[Federal Register Volume 77, Number 33 (Friday, February 17, 2012)]
[Rules and Regulations]
[Pages 9733-9835]
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

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    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

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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\
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    \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.
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    \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\
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    \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\
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    \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.
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    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\
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    \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).
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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.

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[[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\
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    \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 * * *.'').

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[[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\
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    \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.
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    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\
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    \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.
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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\
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    \203\ Proposing release, 75 FR at 80642.
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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\
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    \204\ Markit Feb. 22 Letter, at 3.
    \205\ Id.
    \206\ CFA/AFR Nov. 3 Letter, at 6.
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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.
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    \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.
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    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\
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    \211\ Proposing release, 75 FR at 80642.
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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\
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    \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.
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    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\
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    \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.
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    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\
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    \222\ Id.
    \223\ Id.
    \224\ Id.
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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\
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    \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\
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    \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\
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    \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\
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    \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\
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    \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\
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    \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\
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    \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.
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    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\
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    \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.
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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\
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    \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.
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    \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.
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    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\
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    \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.
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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\
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    \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.
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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:
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    \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\
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    \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\
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    \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.''
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    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.
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    \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.
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    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.
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    \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.
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    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.
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    \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.
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    \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.
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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\
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    \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\
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    \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).
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    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\
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    \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.
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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.
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    \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\
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    \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.
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    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\
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    \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\
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    \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.
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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'').

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[[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.
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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\
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    \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\
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    \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\
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    \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\
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    \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\
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    \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.
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    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\
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    \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\
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    \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.
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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\
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    \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.
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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\
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    \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.

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[[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\
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    \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\
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    \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\
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    \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.
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    \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).
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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)).
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    \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.
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    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.
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    \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.
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    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\
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    \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.
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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\
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    \851\ Proposing release, 75 FR at 80651-52 and 80660.
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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.
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    \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.''
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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\
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    \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.
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    \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)).
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    \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\
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    \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.
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    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\
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    \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\
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    \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).
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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\
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    \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\
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    \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).
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    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\
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    \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.
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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.

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[[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.
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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\
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    \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.
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    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.
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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\
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    \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.
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    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\
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    \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.
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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.
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    \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.
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    \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.
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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\
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    \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.
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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.
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    \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).
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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.
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    \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.
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    \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\
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    \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).
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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.
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    \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.
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    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.
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    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.

BILLING CODE 6351-01-P

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BILLING CODE 6351-01-C

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