a swap is suitable

    for the counterparty--specific suitability (Sec. 23.434(a)(2)). To

    satisfy the general suitability obligation, a swap dealer must

    undertake reasonable diligence that will vary depending on, among

    other things, the complexity of and risks associated with the swap

    or swap trading strategy and the swap dealer's familiarity with the

    swap or swap trading strategy. At a minimum, a swap dealer's

    reasonable diligence must provide it with an understanding of the

    potential risks and rewards associated with the recommended swap or

    swap trading strategy.

    Recommendation. Whether a communication between a swap dealer

    and a counterparty is a recommendation will turn on the facts and

    circumstances of the particular situation. There are, however,

    certain factors the Commission will consider in reaching such a

    determination. The facts and circumstances determination of whether

    a communication is a ``recommendation'' requires an analysis of the

    content, context, and presentation of the particular communication

    or set of communications. The determination of whether a

    ``recommendation'' has been made, moreover, is an objective rather

    than a subjective inquiry. An important factor in this regard is

    whether, given its content, context, and manner of presentation, a

    particular communication from a swap dealer to a counterparty

    reasonably would be viewed as a ``call to action,'' or suggestion

    that the counterparty enter into a swap. An analysis of the content,

    context, and manner of presentation of a communication requires

    examination of the underlying substantive information transmitted to

    the counterparty and consideration of any other facts and

    circumstances, such as any accompanying explanatory message from the

    swap dealer. Additionally, the more individually tailored the

    communication to a specific counterparty or a targeted group of

    counterparties about a swap, group of swaps or trading strategy

    involving the use of a swap, the greater the likelihood that the

    communication may be viewed as a ``recommendation.''

    Safe harbor. A swap dealer may satisfy the safe harbor

    requirements of Sec. 23.434(b) to fulfill its counterparty-specific

    suitability duty under Sec. 23.434(a)(2) if: (1) The swap dealer

    reasonably determines that the counterparty, or an agent to which

    the counterparty has delegated decision-making authority, is capable

    of independently evaluating investment risks with regard to the

    relevant swap or trading strategy involving a swap; (2) the

    counterparty or its agent represents in writing that it is

    exercising independent judgment in evaluating the recommendations of

    the swap dealer; (3) the swap dealer discloses in writing that it is

    acting in its capacity as a counterparty and is not undertaking to

    assess the suitability of the recommendation; and (4) in the case of

    a counterparty that is a Special Entity, the swap dealer complies

    with Sec. 23.440 where the recommendation would cause the swap

    dealer to act as an advisor to a Special Entity within the meaning

    of Sec. 23.440(a).

    To reasonably determine that the counterparty, or an agent to

    which the counterparty has delegated decision-making authority, is

    capable of independently evaluating investment risks of a

    recommendation, the swap dealer can rely on the written

    representations of the counterparty, as provided in Sec. 23.434(c).

    Section 23.434(c)(1) provides that a swap dealer will satisfy Sec.

    23.434(b)(1)'s requirement with respect to a counterparty other than

    a Special Entity if it receives representations that the

    counterparty has complied in good faith with the counterparty's

    policies and procedures that are reasonably designed to ensure that

    the persons responsible for evaluating the recommendation and making

    trading decisions on behalf of the counterparty are capable of doing

    so. Section Sec. 23.434(c)(2) provides that a swap dealer will

    satisfy Sec. 23.434(b)(1)'s requirement with respect to a Special

    Entity if it receives representations that satisfy the terms of

    Sec. 23.450(d) regarding a Special Entity's qualified independent

    representative.

    Prong (4) of the safe harbor clarifies that Sec. 23.434's

    application is broader than Sec. 23.440--Requirements for Swap

    Dealers Acting as Advisors to Special Entities. Section 23.434 is

    triggered when a swap dealer recommends any swap or trading strategy

    that involves a swap to any counterparty. However, Sec. 23.440 is

    limited to a swap dealer's recommendations (1) to a Special Entity

    (2) of swaps that are tailored to the particular needs or

    characteristics of the Special Entity. Thus, a swap dealer that

    recommends a swap to a Special Entity that is tailored to the

    particular needs or characteristics of the Special Entity may comply

    with its suitability obligation by satisfying the safe harbor in

    Sec. 23.434(b); however, the swap dealer must also comply with

    Sec. 23.440 in such circumstances.

    Section 23.440--Requirements for Swap Dealers Acting as Advisors to

    Special Entities

    A swap dealer ``acts as an advisor to a Special Entity'' under

    Sec. 23.440 when the swap dealer recommends a swap or trading

    strategy involving a swap that is tailored to the particular needs

    or characteristics of the Special Entity. A swap dealer that ``acts

    as an advisor to a Special Entity'' has a duty to make a reasonable

    determination that a recommendation is in the ``best interests'' of

    the Special Entities and must undertake ``reasonable efforts'' to

    obtain information necessary to make such a determination.

    Whether a swap dealer ``acts as an advisor to a Special Entity''

    will depend on: (1) Whether the swap dealer has made a

    recommendation to a Special Entity; and (2) whether the

    recommendation concerns a swap or trading strategy involving a swap

    that is tailored to the particular needs or characteristics of the

    Special Entity. To determine whether a communication between a swap

    dealer and counterparty is a recommendation, the Commission will

    apply the same factors as under Sec. 23.434, the suitability rule.

    However, unlike the suitability rule, which covers recommendations

    regarding any type of swap or trading strategy involving a swap, the

    ``acts as an advisor rule'' and ``best interests'' duty will be

    triggered only if the recommendation is of a swap or trading

    strategy involving a swap that is ``tailored to the particular needs

    or characteristics of the Special Entity.''

    Whether a swap is tailored to the particular needs or

    characteristics of the Special Entity will depend on the facts and

    circumstances. Swaps with terms that are tailored or customized to a

    specific Special Entity's needs or objectives, or swaps with terms

    that are designed for a targeted group of Special Entities that

    share common characteristics, e.g., school districts, are likely to

    be viewed as tailored to the particular needs or characteristics of

    the Special Entity. Generally, however, the Commission would

    [[Page 9829]]

    not view a swap that is ``made available for trading'' on a

    designated contract market or swap execution facility, as provided

    in Section 2(h)(8) of the Act, as tailored to the particular needs

    or characteristics of the Special Entity.

    Safe harbor. Under Sec. 23.440(b)(2), when dealing with a

    Special Entity (including a Special Entity that is an employee

    benefit plan as defined in Sec. 23.401(c)(3)),\1\ a swap dealer

    will not ``act as an advisor to a Special Entity'' if: (1) The swap

    dealer does not express an opinion as to whether the Special Entity

    should enter into a recommended swap or swap trading strategy that

    is tailored to the particular needs or characteristics of the

    Special Entity; (2) the Special Entity represents in writing, in

    accordance with Sec. 23.402(d), that it will not rely on the swap

    dealer's recommendations and will rely on advice from a qualified

    independent representative within the meaning of Sec. 23.450; and

    (3) the swap dealer discloses that it is not undertaking to act in

    the best interests of the Special Entity.

    ---------------------------------------------------------------------------

    \1\ The guidance in this appendix regarding the safe harbor to

    Sec. 23.440 is limited to the safe harbor for any Special Entity

    under Sec. 23.440(b)(2). A swap dealer may separately comply with

    the safe harbor under Sec. 23.440(b)(1) for its communications to a

    Special Entity that is an employee benefit plan as defined in Sec.

    23.401(c)(3).

    ---------------------------------------------------------------------------

    A swap dealer that elects to communicate within the safe harbor

    to avoid triggering the ``best interests'' duty must appropriately

    manage its communications. To clarify the type of communications

    that they will make under the safe harbor, the Commission expects

    that swap dealers may specifically represent that they will not

    express an opinion as to whether the Special Entity should enter

    into a recommended swap or trading strategy, and that for such

    advice the Special Entity should consult its own advisor. Nothing in

    the final rule would preclude such a representation from being

    included in counterparty relationship documentation. However, such a

    representation would not act as a safe harbor under the rule where,

    contrary to the representation, the swap dealer does express an

    opinion to the Special Entity as to whether it should enter into a

    recommended swap or trading strategy.

    If a swap dealer complies with the terms of the safe harbor, the

    following types of communications would not be subject to the ``best

    interests'' duty: \2\ (1) Providing information that is general

    transaction, financial, educational, or market information; (2)

    offering a swap or trading strategy involving a swap, including

    swaps that are tailored to the needs or characteristics of a Special

    Entity; (3) providing a term sheet, including terms for swaps that

    are tailored to the needs or characteristics of a Special Entity;

    (4) responding to a request for a quote from a Special Entity; (5)

    providing trading ideas for swaps or swap trading strategies,

    including swaps that are tailored to the needs or characteristics of

    a Special Entity; and (6) providing marketing materials upon request

    or on an unsolicited basis about swaps or swap trading strategies,

    including swaps that are tailored to the needs or characteristics of

    a Special Entity. This list of communications is not exclusive and

    should not create a negative implication that other types of

    communications are subject to a ``best interests'' duty.

    ---------------------------------------------------------------------------

    \2\ Communications on the list that are not within the meaning

    of the term ``acts as an advisor to a Special Entity'' are outside

    the requirements of Sec. 23.440. By including such communications

    on the list, the Commission does not intend to suggest that they are

    ``recommendations.'' Thus, a swap dealer that does not ``act as an

    advisor to a Special Entity'' within the meaning of Sec. 23.440(a)

    is not required to comply with the safe harbor to avoid the ``best

    interests'' duty with respect to its communications.

    ---------------------------------------------------------------------------

    The safe harbor in Sec. 23.440(b)(2) allows a wide range of

    communications and interactions between swap dealers and Special

    Entities without invoking the ``best interests'' duty, including

    discussions of the advantages or disadvantages of different swaps or

    trading strategies. The Commission notes, however, that depending on

    the facts and circumstances, some of the examples on the list could

    be ``recommendations'' that would trigger a suitability obligation

    under Sec. 23.434. However, the Commission has determined that such

    activities would not, by themselves, prompt the ``best interests''

    duty in Sec. 23.440, provided that the parties comply with the

    other requirements of Sec. 23.440(b)(2). All of the swap dealer's

    communications, however, must be made in a fair and balanced manner

    based on principles of fair dealing and good faith in compliance

    with Sec. 23.433.

    Swap dealers engage in a wide variety of communications with

    counterparties in the normal course of business, including but not

    limited to the six types of communications listed above. Whether any

    particular communication will be deemed to be a ``recommendation''

    within the meaning of Sec. Sec. 23.434 or 23.440 will depend on the

    facts and circumstances of the particular communication considered

    in light of the guidance in this appendix with respect to the

    meaning of the term ``recommendation.'' Swap dealers that choose to

    manage their communications to comply with the safe harbors provided

    in Sec. Sec. 23.434 and 23.440 will be able to limit the duty they

    owe to counterparties, including Special Entities, provided that the

    parties exchange the appropriate representations.

    By the Commission, this 11th day of January 2012.

    David A. Stawick,

    Secretary.

    Appendices to the Final Rules for Implementing the Business Conduct

    Standards for Swap Dealers and Major Swap Participants With

    Counterparties--Table of Comment Letters, Statement of the Department

    of Labor, Commission Voting Summary, and Statements of Commissioners

    Note: The following appendices will not appear in the Code of

    Federal Regulations.

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    Appendix 2--Statement of the Department of Labor

    U.S. Department of Labor

    Assistant Secretary for Employee Benefits Security Administration,

    Washington, DC 20210

    JAN 17 2012

    Honorable Gary Gensler

    The Honorable Jill Sommers

    The Honorable Bart Chilton

    The Honorable Scott D. O'Malia

    The Honorable Mark Wetjen

    U.S. Commodity Futures Trading Commission

    Three Lafayette Centre

    1155 21st Street, NW

    Washington, DC 20581

    Re: Final Business Conduct Standards Rules Adopted January 11, 2012

    Dear Chairman Gensler and Commissioners Sommers, Chilton,

    O'Malia and Wetjen:

    The Department of Labor has reviewed the final draft of the

    Commodity Futures Trading Commission's (``CFTC's'') rules to

    implement Section 4s(h) of the Commodity Exchange Act pursuant to

    Section 731 of Title VII of the Dodd-Frank Wall Street Reform and

    The Consumer Protection Act of 2010. These rules prescribe external

    business conduct standards for swap dealers and major swap

    participants and will have a direct impact on ERISA-covered plans

    and plan fiduciaries. I very much appreciate the care that the CFTC

    has taken to coordinate its work on this project with the Department

    of Labor in light of the Department's regulatory and enforcement

    responsibilities with respect to ERISA fiduciaries. As we have

    worked with your staff, we have paid particular attention to the

    interaction between the original business conduct proposal and the

    Department's own fiduciary regulations and proposals.

    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 Sec. 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.

    We look forward to continuing to work with you on these

    important projects and are grateful for your staff's thoughtful

    efforts to harmonize our work.

    Sincerely,

    Phyllis C. Borzi

    Assistant Secretary, Employee Benefits Security Administration

    Appendix 3--Commission Voting Summary

    On this matter, Chairman Gensler and Commissioners Chilton,

    O'Malia and Wetjen voted in the affirmative; Commissioner Sommers

    voted in the negative.

    Appendix 4--Statement of Chairman Gensler

    I support the final rules to establish business conduct

    standards for swap dealers and major swap participants in their

    dealings with counterparties, or external business conduct. Today's

    final rules implement important new authorities in the Dodd-Frank

    Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) for

    the Commodity Futures Trading Commission to establish and enforce

    robust sales practices in the swaps markets. Dealers will have to

    tell their counterparties the mid-market mark of their outstanding

    bilateral swaps every day, bringing transparency to the markets and

    helping to level the playing field for market participants.

    The rules prohibit fraud and certain other abusive practices.

    They also implement requirements for swap dealers and major swap

    participants to deal fairly with customers, provide balanced

    communications, and disclose material risks, conflicts of interest

    and material incentives before entering into a swap.

    The rules include restrictions on certain political

    contributions from swap dealers to municipal officials, known as

    ``pay to play'' prohibitions.

    The rules also implement the Dodd-Frank heightened duties on

    swap dealers and major swap participants when they deal with certain

    entities, such as pension plans, governmental entities and

    endowments.

    The rules were carefully tailored to include safe harbors to

    ensure that special entities, such as pension plans subject to the

    Employee Retirement Income Security Act, will continue to be able to

    access these markets and hedge their risks.

    The final rules benefitted substantially from the input of

    members of the public who met with staff and Commissioners and those

    who submitted thoughtful, detailed letters. The Securities and

    Exchange Commission, prudential regulators and the Department of

    Labor also provided helpful feedback.

    [FR Doc. 2012-1244 Filed 2-16-12; 8:45 am]

    BILLING CODE 6351-01-P

    Last Updated: February 17, 2012